Burnham's Beat

Software Stocks: July Update

July was a flat out ugly month for software stocks thanks to a large number of pre-announcements and generally lackluster earnings guidance for the rest of the year. The average software stock was down a whopping 13.7% in July, compared to a 7.9% decline for the entire NASDAQ. However, the pain was not evenly spread around. Small Cap software stocks (stocks with market caps under $1BN) were down 12.4%, while large cap software stocks were only down 4.4% (handily outperforming the broader NASDAQ). In fact, the software index itself was only down 4.9% thanks to the relatively strong large cap performance.

In terms of my hand picked virtual software stock portfolio, the portfolio once again outperformed both the NASDAQ (down 7.9%) and the software stock index (down 4.9%), but the average stock in it was still down 1.2%. The performance is a bit better than it looks given that the portfolio had only 1 Large Cap stock (which I was short) and was still 20% net long, but it was a loss none the less. On an overall basis, the portfolio is now up 11.8% YTD vs. a 12.4% decline on the NASDAQ, so it continues to out perform the market by 20%+ despite having been strongly net long for the first 7 months of the year. Still 11.8% is down from last month's 14% net gain.

I've taken some steps this month to rebalance the portfolio towards more of a market neutral stance given that Q3 is typically weak for software stocks (although I don't know how much weaker it can get). I think I will ultimately end up net long again, but my wonderings around Silicon Valley didn't generate any compelling long ideas this month.

Details on the specific stocks in the portfolio:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: I continue to like the turn around story here and their Q2 report suggests that are making good progress at becoming solidly profitable again. It will probably take another quarter for this story to play out.
Performance: Since 1/26/04: +2%, Jun vs. Jul: -9%
Comments: Had a bad month (like most small caps), but a decent report held up the stock somewhat.

Company: Blue Martini Ticker: BLUE
Sub-sector: Vertical Solutions
Investment Thesis: A stock in transition from a middleware play to a vertical app play. I made money with a similar trade on ARTG in 2001. The stock is very cheap at 1.1X tangible book, but that's because the market doesn't have any confidence the company can successfully negotiate the transition. After looking over their Q2 earnings report, neither do I.
Performance: Since 1/26/04: -44%, Jun vs. Jul: -37%
Comments: In April I said this was the stock I had the least conviction about. At the end of June I said it was likely to come out of the portfolio and now, at the end of July, I am taking it out of the portfolio, but not after having the stock get killed with a 37% loss this month. If I day traded the portfolio I would have limited this month's losses to about 20%, but lesson learned here is that I should have pulled them out in April when I said they were at the bottom of my portfolio. I think I will do a force ranking each month from now on and kick out the stock I have the least conviction on as a matter of good management.

Company: SumTotal Ticker: SUMT
Sub-sector: E-Learning
Investment Thesis: SumTotal was formed by the merger of Docent and Click2Learn which closed in mid-March. I liked Docent before the merger because as it was relatively cheap, had good products, and was in a space still seeing good corporate spending (E-Learning). The combined companies promise to be solidly profitable after the debris from the merger clears which should help the overall valuation as they cement their leadership position in the e-learning space.
Performance: Since 1/26/04: -23%, Jun vs. Jul: -35%
Comments: Stock got killed this month, most of it before they reported a decent but not spectacular quarter. Still seems well positioned to become solidly profitably in the 2nd half of this year but it is testing my patience.

Company: SPSS Ticker: SPSSE
Sub-sector: Business Intelligence
Investment Thesis: SPSS is another player in the business intelligence space with a particular emphasis on predictive analytics, something that is particularly hot right now. The stock has been battered by a restructuring that the company went through last year as well as an accounting restatement. As the “E” at the end of the ticker suggests, SPSS is in danger of being delisted because they didn’t file their 10K on time due to the accounting problems. The stock now trades at an attractive 1.0X enterprise value to sales. My thesis is that the new product set is strong and the accounting trouble is overblown. In addition, the stock will not be delisted because SPSS is a real company with real revenues ($50M+/quarter) and NASDAQ needs every listing it can get right now.
Performance: Since 4/30/04: 4.1% Jun vs. Jul: -18%
Comments: Tough month in general, but the stock had some good news at the end of the month when finally it filed its 10K and the NASDAQ indicated that it was not going to delist the company. All eyes are now on its August report. If the report is decent, the stock should really start to move in the right direction. Still feel like this is the best value in the business intelligence space by far right now.

Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, content management company that is attractively priced. Q1 was the first quarter of positive cash flow in awhile and Q2 saw pro forma, but not GAAP positive, EPS. With $20-25M/quarter in revenues, Stellent has a lot of room to work on expenses and should be able to return the company to solid GAAP profitability at which point the stock should recover from its current 1.3X ev/sales to something much closer to 2X.
Performance: Since 6/30/04: -19% Jun vs. Jul: -19%
Comments: I was worried about adding STEL at the end of June because it had such a great month (up 25%). Predictably the stock gave up most of that ground in July, but the earnings report was good enough to limit further damage. Still like the stock, but a 20% hole is not how I wanted to start!

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Internet Payments
Investment Thesis: Every portfolio needs a flyer and this sure counts as one. Neteller is Europe/Canada’s answer to PayPal and it has been making a killing by servicing markets, particularly online gambling, that PayPal has been pressured into exiting by the US Justice Department. I know, I know, this is not a software stock, but I still follow online financial services quite closely and I feel compelled to point out this stock because it is such an attractive buy. After going public in London on 4/14, the stock is now trading at just 10.5X estimated 2004 EPS and yet is growing like an absolute weed. Neteller has got to be the best and only Internet “value” stock out there. Sure the stock trades at a steep discount due to the regulatory ambiguities of online gambling, but hey, it's worth taking a gamble on.
Performance: Since 6/30/04: 14% Apr vs. Jun: 14%
Comments: Best long performing stock of the month. Had an interim report which showed a slight slowdown in new sign-ups/day, but still added another 125K new members in Q2 plus announced some new partnerships which should drive more sign-ups. With a little exposure in the US this stock will triple.

Short Picks
Company: Autonomy Ticker: AUTN
Sub-sector: Content Management
Investment Thesis: Autonomy is a UK based purveyor of advanced enterprise search software a space I know well based on my VC investment in Stratify. The enterprise search space is crowded and getting even more competitive with the entry of folks like Google. Autonomy’s secret sauce, its categorization software, is increasingly being duplicated by it competitors. Autonomy trades at a huge premium to the market at 6.3X enterprise value to sales vs. a 1.8X average for the rest of the content management group. This premium appears to be largely an artifact of the fact that autonomy is a bit of a cult stock in its home country of the United Kingdom as well as the small float due to its meager cross listing on NASDAQ. It makes it a tough stock to short, but the valuation and market dynamics remain compelling.
Performance: Since 1/26/04: +45% Jun vs. Jul: 36%
Comments: This month's #1 gainer. A lackluster earnings report + wildly bear market = signifcant share price declines and that's just what happened to AUTN. I said I thought there was a floor at $20, looks like I was wrong. Still trades at a relatively pricey 3.8X Enterprise Value/Sales, so I will remain short during the summer doldrums which hit European companies, like AUTN, especially hard.

Company: Commerce One Ticker: CMRC
Sub-sector: Supply Chain
Investment Thesis: I know CommerceOne well as I was the analyst on their IPO in the summer of 1999. CMRC has lost over $3BN in the last 3 years and while it has reduced the size of the losses, it looks like it will be too little too late. I have watched a number of high flyers implode under the weight of the infrastructures that they built and I think CMRC will succumb to that same fate. With all the institutions long gone, it looks like a bunch of clueless retail investors are currently holding the bag unaware that it contains a ticking bomb. With $12.5M in preferred stock and another $5M in bank lines ahead of the common there’s a good chance that the common stock will get nothing if this company is even sold.
Performance: Since 1/26/04: +65% Jun vs. Jul: +18%
Comments: CMRC remains, yet again, the best performing pick in the portfolio. It would have been even better, but the stock actually traded up strongly at the end of the month despite getting a delisting notice from the NASDAQ. Q2 "earnings" report should make it clear that there is no way for the common holders.

Company: Redhat Software Ticker: RHAT
Sub-sector: Operating Systems
Investment Thesis: Redhat is the Linux poster child and has the largest independent distribution of open source Linux-OS. As the poster child for all things Open-Source, Redhat has been the recipient of tremendous investor interest and its valuation, the best in the software sector, reflects it. Investors apparently are expecting RedHat to take over the world, despite the fact that Redhat sells just one of several Linux distributions and faces competition from IBM, NOVL, and possible folks like SUNW and HP. I have heard an increasing number of people complain about RHAT’s pricing schemes and it remains an open question as to whether any Linux distributor will have any kind of pricing power.
Performance: Since 1/26/04: 25% Jun vs. Jul: 25%
Comments: RHAT announced that it had to restate its earnings due to an accounting charge and the stock promptly dropped 30%. I actually think the reaction to the announcement was way overdone as it doesn't appear to be material, but this just goes to highlight how sensitive richly valued stocks are to even the slightest bad news, which was basically the idea behind shorting it, so I feel partly vindicated by the drop. I struggled with the idea of simply covering this and moving on, but I am going to keep it in place a little bit more as it remains the most richly valued company in the space and its recent moves into the app server market may seriously piss off some of its biggest proponents and channels to date (IBM and HP).

Company: Concur Ticker: CNQR
Sub-sector: Vertical Applications
Investment Thesis: Concur is a nifty little ASP that let’s companies do time and expense management. I used Concur when I was at Mobius and it’s a very good application. The only real issue I have with Concur is valuation. Concur trades at 16X tangible book, almost 6X ev/sales, and 100X 2004e EPS. Now if Concur were on the front end of potentially world changing trend in software (like RedHat) I might not find this to be too expensive, but Concur is niche application focused on corporate expense management. It also happens to face competition from all the big ERP players who all have this capability on their “to do” list at some point in the future. Perhaps Concur is benefiting from the Salesforce.com “halo” or perhaps everyone thinks Salesforce.com will buy them (they do seem like a good fit), but at this valuation just about everything is going to have to go right for right them.
Performance: Since 1/26/04: 0% Jun vs. Jul: 0%
Comments: As I pointed out last month, CNQR is a sleepy stock and that sleepiness, plus a good Q2 report allowed the stock to remain flat during a terrible month for software stocks in general. While I still feel that Concur is way overvalued, the stock's performance this month suggests that it is a bad short as I need a short with much more beta to offset my long losses in a bad month. Given this I am going to cover this and move on.

Company: RSA Security Ticker: RSAS
Sub-sector: Security
Investment Thesis: I have always wanted to short RSAS. I covered the security sector when I was an analyst and basically came to hate the sector due to the fact that almost every company blows up once every 12-18 months and does so with no warning whatsoever. RSA used to be called Security Dynamics and its main product remains a "hard token" called Secure ID which they already have sold to just about everyone on the planet that is going to buy one. The stock's last major blow up was on it's Q3 report last year. I am thinking it's due for a repeat. Even if it doesn't, the stock tends to trade along with the boarder tech market and I need some shorts that more closely follow the market, so this will have to do.
Performance: Since 1/26/04: NA Jun vs. Jul: NA
Comments: Trades at 7X tangible book and 3X enterprise value/sales putting in the top quartile of software stock valuations.

Company: Salesforce.com Ticker: CRM
Sub-sector: Vertical Applications
Investment Thesis: Salesforce.com is a, mostly, hosted sales force management application. It's a good product, most of my start-up companies used it, but it is expensive the longer you use and the larger your company gets. CRM is 2nd most highly valued stock in the software space despite the fact that it is facing increased competition from the big boys of enterprise software and that its very hard to rapidly grow subscription-based revenues. Any mis-step and this stock will down 25% in a heartbeat.
Performance: Since 1/26/04: 0% Jun vs. Jul: 0%
Comments: I thought awhile about adding this stock to the portfolio last month and decided against it because I didn't see a near term negative catalyst. Whoops, I was wrong. At an analyst meeting they slightly adjusted their outlook (but just a penny or so) and the stock got clobbered. It's still very expensive though and it will be tough to please investors that have already been burned.

Application Management Merger Mania

The game of musical chairs in the application management space just got a bit harder today as IBM announced that it had acquired one of the leading players in the space, Cyanea. The Cyanea acquisition is just the latest deal in the space which has seen Veritas buy Precise , Mercury buy Performant , and ASF buy Dirig. Only two independent companies of note are now left in the space, Wily and Altaworks.

Houston, We Have An Application Problem
Why all the interest in application management? Because, as many companies have unpleasantly discovered, getting distributed component-based applications to work correctly is a major pain in the neck. Unlike traditional mainframe applications, distributed applications are composed of many small pieces of software. What’s more, these pieces of software are often distributed across several servers. Throw in some web services and you can have an “application” that spans multiple computers in multiple locations. This may sound cool, but when something goes wrong in such complex system even if you are a rocket scientist it’s almost impossible to figure out what code is actually “broken”.

By monitoring the inner-workings of applications, often down the method and thread level, application management programs attempt to not only figure out what, if anything is broken in a distributed application, but they also attempt to identify resource and performance problems before they end up taking an application down.

The Great Debate: Horizontal vs. Vertical
One major problem for application management software is that there are a lot of factors that can affect application performance outside of the application code itself. Even if the code is perfect, problems with other parts of the technology stack such as database resources, network performance, message brokers, etc. can still seriously affect application performance.

Given the inter-dependence of all these items, the holy grail of application management (and for that matter systems management in general) has always been to build a holistic map of all the hardware, software, and network resources associated with a particular application and to, somehow, build a management solution that can identify the actual root cause of any particular problem no matter where it lies in the stack.

Unfortunately, like most IT holy grails such as universal object libraries, consistent semantics, and stable Windows machines, the vision of a completely unified application management stack is a long way from reality.

In the interim, vendors have generally decided to focus on either horizontal or vertical management strategies. Horizontal strategies stress the importance of following a transaction “in-flight” as it flows throughout its life-cycle, no matter what platforms it may decide to travel on. To support this strategy, vendors must make their software compatible with as many application servers as possible including modern ones (such as J2EE and .NET) and legacy ones (CICS and IMS). The horizontal view is particularly important inside large companies with complex legacy systems as most of their new distributed applications must still interact regularly with legacy platforms.

Other vendors a pursuing a vertical strategy of trying to link together information from the database, network, and application layers in order to derive a view of all of the technology components that affect a particular application. This strategy is better suited to “self-contained” applications that don’t interact with legacy platforms.

The reality is that for most Global 2000 corporations, horizontal solutions are much more practical given the topographical and political realities in those organizations. Most of those companies still have lots of legacy applications and they generally have very complex IT infrastructures. This means that distributed applications not only have to play nice with other platforms, but managerial and budgetary control over IT resources is often widely dispersed throughout the organization. While it might be nice in theory to instrument all of the databases in a company with a particular application management platform, just try telling the database administrators that they are going to be forced to use the same tool as the application managers. In general, that’s just not going to happen.

Sayonara Cyanea
As it happens, Cyanea was pursuing a horizontal strategy. It had a unique “probe/repository” architecture that makes it easily extensible to multiple platforms and it was the first player in the space to support IBM’s venerable CICS and IMS mainframe “app servers”. Given this, plus IBM’s early investment and reseller relationship it’s really not surprising that IBM decided to bite the bullet and buy the rest of the company it didn’t already own.

For me personally, the acquisition wasn’t surprising because I was actually the first investor in Cyanea and had seen the IBM relationship grow in size and importance first hand. While it’s a bit bittersweet to seen one of my promising investments swallowed up by Big Blue just as it is hitting its stride, I must admit that the ample return on investment provides me with more than a little comfort.

Wither Wily?
One of the big remaining questions following the Cyanea deal is what will become of Wily. Wily was the pioneer in the space and has always been the largest player (though Cyanea was rapidly catching up to them). It’s rumored that Wily turned down a $100M buy-out offer from Mercury in early 2003 before Mercury bought Performant for $22.5M (that may just be some good underground marketing on Wily’s part though).

On the one hand, Cyanea’s sale looks like good news for Wily. Not only does it leave Wily as the only substantive independent player in the space, but it removes a competitor that was increasingly beating it in competitive bake-offs.

On the other hand, with IBM buying Cyanea and integrating it more closely into its product lines, Wily will now face all-out competition from IBM, a platform that supposedly accounts for a majority of their sales. In addition, Veritas recently signed a wide ranging partnership with BEA making Precise the recommended application management solution for WebLogic. Thus with Cyanea at IBM and Precise at BEA, Wily faces the unappetizing prospect of having to face “in-house” competition for every WebSphere and WebLogic sale. In addition, Wily’s core product architecture, which relies on code “wrapping” to instrument it, is dated and not readily extensible outside of J2EE environments.

Despite this, some have suggested an IPO is imminent, but that does not seem likely until Wily figures out a growth story beyond J2EE. Fortunately, on the M&A; front there are a few large players that have yet to make a major move in the space, most notably HP, Oracle, SAP, and Sun, so Wily may yet have an opportunity to make it to the alter on time. Whatever Wily decides to do they will have to do it quickly as they are now going from a situation of being top dog to underdog against some of the strongest software sales forces in the business, which is not an appealing prospect not matter how you look at it.

Many Miles Still To Travel
For the application management space in general, the consolidation of the independent players into the major platform players, represents a logical and necessary industry evolution. While the industry is still a ways away from the holy grail of unified management it is making steady progress. Attention will now likely shift towards integrating a few other pieces of disparate infrastructure software, such as business activity management, dependency mapping tools and cluster management tools into the overall application management framework. While each step will take the industry closer to management nirvana, new technologies and corresponding challenges will undoubtedly emerge and thus push the goal further out into the future.

7/31/04: Internet Stock Excel Spreadsheet

Download internet_universe_8204.xls

Attached is an Excel spreadsheet of Internet-focused public company stocks. I use this spreadsheet to help spot potential long/short ideas in the Internet sector. There are two other worksheets in this workbook. One sheet tracks overall industry performance, basically an index of Internet related stocks, while the second sheets tracks additions and subtractions to the universe.

In terms of recent performance, Internet stocks generally got clobbered in July with the average stock down 13.9% vs. a 7.9% decline for the boarded NASDAQ market.

I spend most of my time looking at software related investment ideas so I haven’t added a lot of extra analysis to this spreadsheet. Overall, a lot of Internet stocks still seem very overvalued to me although I do like one, Neteller, which I mentioned in the last update on my software stock portfolio.

The spreadsheet makes use of Microsoft's MSN Money automatic Stock price download toolbar within Excel to get current stock prices for each company. To update the prices you just hit a button. Right now you can only get basic market information via this service. Hopefully in the future you will be able to get some financial statement information.

DIM: Hijacking IM for Data Transport

Move over teenagers, the heaviest users of instant messaging are about to become computers themselves. In the beginning, IM communication was strictly a human-to-human affair. A few years ago companies starting sending alerts (and increasingly spam) via IM making it a computer-to-human affair. Now, with the advent of Data over Instant Messaging (DIM) technology, IM is rapidly set to become a computer-to-computer affair.

Why send data over IM? One reason is that IM infrastructures have solved a lot of tough technical problems such as firewall traversal, multi-protocol transformation, and real-time presence management. Sending messages over these networks allows applications to leverage the investments made to solve these tough problems. Another reason is that many companies already have IM “friendly” infrastructures which means that all the necessary firewall ports are open, the clients are already certified and installed, and operations infrastructure like logging, back-up, and even high-availability are already in place. Thus by using IM for computer-to-computer communication, developers are able to “hijack” all the valuable investment made in IM and use it for a purpose that its creators likely never intended.

Of course, DIM-based communications have many of the same drawbacks that human-to-human IM has. Because IM is a real-time “fire and forget” system, DIM lacks many of the hard-core transaction capabilities that most Enterprise Application Integration (EAI) solutions incorporate. Thus you wouldn’t want to rely on DIM for mission critical transactions management. In fact, a full blown EAI system with a rich work flow capability, rules-based message management and semantic mapping capabilities is more capable and reliable than DIM for just about everything.

However, a full blown EAI system will also cost you millions and take at least 6 months to get up and running. With DIM, the infrastructure is already in place, so not only is the time to deploy radically accelerated, but the overall cost of the installation is also dramatically lower. In addition, because DIM is a relatively simple, lightweight technology it is comparatively easy to integrate into applications, especially desktop applications. DIM is just one of the low-end EAI technologies I have written about in the past that threaten to give the traditional “high-end” EAI vendors a run for their money.

To see a good example of DIM in action you need to look no further Castbridge’s Data Messenger product. Castbridge just released the 2.0 Beta of their product and it is chock-full of DIM goodies. The Castbridge product essentially allows other applications to instant message each other both inside and outside the firewall. Most customers use the technology to link desktop applications together (such as linking two Excel spreadsheets over the Internet) but the platform itself can be integrated into just about any application or database out there.

Castbridge’s customers are putting the technology to use in some very innovative ways. For example, the Singapore Police Department is using Castbridge’s DIM technology as a way to quickly and easily share security information during major events (trade shows, parades, etc.). In the past, each agency had its own systems for collecting and reporting information on any activity (e.g. “Man arrested for chewing gum at entrance”) during a major event. While each agency had a representative in the overall command center, the only way to share information was by yelling across the room to a colleague. With Castbridge, each agency simply enters their data into a standard Excel spreadsheet. The Castbridge technology sends instant messages to all the other spreadsheets as soon as new data is entered effectively keeping everyone instantly up-to-date on the current security status and dramatically reducing the possibility for miscommunication. This problem is not unique. In fact, some F-16s almost shot down the Gov. of Kentucky’s plane over Washington DC recently because the FAA controllers had no easy way of notifying the Homeland Security Department and NORAD about that plane, so it sounds like the US government could use Castbridge’s solution as well.

There are a myriad of other uses for DIM-like technology for everything from keeping sales forecasts up-to-date, to keeping inventory and financial information current. On Wall Street, where spreadsheets abound and real-time communication is paramount, use cases for this technology are rampant. Syndicate desks could create real-time distributed order books, while fixed income desks could give clients “live” lists of inventory and derivative traders could ensure that their pricing models instantaneously incorporate the latest data.

The strong potential for DIM on Wall Street is probably why one of the biggest vendors of traditional IM technology to Wall Street firms, IM Logic, recently announced it’s own DIM product called IM Linkage which is designed explicitly to help Wall Street firms leverage DIM.

As DIM starts to see wider adoption it will be interesting to see how the major IM networks respond. On the one hand they probably won’t take kindly to the idea of computers “hijacking” their networks to send data around the world (hard to monetize that kind of traffic) but on the other hand they may seem DIM as a new revenue source where they can possibly take a cut of license sales in return for certifying DIM-apps on their networks.

However things evolve, you can be sure of one thing: DIM-based applications are here to stay and their impact will be felt by everyone from traditional EAI vendors to application owners, to IM networks. Let the data messaging games begin!