SoundView Technology Group

Quick Takes: OVTI CNN AFFX AAPL T VZ CRIS

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OVTI is down sharply again off a strong quarter but big cut in forward guidance. I’ve never covered or even owned OVTI. They have a strong position in a growth segment of semiconductors (cameras) and have done well in many ways as a company. But the problem with OVTI is the same problem that exists for MU (at least for the last decade or so) – margins are low, capital needs are high and their customers view the product as a commodity. We wrote about the issues we had with memory back in 2007 (Struggling with Memory) and the challenges facing a cyclical industrial player like Micron in 2010 (When will Micron buy into some growth?) OVTI seems to face the same structural issues.

CNN is firing more skilled workers like editors and photographers and leaving more work to “user generated” methods. They already seemed to be absurdly unprofessional and now the story will be complete. Pretty soon www.cnn.com will just forward to YouTube.

Long suffering Affymetrix AFFX made a pretty big acquisition. $330M for eBioscience which is said to have $70M in sales at 70% GM with a 30% EBITDA margin. Is it transformational? AFFX has been in the single digits for 3 years and now trades at $4.73. Recently even the poster child, Ilumina (ILMN) hit an air pocket. Is the $100 genome a thread or an opportunity for these companies?

AAPL looses some patent battle to Samsung. Is it a trend?

AT&T is calling off the T-Mobile acquisition. Should be good news for VZ.

CRIS is an interesting small cap biotechnology company. They seem to be making headway. The “hedgehog” pathway shows some promise in cancer treatments. Genentech is a collaborator on it. $250M market cap at $3.22.

 

 

Investment banking is not investment research

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It was odd to read the article by Andrew Ross Sorkin today in the WSJ. In it he talks about how all the major investment banks “missed the red flags” around Groupon as the company selected bankers for their planned IPO. He mentioned the balance sheet, the sales model and the fact that insiders already cashed out. Much of this was already discussed and written about when the filing came out and subsequent events made the story even more distressing.

Investment banking is purely about transactions

Mr. Sorkin is an experienced journalist and the WSJ certainly should know their way around Wall Street. What’s going on? Investment banks are hired to support a transaction. It’s true they sometimes call their services “advisory” when it comes to M&A but they only get paid when transactions happen and their fee is based on the size of the deal. It’s not hard to imagine what their motivations and priorities are. They get paid the same for good deals and bad deals.

Of course banks care about their brand and prestige. Goldman has standards. However those standards are driven by the market rather than from within. In other words if the market will accept it and thinks it’s good, Goldman is happy to get the print and take the fee.

All this is especially true during the “bake-off” portion of the IPO process. At this stage a company like Groupon invites all the banks to come and do a dog and pony show with the senior management team to prove how valuable they would be as an underwriter. They are not in evaluation mode, they are in selling mode.

Much like a courtship the banks are invited by the company to “show how much they love them.” Only one suitor gets to be the lead bank (although in large deals there can be two or three) and the rest settle for placement that earns then a nice fee for which they will do zero work. And I can tell you it is zero. (The research analysts at those firms will eventually have to provide stock coverage (buy, hold or even sell which never happens) but the bankers and the distribution network does nothing if they are not the lead bank.)

A key part of the process is where each banks provides a “valuation estimate” for where the shares should be priced and expect to trade. This is the most absurd part of the process because the banks all try and find the highest number. They do need some justification which typically involves sending associates out looking for “companies that have something in common with this one and trade at or have traded at obscene valuations.” They put these in a sheet and find the metric that will create the highest valuation. Banks don’t spend anytime on how much *they* would pay to buy stock in the company. Thanks to the new regulations separating research from banking they can’t even involve the one person or people at their firm that would have worthwhile analysis.

It doesn’t have to be this way

In the “old day” some investment banks like Morgan Stanley tried to maintain high standards that they demanded companies meet before being willing to underwrite an IPO. As they watched other banks run away with deals in the mid-1990’s they changed their approach and created one of the best known “investment banking research analysts” in Mary Meeker.

Before regulations there were some small firms (like SoundView) that actually aligned the interests of the firm with investors in an IPO stock. For example before agreeing to be part of the deal the research analyst had to support a “strong buy” rating on the company with some caveats around pricing. More importantly the compensation of research analysts were tied to deals but subject to company execution. For example if a company came public and either missed published estimates or lowered guidance the analyst would not be paid on the deal. Pretty simple but it made analysts much more certain about their estimates which investors in the company would be relying upon.

The little research investors had back then was all stripped away with the new regulations put in place to “protect them” from the unscrupulous research analysts at other firms (guys like Henry Blodget and a few others at the “bulge brackets”.) It’s not unusual for regulators to get it wrong since they don’t have a deep understanding of the markets they are tasked to regulate. Today investors have to realize that “buyer beware” is just as valid in IPO stocks as it is in most other transactions. It’s unlikely that regulations or markets will get more investor friendly.

Conclusion

This situation is one of the reasons we cover newly-public and even some emerging private companies. There’s opportunity to help investors make decisions and in some cases to exploit solid investment opportunities in the absence of strong independent coverage. Much of our IPO-focused research comes out over at IPO Candy.

I hope the WSJ and Mr. Sorkin can start writing from their knowledge base which should be much deeper around investment banking and Wall Street than this article suggests.

Terrified & Bored

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Paul Krugman applied this perfect label to the current situation in Europe about the economy, society, and the Euro currency. He points out some of the tired but scary observations about how countries accounting for about 1/3 of the European economy are teetering on edge of ruin and default. The richer countries like France and Germany have been providing support while insisting on austerity and reforms. But, the bills seem to get bigger and the “rich economies” of France and Germany are low or no growth. That’s the big problem that is leading some to predict the Euro will cease to exist. The best rebuttal to the this argument is the UBS Euro Note Sept 2011 predicts that the Euro will be supported with a slow and very painful integration of fiscal policy over time. It’s worth reading the whole note, but the situation might best be described as “damned if they do, damned if they don’t.” This is due mostly to the fact that the costs for exiting the Euro by choice or force are massive.

Back in 2004 I was attending a small group event in Paris focused on the global economy and the Euro. Trichet came to speak with us “off the record” and made it clear that the reforms required for the Euro to succeed were far beyond what the people of Europe would ever accept. The strategy up to that point was to emphasize the benefits of a more unified Europe and a single currency while avoiding all discussion about other consequences. For example, one might talk about how much easier it would be for people in one country to send their kids to school in another or even move there to take a new job – the promise of more mobility. But, the fact that funding for schools might be severely reduced isn’t mentioned.

For the next few weeks, the world will be wondering what sort of “grand plan” the “authorities” in Europe will craft to unveil at the G20 meeting on November 4th. The current European Financial Stability Facility (EFSF) has a $600B checkbook  which is probably enough for Greece. However, if Spain and Italy are at risk, the estimate for what will be needed jumps to about $3T. It’s only one letter so we should all pause and read that figure as “three trillion dollars” which is a lot of money. The final proposal is likely to be complicated, but the thrust of it is to leverage resources by apportioning the losses from defaults and use the assets of the rich countries to absorb only a portion, say 20 or 30% of each loss. I’m not smart enough to understand why this would actually work but perhaps global markets will see the value of this approach.

That part describes the “terrified” aspect of the Eurozone crisis. The numbers are big, and nobody can be sure if it will work. The “bored” aspect has to do with the structural lack of growth in the rich countries. Without significant growth, the countries in Europe are forced to play a grim zero-sum game. The rich give to the poor and then are forced to cut benefits and reduce their own quality of living. No wonder tensions are mounting. Growth fixes the problem because living standards can rise for the rich countries and give them more resources to share with their poorer cousins.

So how could Europe solve their problem if growth is the only way to do it and they are saddled with tons of debt? There’s only one way but it doesn’t seem likely. It’s an often-dreaded four-letter word called WORK. But, this isn’t just work in the conventional sense of “there I came in and did something” but the kind of HARD WORK that generates a stepwise improvement in results. Even worse the measure of this situation suggests we are really talking about LONG HARD WORK.  People familiar with Europe tend to respond with “Wow! That’s NEVER going to happen!”

It could happen though. One simple solution would be to reinstitute the draft. This would immediately solve two big problems in France. #1 the massive unemployment of young adults would go down, and they would receive training and experience to obtain jobs after their service period and #2 different elements of society would again be integrated under a common cause and belief system. France has also gone some distance in making it far easier to become a freelancer or start a small business. But putting these and more things with bold measures and leadership is out of reach based on most educated guesses.

Back in June of this year I attended the “eG8 Summit” in Paris and came away with a sense that the governments of Europe, particularly France, would have a hard time not overplaying their hand of government intervention. (See the full document in PDF here: eG8 Meeting Summary June 10 2011.) France wants to orchestrate successful growth instead of create a sustainable system that can drive itself. Almost every aspect of growth depends on some government program, handout, or tax break. There are a few brave souls who have built important businesses in France from scratch, some even on the Internet, but they are rare enough to be on display at the eG8 meeting as if they were exotic animals.

The most recent events have not given much reason to hope for better leadership. In August Sarkozy and Merkel put their heads together and came up with little to nothing of substance. After visibly agreeing on how nice the weather was the two discussed meeting more often and raising taxes on financial transactions. It all elicited a groan from anyone with a passing knowledge of growth, wealth creating, economics and capital markets.

So what does it all mean? Only one thing in the medium term that is to avoid European assets and regional investments in favor of global and multinational equities. Many are sporting high earnings yields, rich dividend payments, and excellent coverage ratios. Own the best quality free cash flow relative to equity. They may all remain under pressure for a while as global growth slows, but they are the only attractive long-term investment play right now except technology and startups.

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Update on SMTP – Email Delivery Networks

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  • Since we published our original coverage report SMTP, Inc.: Here Come Email Delivery Networks on May 3rd the company has continued to execute on their growth strategy and the shares have settled into a more stable trading range. (See related post for more information.)
  • SMTP recently completed the acquisition of over 4,000 IP addresses that are the foundation of successful email delivery. This will allow them to support thousands of new customers.
  • The company also recently contracted to build up a new datacenter with a co-location provider that will allow for further growth and delivery of higher service levels. It’s expected to be handling customer volumes in Q3 of this year.
  • Social marketing and behavioral commerce trends led by companies like GroupOn and Livingsocial are adding to the already high demand for reliable email delivery services. Although message volumes are also expanding, email remains the single best common denominator for basic communication.
  • We continue to see this market evolve in a similar fashion as the content delivery space and expect that over time most internet infrastructure service providers (like Amazon and Rackspace) will want to add email delivery networks to their services.
  • SMTP will be reporting results for the June quarter in late July. Due to the nature of their business model we expect no surprises and a fairly smooth continuation of the growth that the company has been generating the last few quarters.
  • Investors looking for a rapidly growing, profitable (27% operating margins), small capitalization internet infrastructure service provider should take a close look at SMTP.
  • The company recently completed a “direct to market” IPO process and is just now accessible to pubic investors. Our intrinsic valuation (IV) remains $3 per share.

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Bravo for Bloomberg!

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It’s been a rough few years for the US economy. After the financial crisis the structural reforms and government intervention started comparisons between the US and slow-growth, socialist-leaning countries like France. Perish the thought!

But years after stimulus and “recovery” the overall US economy has not added many jobs and just doesn’t feel very robust. Some look abroad to China and feel that their sheer size, growth rate and seeming invincibility will make them the global economic power in the fullness of time.

Big corporations are the problem, not the solution. When it comes to job growth it turns out that small and medium sized businesses create about 120-140% of the new jobs in the US. That tells you something about what big corporations are up to. They are reducing payrolls and moving jobs to “more efficient” providers abroad.

The burdens on small businesses though have made it harder to hire. Healthcare costs are substantial and the economy isn’t strong enough to support speculative hiring. Today thousands of college graduates bemoan the lack of $85K annual jobs that will train them to do something useful and wait around for “things to improve.”

Mayor Bloomberg has hit on a perfect opportunity for the US to get back some of the mojo that built the country and made it great. Immigrants have been the key to growth since the US came into being. Our policies are stupid and self-defeating. He lays out a set of proposals that offer the greatest bang for the buck than anything else we have seen in recent memory.

New York Mayor, Michael R. Bloomberg.
Image via Wikipedia

 

Changing our policies would allow the best and brightest to come and remain in the US to get a college education and start new companies that will provide the new products and services, jobs, taxes, and investment opportunities that we need. More companies, more jobs, more demand for housing, more prosperity – all for little to no cost for the country.

There’s lots of attention on QE3, near-term job growth, health care, inflation and quarterly numbers. But the real long term growth engine for the US, the thing that makes it different than every other country in the world, is the strength that comes from immigrants that come to build a better life and in turn our economy and country.

Every day the news is filled with the equivalent of whining over entitlements. Meanwhile so many smart, talented and hardworking people in the world have neither freedom nor opportunity. Their attitudes, efforts and impact is sorely needed in this economy right now.

It’s worth taking the time to read or listen to the entire Bloomberg message and also see lots of the information that backs up the merits of the proposal.

[Disclosure: None. I’m not a particular fan of Bloomberg and a registered independent. I like fact-based legislation that still remembers the positive traditions, honor and character of the country. What Bloomberg is talking about here is a great example.]

 

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The internet wave hits culture.

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In early June I started thinking seriously that it’s time to begin mapping out an investment strategy that goes beyond the immediate digital entertainment world of music, movies and games. Attending the e-G8 meeting in Paris made it clear that governments and societies were being reshaped by the “8th continent” of the internet and the changes have only just begun.

The impacts on growth, jobs, innovation and wealth creation have been noted – along with some fears that intellectual property, government controls and a certain diversity in our cultural wealth might go by the wayside.

We put our notes together and published a summary of the e-G8 meeting over at Seeking Alpha. Fred Wilson also did a post on “Investing in the Cultural Revolution” that is another sign that it’s time to start thinking. (UPDATE: just a couple weeks later Fred did another worthwhile post on this topic. See Science & Art.)

I often get asked “what’s the next big thing in technology that nobody is thinking about yet?” It does seem like cloud computing, mobile internet and social networking companies are well discovered at this point. I still say that “RealVR” which we have been covering for over two years is just getting into the first inning. But going beyond that this intersection of technology on art, experience, emotion and society is just beginning. What will “paintings” be like in 20 years? How will be they be made and experienced? Probably much differently than they are today. The next successful hackers may be digital impressionists.

It’s a topic worth working on. Do it before everyone else does.

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Putting the e-G8 in context

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Nicolas Sarkozy during his meeting in Toulouse...

It’s hard to fathom what the two-day e-G8 meeting in Paris, which starts tomorrow, will offer us. It’s received only minimal coverage, despite the fact that the attendees include such high-profile people as Jeff Bezos, Eric Schmidt and Jimmy Wales, along with scores of other technology company managers, entrepreneurs, political leaders and journalists.

The quasi-governmental sponsorship of Nicolas Sarkozy may explain part of the reason why the event hasn’t received many headlines. He asked Maurice Levy of Publicis to host the event, which is entitled “The Internet: Accelerating Growth”. The aim is to bring technologists and policy-makers together, “to discuss the challenges and opportunities which they believe relevant to the future of the Internet, offering their opinions on a wide range of issues, including for example human rights, intellectual property and technological investment.”

However, we all know that the Internet actually accelerates creative destruction: something France and other countries in Europe are less keen on. That has many wondering whether the real policy objectives of the e-G8 have more to do with additional regulation and control, rather than more freedom, innovation and economic incentives.

The French have an uneasy relationship with the Internet on both an economic and a personal level. Economically, the ability for companies, particularly Google, to be able to extract large economic value out of the French economy is troubling in a model in which the government provides large subsidies (billions of euros) for foundation technologies like broadband. Personally, people in France are just a little less comfortable with the online model, and Internet business, than some other cultures in the developed world. For example, PriceMinister, a French web commerce company, was acquired by a Japanese firm. According to an insider at the French company, “there are no natural French buyers for Internet companies because they don’t really believe in it. They pretend to care about the Internet, and spend some money on it, but they are not serious at all.” [Quote from LeWeb, December 2010.]

There’s a robust band of successful entrepreneurs and business owners on the Internet in France, but big companies see it more as a risk than an opportunity. No wonder they are losing out to more aggressive international competitors. [This is going to get even worse with the dramatic rise of the mobile Internet, but that deserves treatment as a separate and full post.] For most successful French technologists, their path has involved a move or partner outside of France.

There is an agenda, but it’s fairly high level. Other than the welcome by Levy, and the opening speech by Sarkozy, no sessions have speakers listed. We’ve been able to piece together some sessions by matching up Twitter streams with the agenda, but it’s a far cry from a complete, detailed, official agenda. The last time Sarkozy appeared at a technology event, it was LeWeb 2008, which was a disaster. He lectured an unwilling English-speaking audience at length – in French – about the need for interactivity, and then proceeded to end his speech and abruptly leave stage left. The crowd was livid.

But the French are technology friendly and, since then, other French ministers like Christine Lagarde have made a far better impression by appearing at technology events and speaking intelligently and frankly in English to attentive and appreciative audiences. I’ve also met with French officials who oversaw the conversion of many government offices to modern technology using open source software. So all the ingredients are here, but somehow the recipes and presentation are not quite right. This event may be an attempt to improve things, but two days isn’t much time.

Are there Investment Implications?

Probably not the type that will impact 2011 stock performance. But in the longer term, whether we like it or not, business on the Internet is going to be impacted by politics, legal differences, societal needs and human factors. Because the Internet involves personal data, privacy, security and interaction, it’s different from moving a product or a piece of content into a foreign market.

The implications cut in two directions. If countries like France act to protect their near-term interests, it can limit the opportunities for global firms like Google, Apple and Facebook in the local market. We’re all familiar with this from examining the development of business and the Internet in China, where Baidu continues to lead the market. As for Russia, it appears that Yandex will be the Internet search leader there.

Strong domestic companies are important and welcome, but the question is: what cost do consumers and taxpayers have to pay for them? And this isn’t just in terms of money, but also with respect to choice of content, freedom of expression, efficiency and ultimately even the quality of life. Limiting or restricting consumers to narrow and inferior content and tools, merely to preserve local interests, won’t work in the long term.

In conclusion, the objective of the organizers is to have some specific recommendations that can be made to the leaders at the G8 meeting immediately following the event. What kind of things are even possible? Most technologists would say, “spend money on building the roads and ramps (broadband), then get out of the way.” One senses that the leaders of the free world want to put their fingers on the path of progress to influence how it all turns out.

Politics is unlikely ever to welcome the term “creative destruction” into its lexicon, because the destruction part is too lethal for poll ratings. But why not use government power and wealth to incentivize and assist those people who are dislocated by the process? Most developed countries, including the US, still seem to have a problem in creating the jobs that many of us have enjoyed in the past. Healthcare costs are a big reason in the US; slow growth, regulatory burdens and high costs are reasons in France. (Research 2.0 looked into hiring some people in France about five years ago and concluded that it would basically break our admittedly “lightweight” business model.)

With iPad in hand, I’ll don my top hat and tails to stroll under the luxury tents assembled in the gardens of the Tuileries. Few places could host a more sumptuous gathering spot for a discussion of the Internet and policy. At the same time, thousands of students will be shifting gears to spend the summer developing software and Internet sites that may become the next Google, Facebook, Match.com or GroupOn, instead of whining to their parents how they can’t get an interview for that $100K entry-level job at Goldman Sachs that they were planning on. “Dad, maybe if you could get me into that e-G8 thing where I can network…”

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Tangoe Pre-IPO Review

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Summary

Tangoe is a play on mobile for the enterprise. Tangoe provides a solution for companies to manage the usage, devices and carrier relationships for their organization. Gartner and other industry analyst firms recognize Tangoe as a leader in this niche market. The company should do about $90m in revenue in 2011 and generate $11m in EBITDA and a few million in operating income. Our Intrinsic Valuation analysis suggests a share price of $11 to $14 which compares to the current price range of $9 to $11.

Positives, Neutrals and Negatives
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+      Enterprises spend lots of money on communication and have always needed better methods to manage it. The increase of mobile has exasperated the problem. Gartner sees this is about a $1B market today which gives Tangoe plenty of room to grow.

+      Improved management of communications elements generally results in direct and fairly immediate cost savings and generates attractive ROI. Having a clear cost-saving benefit allows the company to grow consistently, even in tough economic times.

+      Industry analysts recognize Tangoe as a market leader in their niche and highlight their size, ability to handle all communication types and global support organization as key advantages.

+      The company has leveraged partners like Dell and IBM for distribution. IBM has accounted for 10-11% of revenue for the past two years. Both Dell and IBM hold warrants in Tangoe.

=   Revenue growth slowed a bit for the year ended 2010 but has picked up in 2011. This may be due in part to the transition to more of a recurring revenue model but the large size of the Tangoe customer may contribute to some lumpiness in terms of new contract signings and renewals.

=   The company provided a target model that looks somewhat aggressive in terms of operating margins. Of particular concern is the planned reduction in R&D spend as a % of revenue.

=   Management and insiders have substantial experience but are a bit of a “rogues gallery” of older executives with very diverse backgrounds.

=   In addition to their warrants and distribution IBM holds special rights that come into play should Tangoe become an acquisition target. This suggests that IBM may be the ultimate acquirer of the company but at the same time complicates any acquisition by someone other than IBM.

–      Although a solid market it’s certainly a niche market within the mobile technology space. The fact that IBM has so far not decided to acquire the company may attest to the fact that this will never be large enough to support a $1B business.

–      HQ in Orange, CT puts the company in a bit of a backwater in terms of a technology ecosystem.

Stock and Valuation

A look at a broad peer group of stocks the proposed price to sales ratio of 3.6x is below the average of 4.4x. A table comparing a variety of operating figures and ratios is attached.

The growth rates and operating ratios driving our Intrinsic Valuation model are all fairly reasonable. At $11 to $14 the IV doesn’t suggest huge upside for investors at the high end of the proposed price range.

We’d be far more interested in these shares if they dip below the proposed filing range and/or the company demonstrates more progress to consistent increases in operating margins.

 

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