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Light At The End Of The Tunnel
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
February 16th, 2001

By Brent Holliday
Greenstone Venture Partners

"What's the use in tryin',
All you get is pain.
When I wanted sunshine,
All I got was rain...
Disappointment haunted all my dreams..."
- The Monkees, I'm A Believer

It's always darkest before daylight. I have repeatedly stated here in this very column that we are not about to crash, economically speaking. The stock market has done a remarkable swoon, reducing some sectors to "drill bit" stocks (you know... 3/8, 1/2, 3/4) and it would appear (if you read, watch or listen to much of the media reports) that we are in for even more troubling times. In the short term, yes. Ugly. Turn of My Yahoo until April. Throw your monthly RRSP reports in the recycling bin unopened. Ignore it. Get on with making real money at your job. Set your alarm for April 15th and then look out at the bright sunny world of stock market investing once again.

In the meantime, do not equate the movements of the stock market to the economy. The two are connected but not related. I will give you my reasoning in a second. Just remember that my perspective as a venture capitalist is to go long. I'm thinking five years out because a) I get great comfort in shaping a world that I essentially make up and b) If I invest in what's hot today, due to the early stage of my investment, I would never make money.

I have been to a few conferences in the past three months in the US, where many of the smartest minds in technology have been busy trying to explain away today's market ills and expound on the future of the technology industry. The most recent trip was this week to Robertson Stephens investor conference where I had the pleasure of listening to many CEOs of top technology companies, fellow VCs like Vinod Khosla of Kleiner Perkins and analysts like Arun Veerappan, uber analyst covering the Optical Components space. Let me synthesize the current thinking of these brighter than bright minds for you:

The Market Today Explained - A stock is priced by the market at a level that takes into account the expectation of future growth of the profits of the company. The faster the expected growth rate, the larger the premium placed on the price relative to earnings. So after the silly season of "irrational exuberance" where the market placed unrealistic expectations of growth on the market, things have come back to earth. Well, duh. That's why we have drill bit stocks today. The real fear cycle in the market today is not related to the dot.combustion, but to the warnings of the giants, the profitable companies that were untouchable before October 24th.

Zeroing in on the optical/internet infrastructure meltdown, October 24th was a key day. As Arun put it, the first shoe dropped. Nortel gave guidance to the market that it would not meet its 4th quarter numbers and stated that demand was slowing. They were the first to admit it and they were punished. Along with everyone else. Salt into the open wound, or the "other shoe" dropping was three weeks later in mid November, when Cisco reported slowing demand and enormous inventories. Just in time for winter, we had a big downward slope to all technology stocks. Good for sledding.

Every year for the past decade, the major "box" makers (Cisco, Lucent, Nortel etc.) showed a decline in inventories over a calendar year (Q1 highest, Q4 lowest). Like clockwork. Except in 2000. For the first year in a long time, inventories went up every quarter and were massive by Q4. Cisco's were 8.5 times what they were just 9 months before. For those that don't do financial statement analysis, this means that Cisco overbought from its suppliers so that they would not be short of parts only to see demand from the carriers (Bell, AT&T, Qwest, etc.) evaporate. The ripple effect, or the third shoe was that the suppliers to Cisco and Nortel would get it in the shorts the following quarter because Cisco et al would stop buying parts and try and sell the inventory. Right on cue, PMC-Sierra and JDS Uniphase said Q4 was great, but Q1 2001 would be bloody awful. Ouch. Down we go again.

Now Nortel gets hammered again for even lower guidance and job cuts (they have announced 13,000 job cuts, which coincidentally is the exact number that they hired in 2000. People, like inventory, must be cut when demand slows. Wall Street says so.)

Essentially 2000 was a watershed year. The biggest guns in the massive buildout of the Internet all got ahead of themselves. Ask anyone that runs a large business, "What is the hardest part of your business?" Answer: predicting demand.

So the market is in a fear cycle. Fear of demand going away for a long, long time. When will it end? I'll come back to that.

The Really, Really Big Picture - Leave it to Vinod Khosla, all over the covers of the latest business magazines and owner of the most enviable track record in VC investment history (since 1997: Cerent, zero to $8B in 18 months, sold to Cisco... Juniper, zero to $55B in 3 years... Extreme Networks, zero to $9B in 3 years... Corvis, zero to $25B in 2 years) to give us some comfort as to where we are headed. He did caution that he is not God and that he was just lucky.

All through history, technology innovation has accelerated. And it scares the crap out of people. In 1885, a group of Yale students whacked down a lightpost because it was too light at night and "more light than they relished". In 1885, there were only a few hundred lightposts. By 1899, there were millions, an astonishing growth rate of a new technology that could not have been predicted by anyone watching the Yale students with their axe fourteen years earlier.

If the pattern of increasing pace of innovation holds, imagine what we will be looking like in 2010. Taking Moore's law as our pace setter, we will see the equivalent amount of innovation and change in the next 9 years as that which occurred from 1970 to today. Think about that for a second. How many recessions since 1970? Four? The Dow was at 1000 back then. The NASDAQ did not exist. Bill Gates was high school dweeb. The point is that if we map that to the next 9 years, we have to expect lulls in the cycle, but we are trending up.

Vinod had another good point about change. In the 70's there were 6 dominant computer companies (IBM, Data General, Sperry, Univac, Wang, HP). In the late 90's, the dominant 6 are Sun, Compaq, Dell, IBM and HP. In a little more than 2 decades a lot changed. Look forward. Assuming that the next big thing is not computer systems, but network systems, today there is Cisco, Nortel, Lucent, Alcatel, AT&T, Sprint, Worldcom. Who will be there in 2010? Lucent is looking downright Wang-ish already. Nortel may not be the big gun in 9 years either.

Look at the world in an old economy way for a minute. IT spending (computers, software, networking, services) has been proven to increase productivity (finally!) in most businesses. Average IT spending is at 3% of revenue today, up from 1% only 5 years ago. As CEOs and managers get a hold of e-business and its inherent efficiencies, it's safe to assume that IT spending will increase over the next 9 years. If it increased to 10% of revenue (which is possible if increasing IT spending reduces the need for some G&A and some sales and marketing expenses) by 2010, we would see trillions of dollars in spending every year. Wanna bet that we will see a trillion dollar market cap company by then? Vinod goes one step further and suggests that the trillion dollar company in 2010 may not even exist yet. That gets a VC's heart thumping.

So back to today. When will the current cycle end? The last two downturns in the tech market were in 1998 and 1996. In each case, the bearish market lasted for 3 to 4 quarters. In each case, the market started going down exactly one quarter before the companies admitted problems (which is what happened here if you look back to the late summer and Nortel and Cisco coming off their peaks). In each of the previous cases, the market anticipated the end of the pain by 2 full quarters. In other words, the bottom of the cycle was 6 months before the companies started announcing good results again. If Oct 24th was D-day and this downturn is a full year (big assumption, but not without merit considering the really big picture and pace of innovation), then Buy day starts April 24th or thereabouts. But no earlier.

Your confidence in that date depends on whether you listen to today's noise or think about tomorrow's inevitabilities. I'm sure those Yale students did not invest in light bulb manufacturers at the time. Would you?

Random Thoughts -

- Drill Bit Stock Of The Week - Onvia is at 7/8 today, one full year after going public and trading at $65 on the first day. They are in danger of being de-listed on the anniversary of Glenn and Rob pushing the button to open the NASDAQ on their first day. As they say, what a difference a year makes.

- Drill Bit Stock Of The Week - Book4Golf.com is at $0.63, which is 3/8 in US funds for those keeping score with your Black and Decker at home. They lost $28 million dollars of investor's hard earned money (remember that during the exuberance, Yorkton coaxed money out of investors at $15 per share) in the year 2000. Revenue? $0.685 million, which I find hard to believe is even that much.

What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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