Tech Futures:  Nov 19, 1999 By Michael Volker Justifying High Valuations, Next New Thing, New Stock Markets and VCP Updates In his column last week, Brent Holliday mentioned the Tony Perkins (of Red Herring fame) talk at Softworld ’99 last week.  He spoke on the so-called internet bubble. His view, and that of many others, is that internet companies are over-valued.  Perkins' analysis is as follows: 133 companies went public on the NASDAQ since Netscape did so in 1995. This group has sales of only $10  billion but has a market cap of over $400 billion. Only 16% are showing any profits. Based on an average Silicon Valley company earning 10-15% net profit, and using a P/E of 40 and a discount rate of 20% (for discounting future cash flows), these companies would have to grow by more than 80%/year for five years in order to justify their valuations today. Yahoo, for example, would have to grow 140% per year. Think that's easy? Compare it to one of the leaders, Microsoft, which grew 53% per year in the first five years since it went public. Dell, one of the fastest growing companies grew 60% per year in its first five years as a public company. Based on this type of analysis, it seems reasonable to conclude that most internet stocks are overpriced. But, this is only one way of looking at the situation. I'd like to suggest two other possibilities. First, the real reason why the market valuations are so high, is due to the basic law of supply and demand. There just aren't enough shares for sale in hot companies and there aren't enough companies in this hot market. Every penny stock promoter knows that the easiest way to drive prices up is by having a tight float. Second, who is to say that P/E multiples, growth rates or profit margins for internet stocks should bear any relationship to software or hardware companies? No one is concluding that Microsoft is over priced because its numbers are out of line with GM's or GE's. Internet companies are in a class by themselves, in a nascent and still totally unpredictable industry. Even if 9 out of 10 firms fail, the ones that succeed will return many thousands of percent gains.  Now, if you're a Warren Buffet type of investor, you will stay away from them. He's often said that he's not a high-tech fan. Yet, tomorrow, when Warren and many of us are long gone, these companies will be viewed in the same way as we (and Warren) view the more traditional bread-and-butter industries. It's just that, at the current rate of diffusion of innovation, tomorrow may be here sooner than we think. And, who wants to be left out of these new biscotti-and-capuccino enterprises? Another speaker at Softworld, Hatim Tyabji, CEO of Saraide, said that "being successful is all about adapting to change". If you buy this maxim, then what can you say about those companies that cause change? Many internet companies may be in this category. "But, if they're all giving stuff away for free", you say, "how can they ever be profitable"? Do you really believe that services like Hotmail are free? Think of the value that's being built in the form of customer databases - not just address lists but tons of information on consumers' behavior and preferences. Remember, it was management guru Peter Drucker who said that the best business strategy was to focus on getting customers first and profits second! The challenge will be to figure out how to garner customer loyalty. Speaking of high-priced deals, there's another phenomenon that many investors don't fully understand. This relates to seemingly high valuations on companies being acquired by other firms. There's been a flurry of larger companies, like Cisco, acquiring smaller firms at hefty prices. A good local example is Broadcom Corp's (NASDAQ:BRCM) acquisition of Burnaby-based HotHaus Technologies Inc. How can a 5-year old, $5 million company with 50 people be acquired for over $400? This can easily be done by paying the purchase price in shares - not cash - of the acquiring company. Driving these high valuations is an only-made-in-USA accounting practice known as a pooling of interest merger. In the U.S., unlike Canada, a large company can acquire a much smaller company (including a Canadian one) for a lofty price and not worry about having to write-off the associated goodwill. That's because there is no goodwill. American accounting rules permit the business combination to take place by simply merging the balance sheets of the two firms at cost, effectively paying for the acquisition with shares valued at founders' prices - not at market values. So the bottom line of the merged company is never affected by an expensive acquisition. It goes unnoticed.  Similar deals done in Canada would impact the bottom line because goodwill (the excess of price paid over tangible balance sheet assets) must be written off. This may explain why Canadian deals appear more conservative, price-wise. As you can imagine, there is a lot of controversy surrounding this practice. It is likely that American accounting rules will eliminate this little "loophole" within the next year or two. Hence, don't be surprised if you see all kinds of deals getting done in the next year before the door's closed. Can you think of any other HotHaus's that might be candidates for such a deal?  The Next New Thing? While on the subject of the internet, have you wondered what the next new thing is going to be? Will it be wireless internet? Possibly. Or should I say inevitably? But, that's too obvious. What else would you guess? Internet appliances, maybe? I'm putting my money on the ultimate internet "appliance" - the ASP. ASP means Application Service Provider - the concept that all your applications will run on a networked server somewhere and you'll just pay for software as you use it. Note Microsoft and Cisco's announcement about creating an internet application hosting company that will let customers rent software. Look what happened to Pivotal's stock price when they announced that they would be considering Pivotal software for their ASP service. Doesn't sound that exciting does it? I don't know about you, but I'm getting pretty fed up with all the desktop bugs and glitches I have to mess around with every day. Whereas computers are supposed to save me time, I find that an increasing amount of time is being consumed by overhead activities - upgrading software, downloading patches and plug-ins, filling up my hard drive with no longer used files (which I'm afraid to delete because, hey - you never know!), and regular crashes and glitches. I'm just getting tired of being told that I have a 43 minute wait when I call help lines for technical support. And, then there are all those great new applications that I'd like to try, but just don't want to burn a weekend installing them in my already cluttered system. Or, what about those programs, like income tax applications, which change every year and which I only need for a couple of weeks anyway? I could go on. Does this sound familiar to you? Do you remember the good old days when your apps ran on a mainframe and someone else made sure they were always up to the latest rev level?  I can't wait to jump on the ASP wagon. No more installs! No more headaches. And, if I also keep my files and data on these ASP machines, I can access my desktop from anywhere without worrying about backups or laptop theft (with all my programs and data). Would I put that much trust in an ASP? Well, as Scott Nealy, CEO of Sun Microsystems said at Comdex, would you rather keep all your money at home rather than trust a bank to keep it for you? Good point!  Technically, we're almost there. Bandwidth is still a concern. But, that's only for the moment. And this won't be just another technical innovation. In much the same way that many internet companies are making their profit from advertising, ASPs will make their money from innovative marketing, branding, and loyalty programs. New Stock Markets I've been talking up the new CDNX - Canadian Venture Exchange - over the past months. This week, a new CEO for the CDNX was announced: William L. Hess, a securities lawyer and recently chairman of the Alberta Securities Commission. Being a bi-lingual Montrealer ought to help him in getting Quebec warmed up to the CDNX. I was encouraged by his comments that "the CDNX plans to prosper by acting as an incubator for not only oil and gas mining juniors, but also for emerging information technology and biotechnology firms".  It is also reassuring that the 20 Board members of the new CDNX will include some people from the high tech community across Canada. Harry Jaako (see below) is one of these. Everything is still set for a Nov. 29th launch for the new exchange. (But, I still hope they change the name to make it appear more international.) Speaking of international markets, Nasdaq plans to launch a net-based European market. Nasdaq-Europe plans to begin operating next year to help high growth companies raise capital while making it easier for Europeans to invest in blue-chip U.S. and Asian stocks. In Brussels, the so-called Easdaq operates a niche stock market. Nasdaq is working with Softbank Corp of Japan to create Nasdaq-Europe based in London, England. Recently, the London Stock Exchange launched its own index for technology stocks, the Techmark. The London Exchange along with Frankfurt and six other national stock markets were planning to create a single market in Europe but have opted for a more modest electronically linked order book.  "Expert" Advice In a recent Globe and Mail column on investing, managers of Canada's hottest funds were asked about their advice. A common view which was expressed was "to stick to companies that have produced profit growth for years and to forget about startups or concept stocks that promise the moon". And that "betting on growth stocks can be one of the most dangerous forms of investing". Do you think that that they'd put internet stocks in this category?  These experts also picked 10 companies that they felt held similar prospects to that of Nortel (which has grown by a 30% compounded annual rate over the past decade). These included B.C. technology firms AnorMED Inc (TSE:AOM) and PMC-Sierra Inc (NASDAQ:PMCS).  AnorMED is a Langley, B.C. company which went public earlier this year (March) at $6.10. AnorMED is a leader in the discovery of metal-based therapeutics. The Company has five product candidates in clinical trials, including two in Phase III, and three other product candidates in pre-clinical development. AnorMED's product candidates target several diseases including cancer, HIV infection and inflammatory disease. PMC-Sierra Inc is B.C.'s most valuable technology company (and also one of its youngest) with a market cap of more than $10 billion (Cdn dollars)! PMC is profitable and produces semiconductor chips used in internet switching and routing products.  Venture Capital Pool (VCP) Update I've been keeping track of Venture Capital Pool ("VCP") companies in this column because they may provide funding to, and in the process acquire, technology companies. A VCP company is a Venture Capital Pool which is created on the VSE by financiers interested in acquiring an active enterprise through a publicly traded vehicle. A newly listed Venture Fund, although not a VCP per se, is Exceptional Technologies Fund 5 (VCC) Inc. (VSE:XF) which started trading on the VSE this month. The VCC in brackets refers to Venture Capital Corp, a  class of B.C. Corporation which gives investors a special investment incentive.  This fund presents investors with the opportunity to invest in a pool of technology companies (5 in this case). The fund was established by Harry Jaako and John McEwen, who are well known and respected in the local high tech scene. The company completed an initial prospectus offering of 529,140 shares at $1.75 per share for gross proceeds of $925,995. Proceeds of the offering coupled with $1.8-million which was raised privately, for a total of $2.7-million in equity capital, will be used to further expand Ex Fund 5's strategic  investments in promising British Columbia technology opportunities. Ex Fund 5 already has strategic investments in five emerging B.C. technology companies.  These five companies are: BFound.com (private) which provides Internet-based location intelligence and related services for mobile assets; Columbus Group Communications (private), a full service on-line agency including implementation of e-commerce and branding initiatives; Inex Pharmaceuticals (TSE:IEX), a biopharmaceutical company utilizing proprietary drug delivery systems and therapeutic compounds to increase effectiveness and reduce side effects of anticancer therapies; Kelsan Technologies (private) which has developed and commercialized a propriety friction management technology capable of controlling friction between metal, rubber and plastic parts; and TIR Systems (VSE:TTY), a developer of advanced lighting solutions and innovative linear lighting products for the traffic safety, architectural and design and OEM markets. So for those investors who'd like to get in on the ground floor in a mutual-fund sort of way, Ex Fund may be for you. Getting back to our list of VCP companies, new entries were added for Astron Resources Corporation, Future Minerals Corporation and Helio Capital Corp. (Looks like a few non-tech ones, here.)  Since the previous update, Spartacus Capital Inc. has come to trade. There are now 47 VCP companies looking to do deals.  Check our Venture Capital Pools chart for a complete updated list of the VSE's VCP companies.  Michael Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Chairman of the Vancouver Enterprise Forum, and a technology entrepreneur. He owns shares in many of the companies he writes about. Contact: mike@risktaker.com. Copyright, 1999. What Do You Think? Talk Back To Mike Volker Tech Futures is a bi-weekly column that focuses attention on new and emerging BC publicly listed technology companies. Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Chairman of the Vancouver Enterprise Forum, and a technology entrepreneur. He owns shares in many of the companies he writes about. Contact: mike@risktaker.com Tech Futures Archive T-Net 20 High Tech Stock Index