The TSC Streetside Chat:
e-harmon.com Fund Manager Steve
Harmon
By TSC Staff
5/7/00 8:50 AM ET
Whither Net stocks?
Last year, investors threw money at all things dot-com,
tacitly agreeing to ignore tenuous business plans,
nonexistent earnings and dwindling cash reserves. Net
funds shot the lights out and no matter how big your
portfolio's return, you felt like you'd missed the boat.
Bonny days.
That was then, this is now.
Today, investors have accepted that many Net stocks
won't be around in 10 years, and it shows. Since its
peak on March 9, TheStreet.com Internet Sector index
is down 33%. But if these stocks were overbought last
year, are they oversold now?
Enter Steve Harmon. He's been writing about Net
companies as an analyst since their infancy, way back
in the mid-1990s. Now he's making the ambitious switch
from media darling to fund manager with his new firm,
e-harmon.com. His Internet fund, currently in
subscription, will launch in less than 10 days. He's also
slated to launch a fund that will track his own Net30
Index, a basket of the 30 largest Internet stocks
ranked by revenue.
In this week's Streetside Chat he tells us how he plans
to separate the wheat from the chaff in the sinking
sector, where he sees opportunities and what stocks he
plans to stay away from. He'll also weigh in on the
proposed breakup of Microsoft (MSFT:Nasdaq - news -
boards), how investors should play the software titan
down the road.
Harmon spoke with TSC Personal Finance Editor David
Landis, Deputy Personal Finance Editor Stephen
Schurr, Technology Editor Jim Cole, Senior Writer Ian
McDonald and Staff Reporter Ilana Polyak.
Ian McDonald: OK, Steve, we'll just get right to it. First
off, obviously, there's been kind of a bloodletting in the
Net sector recently. What slices of the Internet sector
look good to you right now? Everything looks a lot
cheaper than it was a while ago, but where are the
values as far as you're concerned?
Steve Harmon: Well, I think the values are in the
industrial Internet space. There's been a lot of
acronym-tossing around in the media lately -- B2C, B2B
wannaB2B and whatever -- whereas I tend to look
beyond the buzzwords. I think the industrial application
of the Net is really the next decade buildup, that whole
space. What I mean is the unseen glue, the unseen
software, the unseen hardware, the unseen services that
are connecting existing corporations with their vendors,
suppliers, manufacturers.
Ian McDonald: What are some of the companies there
that you think are good opportunities right now?
Steve Harmon: Well, if you look at it, I think what's
going to happen is your older technology companies
with existing customers may move into the space pretty
rapidly. In other words, IBM (IBM:NYSE - news -
boards) is moving into the space, Microsoft will probably
want to be there. Some of those, I think, will be the first
ones to look at.
Second, in the pure Net play -- I think some of the
names are known, like we know about Ariba
(ARBA:Nasdaq - news - boards), we know about
Commerce One (CMRC:Nasdaq - news - boards), we
know about FreeMarkets (FMKT:Nasdaq - news -
boards), we know about Broadvision (BVSN:Nasdaq -
news - boards) -- beyond the initial group, you want to
look a little bit outside the known players and say, well,
who else could be in this group? Who else will migrate
into this space?
And I think we'll probably see Intel (INTC:Nasdaq - news
- boards) being a big player here, because of their whole
shift to being a Net-sector company. I think we're going
to see Sun [Microsystems] (SUNW:Nasdaq - news -
boards) getting into this space. Sun doesn't really have
a play there, today. What that means is they're probably
going to have to acquire companies. You don't have time
to build. It's cheaper, in fact, to buy, especially with
prices depressed like they are.
I think they're going to need personalization companies,
like Net Perceptions (NETP:Nasdaq - news - boards).
They're going to need -- what's the company I'm thinking
about? They're going to need some of the Ventros
(VNTR:Nasdaq - news - boards) of the world, which was
the spinout of Chemdex; I think they're going to need
also some payment mechanism built into this ... I think
we're going to see some consolidation in that area.
There's a couple of start-ups that are not public, but with
the market being depressed, they'll probably just be
taken out by the larger players. PayPal.com is one of
them. I also think we're going to see the telecom players
realizing they're not in the telecom business, and realize
they're in the service business, like AT&T (T:NYSE -
news - boards) and WorldCom (WCOM:Nasdaq - news
- boards) and the others. It's really going to get kind of
busy in the consolidation and M&A space. I think that's
going to be the next 12 months in terms of the value
being realized in Internet stocks.
I don't think we're going to see huge runs in the stocks,
based on internal growth, or based on any earnings. I
think we're going to see runs based on expectations of
consolidation.
Jim Cole: Are you a buyer of any stocks based on
expected consolidation, specific stocks that you see as
take-out targets?
Steve Harmon: What we do -- and we're just launching
our mutual fund, so I don't want to give away the entire
story -- is look at each sector that we've identified, seven
sectors of the Net: hardware, software, commerce,
infrastructure, etc., and we're looking at the top six
companies in each category. And then we're evaluating
the management teams, number one. The technology,
concurrently, is equally important, and any existing
market share that the firm may have in terms of the
technology being used.
And there's really a chance to play sectors. I don't think
you have to be right and pick the one horse out of the
entire six or so that's going to be the winner. I think
maybe a better approach is to take two or three,
because what's going to happen is you're going to see
the larger companies, for example, if Intel acquires one
of them, IBM or Oracle (ORCL:Nasdaq - news - boards)
or maybe Sun or even Softbank will have to acquire
another. You may see the top three taken out in any
space. To me, that's a better approach. It may not be
100% accurate in terms of all three being taken out, but
I think there's room for more than one hunter in each
category. And you know, if you miss the one you're
going to buy, if you score one out of six, then you're
going to miss all of the upside. But if you can hedge
your bets a little bit, and take half the group in each
sector, you've got the better approach.
Ian McDonald: The number has risen pretty quickly,
and everybody really has a different angle. I mean, one
fund has Merrill Lynch (MER:NYSE - news - boards)
and Wal-Mart (WMT:Nasdaq - news - boards) in the top
10, another one is strictly dot-coms. How are you
defining a Net stock?
Steve Harmon: First thing is, 51% or greater revenue
must be derived from or because of the Internet. And the
second litmus test is more informal: If the Internet never
existed, would these companies exist? And, if the
answer is yes, then they're not really Internet
companies.
A lot of companies walking around with the Internet
banner are really Internet-enabled. Most of their
business is actually off the Internet; it's more about
warehousing, shipping, manufacturing and doing other
things, other than the Internet. For example,
Amazon.com (AMZN:Nasdaq - news - boards) is really
Internet-enabled. Now they can do things on the Net that
you can't do offline, for sure. But you can sell books,
video and music offline, and people have done so for
decades. So, they're using the Net as an enabler to sell
more of the stuff. So that's good, it's a great use of the
technology, but means they're Internet-enabled.
Stephen Schurr: The first phase of the dot-com era
was a bit of a shopping spree; you really didn't have to
discriminate, necessarily, to make a profit on your
holdings. But after the bloodletting, I don't know if that's
necessarily the case. Are you going to try and set some
parameters, whether it's a history of sustainable
earnings or being in the top of their peer group?
Steve Harmon: Well, we use everything, we use all the
metrics out there. We use discounted cash flow on our
Web site, we have a thing, "Seven Keys to Value
Creation." Really, those seven things are at the heart of
what we're looking at all the time, for Internet
companies. And they're consistently proving to weed out
the weaker companies from the stronger. And even in
the past, you could have done OK with the Internet
sector bet years ago, but you'd have to have made a
sector bet; you couldn't have done it if you had only
gotten into individual stocks in '94, '95, '96, '97, '98 even
'99, you could have lost money. It gets down to more of
a qualitative process, not really quantitative. They're not
coming at it with a P/E of this or a P/E of that, they're
coming at it with evaluating management teams, if the
technology can scale, who the investors are, if they have
enough capital, who are their partners -- more of a
quality exercise. In '94 when I started, you could have
put money into Telescan, Net Manager, FTP
Software, Quarterdeck and who else? CompuServe,
Prodigy -- you would have lost money.
Stephen Schurr: At some point in time would those
companies have met your seven measures?
Steve Harmon: Net Manager was actually the earliest
one doing a comprehensive software suite that allowed
you to get on the Net with a browser application, an FTP
application -- you know, the whole suite -- and nascent
server software. The problem was, they didn't have the
marketing, they didn't have the management that
understood how to scale quickly in the Net. And
Netscape came along and blew 'em away.
So, the observation that you could have made money
pretty much blindly with the Net in the last five years
has been made many times. The reality is, it was not
that easy to really get the better companies, and the
only way to do it right was to be more diversified in the
Net space. That's one reason why it makes more sense
to take more of a mutual fund approach. Because with
400 stocks and 4,000 private companies that want to go
public someday, it's more of a full-time job for an
individual investor to keep track of this stuff. Even the
daytraders can't keep track of it. They're just really
trading ticker symbols. I think you have to have a
comprehensive approach and almost become an
investor, heaven forbid, rather than a speculator.
Ilana Polyak: Do you see more of a shakeout to come,
or are we done with this? And if so, who are going to be
the winners?
Steve Harmon: I think the consumer winners are
becoming known. I think we're going to get back to the
consumer Internet after this wave in more of a decisive
way, but I think the shakeout will continue in the
consumer space.
In the business space, the companies are still coming
together, figuring out their markets and their customers
and scaling up. I think a shakeout in that space will
happen later. But they're very different. The media tends
to group them together, like B2Bs
[business-to-business] may not undergo the same sort
of drop as a B2C [business-to-consumer] space. They're
really very different areas, entirely. They have different
dynamics. The consumer space is more driven virally, if
you look at it.
In other words, consumers can spread the word about
how to use Napster or whatever. That's very viral. In the
business space, things tend not to be viral because
companies are not going to just pick up and download a
software and start using it company-wide, unless
somebody in the company thought it was a cool idea.
And even if it was the CEO, there's a whole process in
adopting a software, standardizing it, making sure it's
robust and reliable and then teaching the whole
corporate system to use that software. That's different
than somebody in their garage or at home just
downloading Napster and suddenly sharing their music
files all over the world.
David Landis: But isn't that how Linux started?
Steve Harmon: Linux started because the geeks
running the computer systems in all these corporations
were using it as a solution for their corporate needs.
Linux grew virally, yes, but even so, it doesn't have a
dominant market share in the network OS area. It's only
about, what, 12% or something? So, yeah, Linux does
have the viralness, but I think most of the viralness is
really built into the developer end of it, because it's
open-sourced and developers can add to it as they see
fit. Corporations are using it because it's a real solution
to a corporate need. It would be an example, probably,
of a corporate viral sort of thing, but there are very few
like that. I mean outside of Linux, I don't think you'd find
many.
Jim Cole: A lot of people right now are talking about
profitability. Is that an issue in terms of the companies
you're going to be putting money into? Are you looking
for companies with a clear path towards profitability?
Steve Harmon: We are looking for companies that are
profitable or can become profitable.
Jim Cole: In what time frame?
Steve Harmon: Well, it ought to be within two to three
years, you've got to see some profits. I don't care what
space it is, if they come back four to five years, then I
think I'd get a little concerned unless it's a huge, huge,
huge opportunity. Even then, I would say two to three
years would be the minimum [in which] I would like to
see some indication of profits. Doesn't have to be huge,
but it's just got to get above the waterline in two to three
years.
Jim Cole: And what are you looking for in terms of
getting there? Is it companies with strong sales growth
or companies with shrinking expenses, or a combination
of the two?
Steve Harmon: They have to be using the Internet for
what it's good for, which is distribution and computing.
People often use it for distribution, but they forget about
the computing part. The computing part means
commerce for doing stuff online, for getting it away from
people having to answer telephones and process
paperwork -- do things using software. That's computing.
Stephen Schurr: How concerned are you about
valuations? There are some high valuations, even after
this shakeout; are they going to scare you away from
any stocks?
Steve Harmon: Valuations, you know, in certain
companies are still high. But it's better today to be
investing, I think, than it was a couple months ago. I see
it as the best time since last November to be investing
in this space.
A lot of them have been hammered down, and rightfully
so. I think too many speculators were coming after the
same stocks -- not maybe the same stocks, but the
same sectors, and the individual investors got burned.
So, I think we are valuation-sensitive. In my prior life at
Paul Kagan Associates, we did nothing but valuations
for media and telecom companies. There's a couple of
things that always apply. I'd say three relate to the value
of companies. One is on their RGV -- real growth value --
and I think we're seeing a lot of that in the Net space.
Another way is private market value, and the other one's
the public market value. So really, the center of what we
do is: Look at those three ways to value companies;
figure out which company fits where. In certain
situations, the take-out value of a company might be
much higher than its trading value. It also helps to
fundamentally look at the private companies, since we
have a venture capital fund that we're investing in now --
$50 million -- and it allows us to apply the same
valuation methodologies across the range.
Ian McDonald: What are some companies that have
been really sold off very harshly that you think kind of
deserve to stay down and shouldn't come back?
Companies that really have some fundamental flaws
you'd want to stay away from?
Steve Harmon: I think VerticalNet (VERT:Nasdaq -
news - boards) is one of 'em. They're trying to build
trading communities. The trouble with that idea is that
most companies don't really like their engineers to be
hanging out on Web sites. I don't understand the
premise. If you want to be about trading communities,
you've got to be in the software business, enable
companies to link up with their suppliers and vendors.
That to me is the way to do it, not to build Web sites
based on content.
That's one of them. Let me think of another one ...
Stephen Schurr: The e-tailers?
Steve Harmon: Of course. I mean that, to me, is a
goes-without-saying thing. I think e-tail gets back to
what I mentioned at first, which is the idea of
Internet-enabled. These are Internet-enabled businesses
that don't really have the kind of margins that a pure
Internet-centric company would have.
Ian McDonald: You mentioned you thought Microsoft
was a laggard. Could you expand on that? What are
your thoughts on Microsoft?
Steve Harmon: I don't know what's going on but they're
forgetting about their own notion. Their notion is that OS
is the platform, which is Windows. Now Windows is
becoming less and less of a central piece to the open
source, the open network idea. They don't have a
platform that's ubiquitous. They don't have the
standards. And they don't control enough of them to
really be the centerpieces of the interactive revolution for
the long haul.
The thing they should be working on is building and
controlling the standards in the interactive media space,
the interactive media commerce space. Standards for
security, standards for wireless, standards for devices.
They should be more worried about creating and owning
the platform. They're fooling around with content and
travel sites and all this other stuff, you know, even
WebTV.
David Landis: Do you care to venture an estimate of
the breakup value of Microsoft under the Justice
Department scenario?
Steve Harmon: I don't think they're going to do it. But if
they do, I would think, if I'm an investor, I'm going to
want to own the networking side of Microsoft. The rest of
it, they can have. I only want to own the networking
side. That's the future. Networking is the future. The
Internet is the operating system. So, Windows and the
rest of that stuff doesn't matter. |
