Internet: Can the Incubators Come Back?
Page: 1, 2, 3
individualinvestor.com
Staff Writer: Steve Smith (5/12/00)
It's January 1994 and the investment banking firm Piper Jaffray, acting as the lead
underwriter, is preparing for the Initial Public Offering (IPO) of CMGI Inc.(NASDAQ:
CMGI
- Quotes, News, Boards) . Some 1.24 million shares are to be offered at $8 per share
($0.16 split adjusted).
You could almost hear their brokers chirping into their phones: "Hey, I'm telling'ya , this
Internet is gonna be big. It's gonna be everywhere and they got their fingers in every
slice
of the pie. You don't buy this and you'll be kicking yourself for the next five years. More
to
the point, you don't buy this CMGI thing and I'll be kicking you for the next five years."
Flash forward to January 2000; Internet mania has gripped the stock market and CMGI
is
now trading at a split adjusted $163 per share, or up an amazing 10,177% since its IPO,
sporting a market capitalization north of $35 billion. Wouldn't you have loved to get in on
the ground floor of that investment?
Getting in on the ground floor is the secret to CMGI's success and its attraction to
investors.
CMGI shareholders are the envy of all investors and its business model has been
replicated like the "I love you" e-mail virus.
The model, called "incubator," essentially consists of turning venture capital firms into
publicly traded companies. The ultimate goal is for the businesses in its portfolio to grow
large enough to go public through an IPO.
Since many incubators focused their investments on as yet unprofitable
technology/internet companies, the return on the incubators' investment is mostly
dependent upon a successful IPO. A healthy IPO market is the lifeblood of incubators.
And in 1999 the IPO market was flowing like never before. Some 550 companies came
public, up from approximately 220 in 1998. Investors' appetite was insatiable, pushing
some stocks up several-fold on their first day of trading.
The hot IPO market made companies like CMGI, Rare Medium (NASDAQ: RRRR -
Quotes, News, Boards) and Safeguard Scientific (NASDAQ: SFE - Quotes, News,
Boards) some of the best performing stocks last year as buying stock in incubators was
seen as a diversified way to get in on the ground floor of promising IPOs.
Alas, during the Nasdaq Composite's 30% decline since its March 10 2000 high,
incubator stocks have been among the hardest hit. CMGI, at $55.63 is down 65% from
its 52-week high. Safeguard, now $40, is off 60%, Rare Medium has tumbled 80% to
$17.63 while Internet Capital Group (NASDAQ: ICGE - Quotes, News, Boards), which
had hit $212 is currently trading at $37.
The reason for the extreme punishment is twofold. First, the incubators' public holdings
include many of the dot.com companies whose bubbles burst. Second, and more
important in terms of the future performance of this group, is the effect the Nasdaq's
slide
has had on the IPO market.
While 166 companies have gone public so far this year, a 32% increase over the year
ago period, filings to go public have taken a precipitous drop in recent weeks. During the
first three months of the year there was an average of 30 filings per week. That number
has dwindled to about 10 over the past three weeks.
More disturbing is the escalation in the number of postponed or withdrawn IPOs, the
most visible being the twice delayed offering of CMGI-owned search engine Altavista .
A
total of 27 offerings were withdrawn or postponed during the month of April alone,
according to CommScan LLC.
The sober reality is that the IPO mania for Internet companies appears to be over. Steve
Barg, a managing director for UBS Warburg Capital says: "If your company is selling
little
more than an idea and has no profits, you can forget the IPO you hoped would give an
overnight multibillion-dollar valuation." Barg says he has told "a handful of the companies
whose IPOs we were hired to arrange" that they should look elsewhere for financing.
Suddenly investors are exhibiting some discrimination.
Hence, the big sell off among the incubators. As Luke Fichthorn, an analyst with Lazard
Freres, wrote in his March report on Safeguard Scientific: "The deal pipeline is the
critical
catalyst for any internet holding company."
The weak IPO market has not scared away all companies. In the face of the tech
downturn, one incubation company, idealab! filed on April 20 to raise up to $30 million,
with Goldman, Sachs acting as the lead underwriter. It is an Internet focused firm with
stakes in seven public companies, including high profile names such eToys (NASDAQ:
ETOY - Quotes, News, Boards), NetZero (NASDAQ: NZRO - Quotes, News, Boards)
and eMachines (NASDAQ: EEEE - Quotes, News, Boards) and 28 private companies.
So, can the incubators come back? Or are their shares simply souvenirs of what wound
up being simply a great Pyramid Scheme?
The answer: No, they are not scams. However, investors should make clear distinctions
among these companies based on their focus and business models.
In fact, Paul Ryan, chairman of Acacia Research (NASDAQ: ACRI - Quotes, News,
Boards) , an incubation company, who has watched his own stock fall from a high of $59
to its current $18.94 level, views the recent dot.com blow-up in a positive light.
"The incubators that facilitated bringing companies 'just up to speed' to go public will
collapse. The ones that can add true value still represent an intelligent way for individual
investors to participate in the venture stage of companies at a low cost."
So let's start sifting through the rubble and see which companies present the best
investment opportunities.
The drying up of the IPO market, which may last through the summer, actually has a
silver lining. It will force young companies that in the past had been able to turn to the
public markets prematurely to raise money, consider other sources for financing, namely
the greedy hands of V.C. firms.
Michael Ott, co-head of equity capital markets at Deutsche Bank Alex. Brown says,
"We
have been suggesting alternative options [to IPO's] and people are starting to understand
the implications of the correction and are open to rethinking strategies."
This gives the established incubators with deep pockets an upper hand. They will
become the de facto banks. The tightness of available capital will give incubators extra
leverage as the early stage investors to extract more favorable terms from the
companies
in their stable.
Safeguard Scientific and CMGI are head and shoulders above the rest of the
class in terms of available investment capital with market caps of $48 billion and
$17 billion respectively. Their stocks are valuable currency they can use for future
investments and will allow the companies to ride out a weak IPO market. Let's look at
why these two industry leaders are among our favorite investments in the sector.
Safeguard has been operating as a holding company for nearly 50 years. Its structure is
built on an interlocking network of over 160 properties that include eight private
companies, three venture holding companies and an incubator. The companies all look to
cross invest and create a complicated layering of overlapping investments.
Fichthorn's report says Safeguard "leverages its network of private equity funds to build
a
relatively focused collection of companies. It is currently developing and integrating a
network of backbone and Internet infrastructure companies." It forecasts that the
company will make $350 million worth of investments in 2000, up from $250 million in
1999.
In fact, in 1999 Safeguard took public Internet Capital Group (NASDAQ: ICGE -
Quotes,
News, Boards), an incubator itself, which recently decided to specialize in
business-to-business (B2B) e-commerce companies. Safeguard still owns a majority
stake.
VerticalNet (NASDAQ: VERT - Quotes, News, Boards), in turn is Internet Capital's
most
important holding. ICG's tight focus on the B2B market, however, has resulted in a highly
volatile stock. But we believe the company is one of the best ways to play what is
projected to be a $1.3 trillion market by 2003.
We have written about CMGI extensively over the past few years and it has been a
Magic
25 company for two consecutive years. CMGI's roots are in marketing and that is where
it
has focused its Internet investments. Under the Engage umbrella it has been
consolidating the sector and using its various properties, such as Altavista, Raging Bull,
AdSmart and MyWay.com to add value through cross-pollination. While we have looked
at valuing CMGI by a sum of its parts method see recent story we believe this is a
conservative approach.
Acacia Research, another company that we like, came public in 1996 and has recently
replenished its coffers by turning to private placements and partnerships to raise some
$50 million. A good sign is that much of this money has come from blue-chip companies
such as CMGI, VerticalNet and American Express (NYSE: AXP - Quotes, News,
Boards) .
One of Acacia's investments that looks ready to bear some fruit is CombiMatrix Corp., a
biotech chip company that is in beta testing for chips that have DNA and genomics
applications. Ryan expects an IPO of CombiMatrix this fall. Acacia owns 52% of the
company.
Another investment that Ryan has high hopes for is Soundbreak.com, a music-based
website that was launched this past February. The site offers live webcasting and
24-hour
broadcasts of music targeted to college-aged audience. Prior to launch Sounbreak
entered into licensing agreements with ASCAP, BMI and SESAC to protect it from
copyright disputes. This "taking of the high road" as Ryan puts it, seems especially
prudent given the recent controversy surrounding Napster software and has forced
MP3.com (NASDAQ: MPPP - Quotes, News, Boards) to shut its site.
Acacia's strategy is to maintain majority interest in its investments and participate in the
companies' growth. CEO Ryan says, "The post incubation is more important." It recently
hired Michael Mendelsohn, a former Vice President at Disney's Go.com, as the V.P. of
operations for its recently formed Lauchpad.com., a wholly owned subsidiary that will
focus on new investments.
Now that investors have stopped throwing money at anything dot.com, it will become
increasingly important for incubators to be more selective and committed with their
investments dollars.
For this reason we like Rare Medium. The company, which is focused on Internet
marketing and consultation, generates nearly 50% of its revenue from dot.com
companies.
However, it is also an operating company. Its client list also includes Paine Webber and
Microsoft. And Mark D'Annolfo, an analyst with Deutsche Banc Alex. Brown noted its
venture capital portfolio represented only 11% of revenue.
While it posted a loss of $0.05 per share for the first quarter ended March 30 it had
sequential top line growth of 39% and year-over-year growth of 800%. D'Annolfo,
highlighted that "the growth was virtually all organic."
This encouraged him to increase his 2001 revenue forecast by 10% to $175 million. He
now expects the company to turn profitable by earning $0.05 per share in 2001. This
means the company's survival and success are not dependent upon the IPO market.
Bottom Line:
The successful incubators must run successful companies. Meanwhile, the
closing of the IPO spigot will be healthy long-term as investors will have a higher
degree of confidence that the companies that do come public have some
long-term value. And the best way to do that is through incubation companies. |
