for all the market bears out there
redherring.com
Here's the good news...
By Luc Hatlestad
Redherring.com, January 29, 2001
This article appears in the January
30, 2001, issue of Red Herring
Magazine.
After all the hand-wringing and money
spent to avert the Y2K disaster last
year, it turns out the technology
industry was preparing itself for the
wrong catastrophe. April 14, 2000,
turned out to be a far darker day than January 1. But market crashes aren't
what they used to be. Consider this: it might not be so bad after all.
The latest signs indicate that conditions might even be ripe for a renewed
boom (or at least a boomlet) among companies with defensible, patentable
technology in a number of new or growing sectors. And, as has been noted
in many publications (including this one), those companies will have revenue
and profits, not merely the anticipation of profits.
We are not delusionally optimistic. By many estimates, the U.S. gross
domestic product should continue to grow healthily over the next three years,
while inflation should stay relatively flat. And, most economists agree, the
classic symptoms of a recession just aren't evident. Unemployment remains
low. The much-feared credit crunch hasn't arrived, and with banks still
actively lending to their best clients, it shouldn't for now. Consumer spending
is down but still higher than it was during the first five years of the expansion.
If any of this changes, Alan Greenspan and the Federal Reserve Board have
demonstrated a willingness to respond accordingly to ensure a soft landing.
In December, Mr. Greenspan pointed to the fact that three-to-five year
average earnings projections have held firm. Should the condition persist, he
said, it "bodes well for continual capital spending and sustained growth of
structural productivity over the longer term." Another sign that the patient is
alive: private money is still pouring into certain promising sectors, like the
$8.2 billion in venture funds spent on communications equipment companies
in the first half of 2000.
SKEPTICS AMONG US
There are skeptics, of course. Janet Yellen, professor of economics at the
University of California at Berkeley, predicts that technology companies will
experience a much harder landing than the nation as a whole. Stephen
Roach, chief economist at Morgan Stanley Dean Witter (NYSE: MWD),
foresees an economy that slows close to a stall as a result of the Fed
tightening interest rates again, higher energy prices, higher corporate financing
costs, and the realization that there is an IT cycle after all. He predicts a
recession in the event of extreme worsening of any of those conditions. But
even considering that risk, Mr. Roach still gives recovery a 60/40 edge.
Mr. Roach's most useful insight may be the realization that IT has a cycle.
When the boom was in full effect, devotees of the so-called new economy
crowed that one thing IT ensured was a demand for more of it, which would
keep the economy bouncing along in perpetuity. But the crash showed that
consumers and companies can upgrade only so fast -- something the
mid-'90s client/server revolution should have taught (those who expected
massive investment were disappointed: companies took much longer to
invest in the new technology than anticipated).
Even though everyday technologies can routinely do things we would have
called miraculous only a few years ago, daily life doesn't require so many
miracles, especially when they all cost money. Peter Cappelli, management
professor at the University of Pennsylvania Wharton School, says the
technological imperative of making an application, selling it, then making its
successor while the usefulness of the original fades was a fantastic plan
during the boom, but that the strategy no longer flies. "The long-term
question is how many of these successes you can have, and at what pace,"
Mr. Cappelli says. "It wouldn't surprise me at all if they don't come in a
steady stream. We may be experiencing one of those paradigm breaks right
now in which we settle down to a lower need for information technology."
THE STRONG WILL SURVIVE
If we are witnessing a downturn in the technology cycle, the companies
best-suited to survive are those who are bulked up for the capital market's
winter: well-funded, established, profitable companies that are in their second
or third generation of product development -- while developing products in
hot, emerging sectors. This is why the best companies in sectors like
communications equipment, biotech, distributed computing, enterprise
software, and wireless Internet aren't particularly worried (see "Maybe
Boomers").
One such company, Gold Wire Technology in Waltham, Massachusetts, a
maker of router configuration software for ISPs, raised $20 million in a series
B round in September (when times had, arguably, never been tougher for
startups seeking funding). "In a recession, you have a difficult funding
environment," says president, cofounder, and CEO Jonathan Wolf. "So
when there was an opportunity to raise money, we raised enough to carry us
through our business plan and get a cushion." He says the company's
valuation was "attractive," though about 25 to 30 percent lower than it would
have been pre-crash.
Still, Gold Wire is one of the fortunate companies. Compare it with
SkyScout, a wireless ISP for businesses. The company, based in New
York, raised a $1 million seed round from angel investors in early 2000 and
now is seeking institutional investments. Company director of corporate
development Andrew Milgram says SkyScout will need help from the
economy's overseers to be able to sell its story: he thinks that only lower
interest rates will foster investment in his sector. SkyScout will have an uphill
battle, because as telecom carriers struggle to get funding to build
third-generation networks, purchasing the snazzy services that run across
them will be put on hold.
WARILY UPBEAT
Optimism runs a bit higher among the better enterprise software companies.
New York-based Mimeo.com launched its digital document copying and
delivery service in February 2000 with $21 million in funding from
Hewlett-Packard (NYSE: HWP) and angel investors. A new entry in a
strong market, Mimeo.com is the sort of early-stage company that has a
fighting chance to survive a downturn. Cofounder and CEO Jeff Stewart
says although the company has scaled back its branding campaigns, he still
likes its prospects. "I'd be very concerned if we were deploying a new
business model that people aren't already spending lots of money on, and
before April, I'd have been very concerned about new entrants into our
sector," he says. "But given the market pullback, this space is not going to
have a lot of players." For some, then, the downturn was welcome.
The mood is warily upbeat at Arcot Systems in Santa Clara, California, a
provider of digital security products for Internet transactions. It raised a
series D round of $21 million last fall, and president and CEO Chet Silvestri
says Arcot has $22 million in the bank. Still, given the state of the economy,
there's no such thing as too secure. "Financial moods have a way of changing
overnight in ways I could never explain," he says. "But we're clearly the kind
of company that will go public, or we don't want to live in this world."
What sectors hold the most promise? Frankly, ones that are too esoteric and
dense for the layperson to decipher -- biotech, communications, storage,
wireless Internet, and distributed computing. Sectors where massive
expenditures on (usually) infrastructure-related equipment and services for
next-generation technologies mean there's no turning back.
TURTLE VS. HARE
The communications sector has two faces. The good news is equipment
makers will continue to grow as networks are built and upgraded. The bad
news is in services, where the networks can't be built fast enough for service
providers to begin selling profitably. Business software will continue to be a
slow but steady growth sector, but consolidation is inevitable as the myriad
upstart Internet consultants are forced to fold or sell out.
Systems manufacturers with strong penetration in international and business
markets -- IBM (NYSE: IBM), HP, Compaq (NYSE: CPQ), and Dell
(Nasdaq: DELL) -- should weather the storm, but Gateway (NYSE: GTW)
and Apple (Nasdaq: AAPL), which rely heavily on consumer sales, could
suffer. Semiconductor projections are mixed; the sector is slow all over right
now, but communications chip companies could rebound this spring with
renewed anticipation of demand.
Meanwhile, if high-tech has created anything, it has created data, which is
why storage may be the closest thing the industry has to a recession-proof
sector. Take EMC (NYSE: EMC): the company traded in the high $60s
before the correction, split its stock in June, and was up to $90 at press time.
Finally, biotech is the one high-tech area that could ignite another boom. The
genome has been decoded, the sector has never been so well capitalized,
and its research and development arms are poised to explore a wide array of
new technologies and services. No wonder it supports a thriving IPO
market: no fewer than 54 biotech companies went public in 2000 -- after a
mere 14 in 1999. The Nasdaq Stock Market Biotechnology Index is up 46
percent for 2000, and its American Stock Exchange counterpart is up 97
percent.
Though it's hard to comprehend now, the stock market crash was a good
thing. It reined in our "irrational exuberance," it's beginning to illuminate which
companies and technologies will truly change the world, it proves that
markets work, and it shows that the best companies no longer will have to
compete with publicly listed experiments that could never turn a profit. As
U.S. Treasury Secretary Lawrence Summers says, "The essence of
understanding capitalism is to recognize that the interest is not in the survival
of particular capitalists, but of the system of capitalism. The most sclerotic
economies are those where there never are any shakeouts; there never is any
competitive pressure where failure is not a possibility. While shakeouts are
painful, they set the stage for redeployment of resources for more productive
uses in the future."
Reporting by J.P. Vicente, Eric Moskowitz, Justin Hibbard, Michael
Copeland, Scott Tyler Shafer, Mark Chediak, Christopher Locke,
Ronald Recinto, and Stephan Herrera. Write to
luc.hatlestad@redherring.com. |
