For VCs It's Deja Vu All Over Again

It seems like the Venture Capital (VC) sector has just emerged healthy again from the tech bubble, when now it faces a potentially greater challenge as it deals with larger systemic financial problems. A Survey done by the National Venture Capital Association (NVCA), and reported on by the Associated Press, paints a bleak portrait for the next several quarters.


During the period of 1998 to 2001, Venture Capital was investing in "new business models" associated with the emerging information technology economy. Investment decisions were clearly flawed by greed and speed and a lot of dubious business concepts were funded. Everyone has heard the legends of multi-million dollar investments made into business plans drawn on the back of paper napkins.

I'm not so sure about the legends, but one thing I am more certain about is that there were some pretty important business models that have emerged from that period. Some models that were expected to be dominant became fairly minor relative to some surprising ones. Most of the big bets were placed on e-commerce because everyone was going to buy online. People definitely buy online, but not at the rate expected - and a lot of investments went bust. Remember trading networks? A lot of capital was placed on this model, and it never really materialized. Whoda thunk that the Cost-per-Click (CPC) ad model would be the single most valuable revenue model of the information economy? Investors in Google (GOOG-Q) got it right. I remember the buzz surrounding the Application Service Provider (ASP) model. Although the details of that business model may have been flawed, it has spawned some key variations such as Software as a Service (SaaS), which may be a model that ensures survivability for many software companies during this brutal economic period. The bottom line is that, although the VCs made some dubious investments, the era spawned a bunch of tough-as-nails tech companies with cashflow, earnings, visibility, and , frankly, a lot of happy investors.

The ASP model itself could be considered an ancestor of Cloud Computing which many, including myself, believe could be a foundational element to IT innovation when capital budgets are tight. And according to the NVCA survey, there is likely to be very little IT venture funding to go around for a while. As VCs continue to deploy a greater share of increasingly constrained capital towards cleantech, venture investments in information technology should decline. According to the survey and in my opionion, easily commoditized high risk technology like chips, firmware, and hardware should experience challenges, along with consumer facing innovation in media and entertainment (I think that social networking fits into this category).

From an IT perspective, innovation in mobile technology should continue to receive VC funding, as well as infrastructure plays that improve efficiency. Storage, virtualization, security, and network capacity should be general categories that may continue to attract VC capital. Although most capital is likely to be follow-on investing.

In general, start-up funding should be increasingly difficult to find throughout 2009. Entrpreneurs probably need to find ways to bootstrap and self-fund. As a result, we should see a few more greybeards with previous success among the next crop of upstarts. I think that we may have seen the last of the 25-year old billionaires for a while.

The NVCA survey infers that VCs are likely to try to fund more established IT operations with cashflow and scale that are cheap. There is not much venture in that capital. I think that VCs will struggle to compete with Private Equity funds and even some of the junior public indices for these type of deals.

Again, I believe that public companies with cash on balance sheets and liquid stock should be in great position to gobble up some pretty good venture enterprises cheaply, as VC capital dries up. Where there is pain, there is opportunity.


Delta Airlines (DAL.NYSE) Inflight internet plans and Guestlogix (GXI.V)

Yesterday, Delta Airlines announced that it has launched inflight internet access on a few east-coast shuttle flights with AirCell's GoGo Inflight Wi-Fi Service. According to the linked article below, Delta is planning on completing the roll out of this service to its entire fleet, including Northwest, by sometime in 2010. It is quite the commitment, including some rewiring of a plane.


The other beneficiary to this commitment by Delta Airlines is Guestlogix (GXI.V). According to the release, passengers are required to pay $9.95 for unlimited access on flights less than 3 hours, and $12.95 on flights more than 3 hours. According to Management at Guestlogix, its Mobile Virtual Store will be used by Delta to execute the financial transaction and invoke access.

Guestlogix has deployed its onboard retail network with Delta Airlines, American Airlines, Southwest Airlines, GermanWings, AirAsia X, and Saudi Airlines among others and receives a percentage transaction fee for every onboard retail transaction. It has a backlog that includes airlines such as Westjet, US Air, British Airways, and Ryanair among others. Guestlogix has integrated its retail systems with Thales onboard entertainment systems, and has a distribution partnership with logistics monster LSG Air Chefs.

I think that there are a couple key points for consideration. First, the increased transaction volumes and higher valued transactions should help to increase high margin revenue for GXI beginning in 2009. Second, the integration between AirCell and Guestlogix is interesting. Both Companies are heading towards dominance in their respective niches, which likely creates some future partnership synergies.

Guestlogix continues to be a high growth story defined by rate at which it can roll-out its platform to airlines and rail carriers worldwide, then by the scope of merchandise that it can transactthrough its platform. Last quarter, Management claimed that its solution was available on flights serving nearly 220 million passenger trips worldwide, and that it had nearly 700 million flights under contract, inferring that well over 400 million passengers trips were still to be rolled out.

There continue to be timing risks on deployments and I expect that the Company should perform to approximately $20 million to $22 million for 2009, up from a forecasted $11 million this fiscal year. I think that we may see the Company post a breakeven quarter for Q4 2008, with consistent earnings growth throughout 2009. Investors could see between $0.07 and $0.10 EPS next year, depending on the timing of roll-outs and the cost of equipment lease facilities. Regardless, GXI.V remains a solid early stage growth Company with a chance to become dominant in a niche. Although there are 7 to 9 analysts that cover the story, investors do not seem to care because the stock has been trading at $0.50 range for an extended period of time with little volume.

I do not own shares in GXI.V, nor do I receive compensation in any way from the Company.


Mobile Subscription Trends - WSJ article.

Yesterday, there was an article on the WSJ website that identifies the trend of people switching from post-paid subscriptions to pre-paid subscriptions.


This is a trend that I see could strengthen throughout 2009, and it is a concept that I attempted to encapsulate in a previous post on November 28th. I referred to the trend as "downchurning". Carriers with large post-paid subscriber bases risk losing customers to pre-paid carriers as financially stressed people switch to lower cost pay-as-you-go services. This trend should benefit Companies like Virgin, along with pre-paid payment networks like Euronet, Blackhawk and Vendtek Systems (among others) that support POSA (Point-of-sale-activation) and top-ups.

Hard card retailing should increase, although the profit margins should be stressed by increased crime related to "shrinkage" or theft. A box of pre-paid cards the size of a business card holder could be worth thousands of dollars. We should see more electronic distribution as a result.


Tech is Cheap; Do Something.

I would like to take this opportunity to link a blog post by Mark McQueen.


Mark has identified a handful of the Companies that intersect with my view of the top 30 and the top 80 stocks on the Toronto Stock Exchanges. Typically, the top 30 are companies with cashflow, excess cash and projected earnings growth (even in these markets). The remaining stocks are not cashflowing but are close and have oodles of cash to execute plans (even in these markets).

Mark is right. There are dozens of small cap and microcap companies with great assets, great technology, and great skills that are essentially valued at next to nothing. Another enigma is Grey Island Systems (GIS.V), a profitable telematics operation with no debt that, depending on the day, trades near or below cash value.

Smart CEOs with cash and a little moxy should be making some buy versus build decisions and bulk up as the world economy exits from this recession as a very different animal. Really ballsy CEOs may be seen divesting resources from R&D and investing resources in M&A. Why build something when you can buy it at a fraction of the expense? On the flip side, there are probably over 100 tech CEOs who should be working with their Boards and key shareholders right now to repair operations and maximize asset value for roll-ups and mergers. See my previous post.

I do not own shares in Grey Island Systems, nor do I receive compensation from the Company in any way.


After chaos; a new stasis with big implications for small cap.

The world economy is gyrating through a chaotic period, out of which should emerge a new stable complex; a new world economic order so to speak. And I think it may look a lot different than the one we are currently exiting. Here are some things that I think will be different based on some conversations that I have had with people close to capital over the past few weeks:

Risk is being recalibrated; destroying liquidity for small cap stocks – By their nature small cap and micro cap stocks are defined by their above average or speculative risk ratings by analysts. In a market where there is limited volatility, professional investors seek out higher risk/higher reward investments where they can benefit from imperfect information and market inefficiencies. Often, small cap portfolios have vastly outperformed the indices. Over the past 20 years, fortunes have been made as fund managers, and retail investors, have made bets on small cap growth stocks, and won. With the disappearance of many hedge funds seeking alpha, the market for small and micro cap stocks has largely dried up. Remaining investors are fleeing to “quality stocks” which are Companies with low beta, and low relative risk. In fact, many investors currently find equity altogether too risky and are fleeing to the bond market.

Equity risk capital is becoming scarcer for expansion and growth– As the world economy ultimately begins to recover (many call for the 2nd half of 2009), between $15 and $20 trillion dollars worth of wealth could be destroyed in the financial markets since August of 2007. This represents between $2000 and $3000 for every man woman and child on earth. One of the reasons that the VIX chart is at historical levels is because there is less equity capital and fewer parties trading stock then there were only 1 year ago. It’s like boiling water; when water level is high, the boil seems less violent then when water level is lower. As capital becomes scarcer, stock trading becomes less dense, but more focused on only a few stocks. The volatility scares away capital. Skittish equity capital is much less likely to fund growth and expansion, which is essential to many small cap and micro cap stocks. CEOs are going to need to focus on other ways to fund growth and expansion if they are not cashflowing or if balance sheets are not solid enough to self-finance.

A period of major consolidation for small caps- Without cashflow or balance sheet strength, many microcap and small cap companies are likely to consider being consolidated into larger, stronger entities. It appears that approximately 20% to 25% of small cap companies have adequate balance sheets to fund growth over the next period of time. Those with weak balance sheets and a distance to cashflow will need to conserve cash through restructuring, selling assets, or merging operations with larger players with cashflow and/or stronger balance sheets. For example, of the 260 or so small cap and micro cap technology stocks listed on the Toronto exchanges, only about 60 to 70 have adequate cash to execute plans. Only about 30 stocks have excess cash and consistent cashflow. These Companies are likely to emerge at the top of the food chain among small caps, although they will still not attract liquidity if they remain small.
Size Matters: Even among the top 30, it is likely that they will not have enough scale to attract enough liquidity to increase shareholder value any time soon. Acting reasonably, Managers should look at leveraging their position to consolidate smaller or complimentary operations. Their goals should be to gain the attributes of mid-cap stocks.

Share Price Does Not Matter Right Now- Almost all small caps are down by 50% to 60%. Share buybacks are akin to throwing money in a hole – in the end, if there is no business scale, it won’t matter how many shares are outstanding. Forward-thinking CEOs are using shares to acquire for scale because, for the most part, dilution is relative because all shares are depressed. When the chaos has subsided, with limited equity capital remaining in the market, scale and profitability will be the major attributes sought by investors as they return to the equity markets.

Cashflow Matters- Managers of small cap and micro cap enterprises need to accelerate towards cashflow by cutting expenses while focusing on only what is profitable. Unless self-financed, investments in innovation should, unfortunately, be delayed. Since the tech bubble, analysts have been enamored with recurring revenue stream models for good reason. With long-term contracts, minimum guarantees, and consistent monthly revenue streams, Companies are better able to maximize cashflow potential in a recurring revenue business model. These Companies are highly attractive to consolidators as well.

Cut Losses- CEOs with cash burn and dwindling reserves should take a hard look at assets and preserve shareholder value by considering asset sales, or distressed mergers. This is painful and demoralizing for many entrepreneurs, but as the new world economic order emerges, there is likely to be a serious gap in venture funding for many quarters to come. Responsible managers should consider preserving some shareholder value.

Adapt or Die- Within the Canadian tech sector, there is a possibility that a significant number of venture listed public Companies could simply disappear over the next year or so. The good and the lucky are likely to be acquired or merged, others will be forced to wind down and sell assets. Regardless, it will be a different environment for small cap and micro cap equities by the beginning of the next decade. There are likely to be a lot fewer listings, because many could be taken private, some merged into larger entities, and others simply go out of business. I continue to hear about Management teams of microcap Companies demanding 10x EBITDA or up to 2x sales for their businesses. Reality is likely less than half that – adapt or die.

The Tech Sector Advantage- The tech bubble toughened up the survivors. Notwithstanding the echo chamber that is now the small cap sector; many small cap technology companies have strong cashflow, emerging cashflow, or strong cashflow potential in relatively short order. There are a lot of solid companies among the carnage that, with a few effective moves, can create long-term shareholder value.

A New Era of Innovation- As all of this tumult unfolds, scores of very talented people will be laid off. Without the layoffs of the 1991 recession, we would not have seen the talent available for the myriad of startups in the 1990s that helped spawn some of the giants of our generation like Google (GOOG-Q), Amazon (AMZN-Q), and Yahoo (YHOO-Q). A decade from now, we are likely to see a new breed of giants that were germinated in 2009.

I do not own shares in any of the Companies mentioned above, nor do I receive compensation in any form from the Companies mentioned.


Canadian Politics: Whose hijacking Whom?

"I cannot have confidence in a prime minister who would throw the locks on the door of this place, knowing that he's about to lose a vote in the House of Commons. That's denying about as fundamental a right as one has in a democracy." Jack Layton

Yeah, right Jack. And creating a backroom coalition designed to deny an elected government the ability to govern immediately after it has been voted in by the people is a bastion of democracy. It may be constitutional in a parliamentary democracy, but it it certainly cannot be viewed as democratic. Jack, niether you nor Stephane Dion can claim that you have even come close to earning the honour of leading a government with each party earning below 25% of the vote.

Theoretically, Canadians vote for the party and not the Prime Minister. Theoretically. In reality Canadians cast their votes based on who will lead parliament. You are crying wolf because the Conservatives are not providing enough stimulus for the economy. How disingenuine! The Conservatives, and the Liberals before them, have spent the past decade putting the Canadian economy in a position of strength for inevitable recessions. The Canadian economy is in better shape than any of the other G20 countries as this recession deepens. And the Conservatives have stated all fall that they are about to spend to stimulate the economy. Despite voting confidence for the throne speech a week earlier, you have decide to take over government a week later because it wasn't planning on spending enough to stimulate the government - even though the budget was not to be released until January.

Jack, what you and Bob, Mike, Stephane, and Gilles are really pissed off about is that Steven Harper poked you in the eye by attempting to turn off the party subsidy spigot that you so much rely on for campaign financing. This is why you want to overthrow the government. Oh yeah, and I forgot that whatever CUPE wants, you want too. And when CUPE is potentially denied to the right to hold taxpayers hostage every three years or so, that makes you want to overthrow the government.

Steven Harper pulled a boneheaded move. It was arrogant and overly partisan to shut off the spigot. Your reaction is worse.

I hope that there is an election in January. At that time I bet that the voters will demonstrate what they really think about this move. And the Conservatives will run away with a majority.

Yeah, Jack. You are are a pillar of democratic procedure. But do you really care about the democratic will of voters? Errr...not so much.


Nokia (NOK-NYSE) has reduced outlook.

Errr...see my two latest posts, I think that Nokia is seeing the market conditions playing out as I postulated earlier this week.

The question now may be how long will this last?

I do not own shares in Nokia, nor do I receive compensation from the Company in any way.


RIM miss should not surprise.

This morning RIM (RIM-TSE) reported that it sold 300,000 units less than analyst expectations of 3 million.

Its a pretty big miss, but it should not surprise investors for the following reasons:

1. RIM and Apple (APPL-Q) are relying subscriber upgrades from regular cellphones to smartphones. In uncertain times, people are slower to make those decisions. The mobile subscription is essential; the latest and greatest handset is not.

2. RIM has lost a significant buying group. The financial services sector has been one of RIM's major customer segments. With the loss of hundreds of thousands of jobs, mergers and consolidations, this previously lucrative market cannot be relied upon to drive device sales, or BES server sales.

3. For similar economic reasons, RIM's entry into Europe and Asia should not be as explosive as originally expected. Although everyone seems to have a mobile device, fewer businesses or consumers are likely willing to spend the money to switch from their cheap and cheerful (mostly Nokia) devices to the more feature-laden RIM smartphones.

I expect to see dissapointing unit sale results from RIM along with Apple and Nokia (NOK-NYSE) for the next couple of quarters. Until US consumers feel confident enough to buy bling again, sales of the latest smartphones are likely to disappoint. For long-term investors, it should be noted that, despite reduced short-term performance, these three vendors are likely to consolidate their market dominance coming out of the recession. I suspect that the share price for RIM could be at multi-year lows for the next few weeks, which would be a good entry point for those who like the story, but couldn't swallow an $85.00 shareprice earlier this year.

As per my last blog entry, look for carriers to:

1. Maintain subscriber bases with lower churn rates.
2. Disappoint on growth in data services (related to lower smartphone growth)
3. Disappoint on migration from 2G to 3G networks.
4. Slow down investment into FTTH and FTTC initiatives.
5. Begin consolidating wideband and broadband wireless infrastructure.

Bottom line, unlike device manufacturers, many consumers are tied to long-term subscriber contracts, and those that are not, are prepaid and, due to economic conditions, are not likely to switch. Downchurning is the biggest risk, where post-paid consumers are no longer able to manage subscriptions, and need to move to prepaid services. One can anticipate that this is the major churn risk for carriers.

Due to credit constraints, and balance sheet caution, we should see a decline in the big capital intensive upgrades to the carrier networks in the short-term. The future of network upgrades is likely linked to President-Elect Obama's stimulus packages. If Internet is included (as it should be) in infrastructure related stimulus packages, then carriers are likely to go forward with plans.

See my previous post.

I do not own shares in any of the Companies that have been mentioned in this post, nor do I receive any compensation from these Companies.