In the Windows vs. Linux showdown, it’s all about other

Posted on November 29, 2007
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The always anticipated IDC Worldwide Quarterly Server Tracker factory revenue numbers were released November 29. This batch is for the period ended September 30, 2007.

In the numbers, Windows-based server shipment revenue crossed the 40% threshold for the first time. But despite conventional wisdom about a battle between Linux and Windows, Windows gains over time are at the expense of “other,” basically the mainframe. Unix/Linux-based system factory revenue maintained its overall market-share leadership at just under 45%.

The calendar 3Q 2007 results for Unix/Linux were 8% higher than the same quarter a year ago but last year’s quarter was most likely an anomaly. As shown in the column-chart below, calendar 3Q 2006 was the low point over the last two years by two or more percentage points of share. Research 2.0 believes calendar 3Q 2006 results were depressed by the then anticipated release of new servers optimized for Unix/Linux.

It appears from almost two years of IDC data that the Unix/Linux share of the market is stabilizing in the 40-45% range. The major question is how quickly Linux systems will displace Unix (for more on that issue, see my analysis at ebizQ.net).

That’s the market chunk that Red Hat (RHT) is aiming at with its recent announcement that it plans to “own” 50% of the server market by 2015. It is the mothballing of a lot of Digital UNIX, AIX and HP-UX systems that make that objective doable but it will require perfect execution since Red Hat will need to grab a piece of “other” as well. That’s why Red Hat sees its products becoming a mainstay on the mainframe as well.

Also as noted when the calendar 2Q server shipment numbers came out of IDC, Windows also continues toward the 50% of sales mark formerly held by UNIX and MVS at different points earlier in this decade and in the 1990s. In that sense, there is a Windows-Linux battle on the horizon; it’s just a few years away and its all about “other.” Of course Red Hat does not have the lock on Linux shipments that Microsoft has on Windows shipments so its shot at the 50% threshold will be more difficult. — Dennis Byron
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Struggling with Memory

Posted on November 27, 2007
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It’s no secret that memory supply/demand forecasts are not positive for the DRAM and NAND players like Micron (MU) and SanDisk (SNDK.)  At these levels most analysts are pointing to a bottom in these names and a chance to buy them into an improving supply/demand balance which brings better pricing and improved earnings for these companies.

The problem that I have with this line of reasoning is that everyone knows that the industry balance is fragile and very cyclical.  There was a time from 1992 to 1995 where memory (and semiconductors in general) were said to be growing based on secular demand trends.  This propelled earnings and the stocks to huge and sustained gains.  There may have been a little price fixing around this period but we’ll let that one go.

Since then it just seems to be very easy for companies in increase supply when prices look like they will be slightly attractive.  A holder in Micron stock would actually be down today versus the price paid anytime in the last 10 years.  So where is the secular growth story here?  Lots more bits are shipped every year but at an every declining price per bit. 

The commodity run has investors saying that maybe memory will work this way too since we aren’t adding to capacity at these prices.  This parallel is problematic in part because one has to discover sources in commodities and the costs and lead times required to deal with the physical and hazardous extraction and processing are fairly high.  While a brand new fab is not cheap, there seems to be plenty of capacity for increases in production by starting up or adding new lines.

SanDisk at least has evolved into a memory company with a consumer retail facet and trades at a much higher multiple of sales than a pure commodity producer like Micron.  However the same logic about better supply and demand applies here.  Even if everyone is right and SanDisk has a big December quarter due to higher revenues and slightly better margins, nobody will think it can be sustained so the multiple stays low and the stock appreciation is limited.

If the commodity producers don’t have strong pricing power then the argument favors the branded device makers like Apple, Research in Motion and even Dell over the component suppliers.  If memory is cheap it also helps move units and provides software makers like Microsoft very favorable revenue and margin dynamics that are more sustainable.

We welcome arguments to the contrary but we haven’t owned Micron since the mid-90’s and have been tempted by SanDisk but always scared off by what seems to be the same long-run truth about the memory business.

– Kris Tuttle

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A Demon of our own Design

Posted on November 16, 2007
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The book by Bookstaber won’t provide much additional information if you are already familiar with most of the major leverage-driven derivative trading events in recent history.  However Bookstaber provides a very readable overview as someone who was there but one step removed from the inner circles.

Towards the end of the book he makes an interesting point.  Starting with Godel, Heisenberg and Lorenz (bravo!) he moves into a discussion of biological methods for dealing with risks that are unknowable.  What comes out is a powerful reminder that the right designs for dealing with *known* risks often come at the direct expense of being able to deal with *unknown* risk.  This helps to explain why one set of regulations often leads to another different crisis, followed by a new set of regulations and so on.

Lastly there’s a good quote about research we have to include here for future use.  "There is no reason to think this exercise of tearing apart the accountants’ aggregation (10Q’s and the like) and then trying to re-aggregate it into a meaningful form can be successful.  And it certainly is not the ideal.  The ideal is not to take something that is pieced together incorrectly and then redesign it; the ideal is to start with the raw materials, the actual transactions themselves, and build from there. For example, beyond the standard accounting numbers, statistics that might be helpful for companies with non-tangible assets are the cost of acquiring new customers and the retention rate for those customers - think of the insight these would have provided into America Online (AOL) in its years of burgeoning growth - sales backlog, contracts received versus proposals made, training expenditure per employee, revenue from new products compared with revenue from old productions, the proportion of business that is done with existing customers, and the time it takes for a new product to recover its development cost." A Demon of our own Design, Richard Bookstaber, p139.

Bookstaber may not realize that most fundamental equity research looks at precisely these sorts of things but it’s still not the rule and sometimes people who know better forget.

– Kris Tuttle

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Big Opportunity Looms in Apple Support

Posted on November 15, 2007
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We’ve had three hard failures recently in getting timely Apple support to hardware malfunctions and some Apple-induced support needs.

In any high-growth situation the need for support often spikes up before a company can adequately address it which is the case with Apple.  They also have little experience in handling corporate or business customers so the notion of escalation procedures is still foreign.

The latest examples range from simple to complex.  In one case a broken AC adapter for a MacBook Pro was not in stock anywhere in France.  There are no Apple stores there yet (not even Paris) and the retail "partners" don’t bother to even sell many add-on or replacement parts.  Because the Apple AC adapter is unique, none of the myriad of PC adapters could substitute.  Oddly there were none to be had in the Cambridge MA store in the US either.  There was one available in the *state* which was air shipped to France.  Net wait time for this was one week.

Secondly Apple has buried the news that their microcode update V2.1 for MacBook Pro models disables aspects of the SuperDrive.  There is no fix as of yet other than bringing your machine in and having them ship it somewhere to replace the drive.  In the US this is a few days of downtime.  In France it is 10 days.

Lastly and perhaps most oddly there is a bug in the online battery recall system that prohibits valid addresses from being accepted.  Again this is a situation that Apple caused rather than a customer request.  An Apple store manager cannot help but they can give you an 800 number.  That results in numerous conversations and an hour or two on the phone to figure out how what to do.  We don’t know the time needed to comply with Apple’s needs yet on this one because it’s still an open item.

Most of this can be ascribed to growing pains but we did have similar experiences with Dell (before we stopped doing business with them.)  Dell however has a small business program that knows how to fix problems for people that depend on their computers. 

There is something disturbing about the way Apple tries to cover up mistakes and silence customer forums on known problems rather than responding to them.   Customers who experience this certainly question their long-term view of Apple as their favorite technology supplier.

Fortunately for them the world still drools over their latest technology and wants to buy it.  This probably means that there’s a great opportunity for someone to solve some of these problems for them and execute a profitable business plan.  Businesses need and will pay for support.  You’d think with Apple prices one would get this but it’s not the case.  Not with AppleCare or any of their add-on programs either.

– Kris Tuttle

Disclosure: We have no position in Apple at the time of this writing but we do have positions in RIMM and MSFT for completely different reasons.

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Playing with the fire at E*Trade

Posted on November 14, 2007
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We had a small position in E*Trade which we initiated last week in part due to agreeing with some of the long-term conclusions put forth by Bill Miller at Legg Mason in is 3Q letter to shareholders. 

E*Trade was doing what many were doing in the mortgage business.  Based on a credit score alone you could easily get a mortgage with no documentation, no appraisal (other than a supposed "drive by") and very low fees.

E*Trade has been in crisis mode before and one of our larger clients bought a huge position. His analysis suggested that the replacement value alone for their technology platform was close to the total market capitalization at the time. 

The problem now is that it is impossible to know to what extent the value of E*Trade could be impaired by the risk in the banking business.   When Enron collapsed a day of research would show that the company actually had no real assets to use to support a stock price.  In our view E*Trade has clear value in their platform, their customers and capabilities.  In fact we don’t think there is any way E*Trade is going to disappear but there could well be a re-capitalization and/or merger with another player. 

On the question of customer panic and business impact we think there will be some.  Trolling the online reactions there are clearly many individual investors who will switch their accounts to other brokers like TD Ameritrade and possibly shift their banking to places like ING or even regular full service banks.  This is true even though there really isn’t any risk for most account holders but many people get emotional about what they read in the newspaper.   Unfortunately having "possible bankruptcy" all over the news and watching the stock plummet to $3 creates alarm and concern that will probably cause customer and asset shrinkage in the short term.

Research 2.0 acquired a substantial position in E*Trade stock yesterday.  It’s probably not going to go up in a straight line and the immediate 40% rise will certainly lead to some near-term profit taking.  However it’s likely that we will continue to own some position in ETFC even after today.   If the company can get through the crisis as an independent the stock could certainly be worth $10 to $15.  If the problems are not surmountable the company will be absorbed but equity holders can’t be certain to profit from these levels due to the fact that additional capital infusions might be needed.

– Kris Tuttle

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Sometimes it takes fundamental research a long time to work.

Posted on November 14, 2007
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Way back in 2002/2003 one very senior analyst that will remain unnamed was very impressive but just outside of what we could afford to pay in compensation.  When asked about  best ideas he made a compelling and high-conviction case for Nektar which at the time was trading for around $18 and he insisted it would be $30+ inside a year.

Another very different analyst named Richard Yeh was quite young and inexperienced.  But he was smart and hard-working.  As was typical for less-experienced analysts he was asked to do some research work and present his findings.  We asked him to research Nektar and to look into the whole Exubera idea and process to see how it might play out.

Over a very nice dinner at Aqua in San Francisco and we talked about what he had learned.  Not knowing the answers himself he managed to track down the scientists who had pioneered much of the fundamental research ideas regarding the process in general and some of these molecular pathways in particular.

Although the precise details are a little faded, one thing was clear, in the opinion of the most expert of the experts, it wouldn’t work.  After listening to the science behind it was pretty convincing.  At least enough to avoid investing in Nektar. 

Since 2003 NKTR traded between $15 and $20 and sometimes made a run towards $25.  Starting in 2007 the stock marched down from $15 to the current $6 as the reality of a non-working Exubera penetrated the market. 

It’s not an area we know enough about to have shorted the name but now that the wheels have come off it’s a vivid reminder of Richard’s spade work and that capital-preserving dinner. 

– Kris Tuttle

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What do IBM and Microsoft do when Oracle has a captive audience?

Posted on November 13, 2007
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When I did software marketing back in the day, user group meetings were not major events. The key information-technologist and IT-staff meetings of the year were the spring and fall ACM/DPMA/IEEE/etc. “Joint” conferences in the 1960s followed by the annual National Computer Conference (NCC) in the 1970s and—in the 1980s—the geeky tradeshow that probably single-handedly drove the mob out of Las Vegas, Comdex. From a marketing perspective, every IT supplier was on a level playing field in trying to get the attention of the press and prospective customers.

Beginning in the 1990s, smarter software marketeers than my generation’s figured out it would be much better to deal with a captive audience of already committed customers. Thus IT suppliers began to put the full court press on their own user conferences and the great all-comer IT trade shows faded away.

I noticed today that that idea has lead to another marketing technique. Rather than give the company holding its user conference the entire weekly news/blogger cycle, which this week could have been Oracle’s (ORCL) with its OpenWorld beginning November 12 in San Francisco, the other guys’ PR folks try to come up with a news blast that can’t be ignored. Hats off to IBM (IBM) with its proposed purchase of Cognos (COGN), announced on November 12, and Microsoft (MSFT) with its November 12 rollout of Windows Server 2008 details. Of course, IBM would say that they could not control the timing of the release of the Cognos deal once it was signed and Microsoft is holding its European TechED in Barcelona this week.

So the question is does Oracle have any news blasts itself to counter the IBM and Microsoft efforts? Based on Charles Phillips kick-off keynote, the answer is a resounding “maybe.” In addition to the usual platitudes about market and technology leadership in the various segments of its business (database/middleware and applications) in his keynote, Phillips joined with the “new” head of all Oracle development, Chuck Rozwat to demonstrate some mildly interesting new products. (With John Wookey’s recent demotion/departure, Rozwat now moves into a spot at Oracle that has about the half-life of a baseball manager’s.)

To kick things off, the pair demonstrated:

The show goes on all week at Moscone and there maybe a news blast buried somewhere. In terms of investment potential, unless Oracle uses the new Enterprise Manager functionality to more directly take on BMC (BMC) and CA (CA) or the VM product to be more aggressive in its Red Hat (RHT) Linux program, this week’s PR battle looks like “advantage” IBM and Microsoft.

–Dennis Byron

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Ahhhh… Correction

Posted on November 9, 2007
Filed Under Companies, Markets & Finance, Software, Technology & The Web | 2 Comments

Nice to see some of the froth blowing off.  Fundamentals still look solid so it’s a good opportunity for shifting positions around.

One new short idea we see that hasn’t gone down with the market is Constant Contact (CTCT).  It’s held up very well at $24 post their IPO and we are looking forward to the new supply coming once the lock-up comes off.  (The date is 11/11 and the shares coming off are 15M+)

A few numbers will help. The company just reported and guided 2007 to $50M and 3M EBITDA (they lose money) and 2008 to $82M and 4M EBITDA.  (These numbers are mid to upper range.  See the press release for details.)  The customer account expanded to about 145,000.

With a current market cap of $665M we are puzzled.  If we were buying this company we would put a price of about $60-120M on it and feel pretty fair.  This is email after all.  A bit of a pain but not a revolution.  There are almost no barriers to entry and CTCT focuses on the SMB market where a switch can happen overnight without pain.

Doing some math it’s clear that the stock is well over 100x EBITDA and trades at $4,500 per customer.  I’d expect it would be cheaper to go get them again at $1000/per.

The company appears to serve a purpose, is well meaning, has good products, nice growth, good backers and we think email has a future.  However at these prices the stock doesn’t make sense.  If we were an LP in this one we’d be going right to the "sell all at market" box on the decision form.

Since the company doesn’t make money it’s hard to say where we might cover.  At some point investors will not be willing to sell shares but that level would probably be in the teens as a starting point.  If you use the math above the shares are worth $3-4/share.  They won’t likely get there but $24 is far above value.

Disclosure: Research 2.0 is short CTCT.

– Kris Tuttle

Beware OSS propaganda when researching investments

Posted on November 6, 2007
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Investors beware: there is an increasing drumbeat of propaganda in the software blogosphere about providers of open source software (OSS) such as Linux overtaking the leaders in the software and information technology (IT) markets. Like all good propaganda, there is a hint of truth to it but those hints have only minimal or secondary implications to investing in the software industry. This recent CNet blog post is a good example; it cherry picks Saugatuck, Gartner/Dataquest and IDC data to imply that OSS pure plays are a major growth opportunity for investors. It was—surprise/surprise—written by an “OSS pure play” marketing executive. A recent press release from a group called the Federal Open Source Alliance is another example; it touts a U.S. Government “referendum” in favor of OSS. The survey was conducted by the ad agency of the pro-OSS group that—surprise/surprise—discovered the favorable pro-OSS results.

OSS bloggers such as IBM (IBM) software executive Savio Rodrigues at InfoWorld have tried to counter the propaganda. But of course, he’s an IBM guy so what do you expect? I, on the other hand, have no dog in the fight and have been analyzing the kind of data that underlies the OSS propaganda for 20 years. I have done extensive research into the OSS development model and market dynamics for IDC, Research 2.0, and ebizQ.net. Before that, I successfully helped create IT propaganda. I know how the game is played from both sides and I think Savio is right.

First, I have found that OSS is having a major effect on reducing the R&D expense budgets of existing leading software suppliers such as IBM (IBM), HP (HP) and Oracle (ORCL). So OSS is a good thing for those investing in these leading software suppliers.

Second, I think there is a 50/50 chance that one supplier that began as an OSS pure play will make it into the ranks of the leading software suppliers. Research 2.0 will be happy to consult with you about which OSS supplier we think it might be.

Third, I think OSS will possibly (less than 50/50 chance) be a major driver in populating services repositories. Tens of thousands are needed to make the service oriented architecture (SOA) concept favored by Novell (NOVL) and Red Hat (RHT)—as well as the suppliers mentioned above and below—succeed. This possibility, including the OSS implications, must be watched by anyone investing in SOA.

Fourth, the jury is still totally out on whether OSS will disrupt the very large revenue flow associated with subscription maintenance of software. This might happen if OSS is of such high quality that it doesn’t need such maintenance. But it would only affect smaller software suppliers because the leading software suppliers are now also the leading OSS suppliers. IBM, Oracle, and so forth have become hybrids that offer OSS terms and conditions relative to source availability and distribution rights right along with their traditional Ts&Cs.

Fifth, if OSS does disrupt the subscription maintenance revenue flow, it might also hasten a trend in which IT is more about enabling business and consumer services than a major subject for investment research in its own right. But a “back to the future” movement to such services will happen with or without OSS. Microsoft (MSFT), SAP (SAP) and many others are actively pursuing that opportunity and are only peripherally interested in the OSS drama.

OSS is really about a culture and how software is developed. The above five points summarize the important but basically peripheral implications of OSS in investment research. Although Savio’s too nice a guy to say it, I can tell you the rest of the OSS pure play propaganda about its investment implications is outrageous claptrap (I don’t think I can say b——t on a family Web site). Before you angel invest or venture fund an “OSS IPO” or before you bet your company’s treasury on an “OSS acquisition” remember that you are being claptrapped.

–Dennis Byron

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RIMM and Microsoft get more interesting…

Posted on November 5, 2007
Filed Under Companies, Markets & Finance, Software, Technology & The Web | 1 Comment

We have already writ large our appreciation for the under-appreciation of the investment community for Microsoft’s prospects.  With the stock at $37 maybe it needs time to rest before a sustainable move into the $40’s.

Although RIMM is not a stock we have followed it has been added to our Cloud Computing Theme group in part because of their new product offering that finally addresses the huge market in between the large enterprise where RIMM has long held sway and the individual consumer.

Small businesses can now get the RIMM offerings in bite-sized pieces starting at 5 users.  Also of interest to our positive outlook for Microsoft they are tightly integrated with Exchange (also Lotus but who cares.)   The facts are that Microsoft continues to have a much richer, more secure offering than what the upstarts Google and Apple can offer today.

We remain huge fans of Google and Apple as companies and sometimes stocks but investors are probably over-estimating their near and intermediate opportunities in the business market.  The move by RIMM makes it even more apparent.

The best call we saw recently was the set of points made by American Technology Research in supporting their new higher price targets on RIMM.  They pointed out that low penetration, better carrier strategy, new offerings and huge earnings from replacement phones make RIMM a great long-term growth stock, even at $130.

– Kris Tuttle

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