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Today the Fool published an upbeat article by Jack Uldrich about Harris and Harris -- a stock I'm short. As a rebuttal of sorts, I'm posting my short thesis that I submitted to Value Investors Club late last year. It was not accepted, but a couple months later, another write-up of the idea was posted and got scores in the mid 5's range.
SHORT: Harris and Harris Corporation is a publicly traded business development corporation that makes venture capital investments in nanotechnology-related companies. The short thesis is elegant and simple: driven by speculative fever surrounding nanotech stocks, TINY trades at a price equal to 240% of NAV, with no prospect of realizing investment gains to close that gap within a meaningful time frame. What's more, over 45% of NAV (approximately $2.00 per share, or $36 million) consists of US treasuries, and at the company's current rate of investment, it will take 4 years to invest fully. In the meantime, that cash will sit earning low single digit returns, further diminishing the prospects for any NAV growth that could support the stock price.
Harris and Harris has been incorporated since 1981, operating in various forms as an insurance brokerage and trust company, a biotechnology company developing a human blood substitute, and later a closed-end investment company and business development company. In 1995, the company made its first investment in a nanotechnology company, and in 2001, management decided to dedicate their investment efforts to the field of nanotechnology exclusively. Since that time, the company has invested approximately $24 million in portfolio companies, yet reports a value of its investments of only $36 million, including $22 million in Neurometrix, a recent biotech IPO that was one of TINY's portfolio companies before it committed to investing exclusively in nanotechnology. TINY's cost basis in Neurometrix was $4.41 million. Over 80% of TINY's private portfolio consists of nanotech companies now.
NAV and Portfolio
TINY has a net asset value of $4.61 per share, up from a low of $2.75 at the end of 2001. Unfortunately for TINY shareholders, this 61% increase in NAV has not been driven by strong investment returns. Instead, it has been driven by TINY's repeated ability to exploit nanotech fever on Wall Street in the form of secondary stock offerings at a premium to NAV. On December 30, 2003, the company raised over $17 million at $8.00 per share in an offering led by Punk Ziegel, and on June 30, 2004, Punk Ziegel helped Harris & Harris raise another $31 million, this time at over $11.25 per share. Another $30M is being raised in August 2005. In a very real way, Harris and Harris has been buying nanotech cheap in Cambridge and Palo Alto and selling it dear on Wall Street.
The majority of TINY's $14 million private placement portfolio consists of stakes in private, development stage nanotechnology companies that have yet to show product revenue. The majority of these stakes represent less than 15% of the portfolio company's fully diluted equity, since TINY invests in syndicates of venture capitalists and typically invests far less than its partners. Over $5.2 million of the company's investments are in three companies (NanoOpto, Continuum Photonics, and NeoPhotonics) developing components for optical networking, possibly the most over-funded sector of the tech bubble. Transactions in the space, led by consolidators like Bookham Technology and Avanex, have been done for less than 20 cents on dollars invested by companies like Alcatel, Nortel, Vitesse and other companies that have sold out. As a preferred shareholder with liquidation preferences, TINY has some degree of protection against sales for a loss of its optical investments, but I don't think investors should count on any returns from these three companies.
Additionally, liquidity in the rest of the company's portfolio will be difficult to achieve. To use just one high profile example, TINY portfolio company NanoSys tried to go public in one of the more entertaining efforts of 2004. Because the company had no products, no revenues other than grants and partnership revenues, and no real prospect for products for several years, investors balked at the $100M+ offering, which was eventually pulled. TINY owns 800,000 shares of NanoSys valued on the books at $1.5 million.
Finally, I have personally reviewed the business plans of two TINY portfolio companies, representing 6% of the company's equity investments. I have gained this access as a former employee at a major Tier 1 California venture firm. While I will not discuss the business performance of these companies by name to maintain professional business conduct, I can say that each of these companies has little to no revenue beyond research contracts and partnerships. Additionally, both are well over two years behind the product development plans that they used to raise their first venture money, as is common for bleeding edge research projects. This phenomenon is not limited to nanotechnology companies backed by Harris & Harris but is endemic to the dozens of companies that I have reviewed in the industry. To date, there have been only three products of nanotechnology research that have been commercialized successfully at anything resembling scale: i.) Stain-resistant khaki pants, ii.) Zinc oxide sun block, and iii.) High performance tennis balls. Hardly the stuff of technological revolutions.
The primary risk to shorting TINY is the possibility that one or more of their equity holdings, either current or future, proves to be a dramatic 50 or 100-bagger of the type that was so common for venture capitalists prior to March 2000. I believe I can prove that this risk is mitigated in several ways:
1. Even if it does happen, it would not push NAV above the current price of $12 per share. For example, TINY portfolio company Optiva designs nano coatings and thin films that reduce size, improve display characteristics, and enable new modes of production for the flat panel display market, which is growing rapidly. TINY reports a $1 million interest in the company, which they claim represents 1.74% of the fully diluted equity. Because the company has three series of preferred stock, we can only guess at the true post-money valuation, but a number like $50 million has the benefit of being round and, in all likelihood, fairly close the mark. Let's assume that Optiva's solution gains acceptance in the market, and the company executes an IPO. Here's how various valuations of Optiva would affect TINY's NAV:
Optiva Valuation $500 million $1 billion $2 billion
Return off $50M post-money 10X 20X 40X
Return to TINY $10 million $20 million $40 million
Increase in TINY NAV $0.58 $1.16 $2.32
You may say that Optiva is an unfair company to use, because TINY owns so little of the company's equity. That's a fair point, so let's run the same numbers with Agile Materials & Technology, which is 8% owned by TINY. Agile Materials develops innovative thin film products for wireless communications. Its tunable matching networks improve the functionality of power amplifiers in cell phones; its tunable filters reduce the number of frequency filters needed in cell phones; and its thin film ferroelectric phase shifters lower the cost of phased array antennas by replacing costly gallium arsenide components. The implied valuation of the company based on TINY's ownership is less than $10 million, but the company will need to raise more money to bring its products to market, since they have only raised one round to date. If the company raises another $10 million on a $10 pre, its post-money valuation would be $20 million, the number I'll use. Here's how the following IPO scenarios would affect TINY's NAV, not taking into account any dilution to TINY from subsequent venture rounds:
Agile Valuation $500 million $1 billion $2 billion
Return off $20M post-money 25X 50X 100X
Return to TINY $10.5 million $21 million $42 million
vIncrease in TINY NAV $0.61 $1.22 $2.43
It should be clear that to grow into its stock price, Harris & Harris would have to realize 50-100X returns on multiple portfolio companies. According to the National Venture Capital Association, just 10% of venture-backed companies completed IPOs since 1999, and of those that did in 2004, the average post-offering valuation was just $784 million. With its 16 current portfolio companies, TINY can expect at best one or two IPOs in the next 5 years, making it tremendously unlikely that TINY could grow into its valuation via multiple IPOs.
2. Exit by acquisition is much more likely for a venture-backed firm, by a ratio of 1.75 to 1. According to the National Venture Capital Association, in the first three quarters of 2004, 247 venture-backed companies were acquired by other companies, or about 1.5 times as many IPOs (the ratio was lower than historically because the IPO climate was strong). Of those M&A exits with a disclosed value, the average valuation was $90 million. Obviously, TINY could sell most of its portfolio of companies in $90-$100 million transactions and not have a NAV close to $12 per share, given that they own less than 10% of the equity of most of their companies. Historically, only about 17% of VC-backed companies create exits through M&A.
3. A successful IPO of $1-2 billion market cap would exceed the value of all currently public nanotechnology companies. Public nanotechnology "leaders" like Nanogen, Nano-Proprietary, Nanophase, Lumera, and Altair Nanotechnologies are valued at a combined $750 million today. Thus, even a $1 billion IPO�an event that would raise TINY's NAV by just over a dollar�would pretty much equal the value of the entire "industry" today.
4. VC's have invested in 24,000 deals in about 10,000 companies since 1999, and exited since then 1758 (17.6%) via M&A and 1026 (10.3%) via IPO. If TINY successfully exits just 28% of its investments, it would have to justify its entire $200 million market cap from the performance of just $3.92 million worth of current venture investments ($14M in private companies x 28%), plus the performance of investments made in the future.
Closing of the IPO window: When the IPO window closes again, investors in TINY will be forced to think about how long it will take for them to see growth in NAV.
Investors realizing that $4.61 in treasuries and nanotech companies is probably worth closer to $4.61 than it is to $12.00.
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