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Fool On The Hill

Tuesday, April 20, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

My Way To Connect


As a predominantly value-oriented investor, I haven't participated extensively in the Internet stock euphoria of the past few years. While looking in awe at the returns these stocks have provided, I haven't been able to justify most of these company's valuations. The Internet certainly will transform the way much business will be performed in the years ahead, but I don't yet see many business models that will likely create the value expected by investors. To my portfolio's detriment, I haven't ever owned a share of America Online (NYSE: AOL), Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), or Yahoo! (Nasdaq: YHOO). If the truth were known (which it now will be -- and many Fools will be aghast), I wouldn't buy into any of these companies if their prices were chopped in half tomorrow.

My miniature, myopic mind just can't be joyfully optimistic enough to see these company's valuations justified. I could easily be proven wrong, but I still am not able to overcome my valuation reservations. That being said, I don't particularly like to see somebody else having a party without inviting me. So I have made a bet on an Internet-related company about which I feel pretty good. While the traditional valuation side of my mind is saying "you can't recommend this stock, it's too expensive," the more aggressive side says that I have to remind readers once again about this stock. As far as I can tell, it's the cheapest stock that has significant direct exposure to the Internet with an excellent management team. My Internet pick: Safeguard Scientifics (NYSE: SFE).

I first heard about Safeguard about three years ago at a financial analyst meeting. Management wanted to spread the story of this publicly traded venture capital (VC) firm that generally takes a long-term interest in its "partnership companies." Unlike some VC firms that focus solely on making a quick buck off their investments, Safeguard tends to stick with its investments for a fairly long time. When an upstart company funded by Safeguard has grown to the point where it is ready to go public, Safeguard historically has arranged for a "rights offering" in which Safeguard shareholders get to purchase the newly issued shares. Under this system, Safeguard shareholders benefit from the success of partnership companies in two ways -- through the appreciation of shares purchased in a rights offering as well as through the appreciation of shares continued to be held by Safeguard.

Safeguard has been focused on investing in emerging technology companies for decades. One of its most successful rights offerings was Novell (Nasdaq: NOVL), the networking company which has returned over 11,000% since its 1985 debut. A number of successful companies have also been incubated in the 1990s. The 1993 rights offering of Cambridge Technology Partners (Nasdaq: CATP) has earned shareholders an annual return of over 29% a year. Safeguard brought Coherent Communications public to its shareholders in 1994, which has resulted in an over 18-fold increase in value (Coherent merged with Tellabs (Nasdaq: TLAB) in 1998). More recently, Safeguard offered shares in Sanchez Computer Associates (Nasdaq: SCAI) in 1996. From an initial offering price of $5 per share, Sanchez has risen recently to over $50 a share on excitement about the company's Internet banking software offerings.

In early 1999, Safeguard announced that it was going to focus its new investments on the three areas of the technology revolution: eCommerce, enterprise applications, and network infrastructure. In eCommerce, the company wants to fund companies focused on business-to-consumer interaction, content aggregation and management, and enabling technologies. Safeguard's enterprise application investments will target companies developing novel software, as well as consulting firms that help implement and support them. On the network infrastructure front, the company wants to find companies that provide computing and communication hardware needed to support a wired world. With this investment focus, Safeguard's fortunes will now rest almost exclusively on the technology and Internet sector.

Last year's unsteady markets slowed down the pace of rights offerings to one from three the prior year. With the healthy initial public offering (IPO) market and the company's solid array of companies, Safeguard believes it might be able to bring up to five or six public this year. Due to various factors, the company may not engage in rights offerings for all of these candidates. If one of its companies uses the regular IPO process, Safeguard has stated that it will try to direct a portion of the new company's shares to Safeguard shareholders (individual investors are often left out of popular IPOs). This strategy demonstrates management's intent to provide Safeguard owners with strong returns.

Some of the companies in Safeguard's portfolio look quite enticing. The most likely to spark the interest of today's investor is Internet Capital Group (ICG), a venture capital firm for Internet companies. Safeguard owns 26% of this company, which among other successes brought VerticalNet (Nasdaq:VERT) public this year. U.S. Interactive, 15% owned by Safeguard, is a rapidly growing Internet professional service company. Who? Vision Systems is a Safeguard company that uses fingerprint imaging technology to provide eCommerce and network security products. On the network infrastructure side, Safeguard has a 16% interest in Pac-West Telecomm, a California competitive local exchange carrier (CLEC) that helps provide communications solutions to Internet service providers. These are only a few of Safeguard's companies. To get the lowdown on more than 15 other private companies in the Safeguard's hopper, check out its home page.

In this world of Internet euphoria, I have no idea about how to go about putting a valuation on Internet companies. Any benchmark or yardstick I've ever used has been thrown out the window. The underlying value of Safeguard's ownership in publicly traded securities was about $24 as of last Friday. The difference between the current stock price and that value -- $48, or over $1.9 billion, including debt -- is attributable to privately held companies. That premium for the private companies is the highest I've ever seen it. But, then again, so are the values of Internet companies. While I can't put a value on the private companies, it does seem to me that $1.9 billion is a very low price for these stocks in today's market.

To put my reasoning in perspective, let's look at the value of Safeguard's indirect ownership in VerticalNet. Safeguard's proportionate interest in VerticalNet, through its ownership of ICG, is about 10%. With VerticalNet sporting a market capitalization of $1.6 billion, Safeguard's ownership stake is about $160 million. And this value represents only one company in ICG's portfolio. On top of that, ICG is only one company in Safeguard's portfolio. With companies like Priceline (Nasdaq: PCLN) valued at over $9 billion, eBay priced at over $20 billion, and Amazon worth more than $26 billion, I feel pretty good about picking up all of Safeguard's private portfolio for $1.9 billion.

Even with Safeguard looking like a relative value, the stock performance of this company is going to be dicey. Starting out at $67 a share at the end of April, the company went on a wild ride up to $120 before coming back down to $73 1/2 today. If Internet stocks come crashing down, so will Safeguard. You've got to have stomach to stay with the company. Given my relative conservatism, I took a bit of my bet off Safeguard after it increased over threefold in less than six months. I occasionally feel stupid for selling some of my shares (like when it nearly doubled in two weeks), but then again I put that money into other investments that were well- suited for me. Even after my partial sale of shares I have more riding on this company than I initially invested. And I believe those dollars are invested in the best Internet stock out there. With my Safeguard investment, I feel slightly connected to everyone else in the Internet world.

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