Rule Breaker Portfolio Where's the Money Going?

Venture capital still funds new and emerging industries. But venture capitalists must be waiting longer for their IPO payback.

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By Tom Jacobs (TMF Tom9)
February 11, 2003

Capitalism is the worst economic system -- apart from all the others. It ain't pretty. It's a wild, wild West. New companies don't appear in a nice, orderly manner. Rather, boatloads of money rush madly hither and thither, and CEOs must be carnival barkers, seeking funds for their dreams.

In good times, the public markets are only too happy to fund newer, unproven companies, but in slower times, those companies must wait. And if they can't attract more venture capital, they either die or go public in desperation and watch their price crash. But if they are able to make ends meet, they can live for a better day.

Let's see what venture capital seeks today, and examine the friendliness of capital markets by checking the crop of recent and on-deck initial public offerings (IPOs). The two reflect the very normal contrasting appetites of two very different groups of investors: risk-hungry venture capitalists and risk-averse investors. Higher-risk ventures still receive money in initial and subsequent financings, but the IPOs are going to very straight stuff.

Where is venture capital going?
According to Venture One/Ernst & Young, venture capital today flows to health care, information technology, and products and services, broken down like this:

  • Health care: biopharmaceuticals, health-care services, medical devices, medical information systems;

  • Information technology: communications and networking, electronics and computer hardware, information services, semiconductors, software;

  • Products & services: consumer and business products and services, retailers;

  • Other: misc. (I loved writing that).

According to the survey, health care received 27% of venture capital (new and additional rounds) in 2002, up from 17% in 2001, though it declined in absolute terms from $6 billion to $5.2 billion. That 14% drop must have made the industry giddy, when compared to the 48% decline in information technology and 60% in products and services. The bright spots in health care were medical information technology and medical devices, while money dropped significantly for biopharmaceuticals. That sector is highly cyclical, completing its fourth boom and bust in 1999-2000.

The biggest single hit? A whopping $156 million for WildBlue Communications, reportedly developing the first Ka-band GEO satellite system capable of providing continuos, two-way broadband access.  

Here are the overall numbers:

                   ($ bils. rounded)
            2002 2001 2000 1999 1998 1997 1996
Health care  5.2  6.0  9.4  4.9  3.5  3.3  2.7 
IT          11.7 22.5 57.6 28.5 10.6  7.5  5.6
Products &
  Services   2.3  5.8 26.3 15.4  3.4  2.1  1.5
Other        0.3  0.2  0.4  0.2  0.2  0.2  0.2

I think the press release strains to find some useful numbers. It seems to me that the story is that all of the areas are ahead of their 1997 levels, with health care and IT up over 1998, and "other" over 1999.    

What's going public?
I consulted the very handy tally provided in Investors' Business Daily (free trial available) on its regular "New America" page. There's a list of IPO filings waiting to be priced and the prices of recent IPOs to see how they have been received. Today, there are six IPOs waiting to be priced, and 24 tracked since IPO dates beginning Oct. 11, 2002. For the most part, these are old economy businesses:

9 -- Financial services (banks, savings and loans, mortgage bank, investment bank)
4 -- Insurance (property, casualty and title; brokers)
4 -- Energy (oil and gas equipment, services, refining) 
3 -- Retail (sporting goods, restaurants)
2 -- Leisure (Chinese amusement park, gaming resort) 
2 -- Health care (HMO, nursing home)
2 -- Software systems (cancer care, federal government)
1 -- Containers (company recap/restructure)
1 -- Telecom (Chinese state-owned telecom)
1 -- Medical devices (blood filtration devices for end-stage kidney disease)
1 -- Collections (a.k.a., "outsourced receivable management")

Four of these companies are in industries venture capital funds today: the two sporting-goods retailers, Second Swing and Dick's Sporting Goods (NYSE: DKS), medical device maker Nephros, and cancer-care software company IMPAC Medical Systems (Nasdaq: IMPC). The rest are far from it.

For fun, I took a quick tour through the offering prospectuses of Second Swing. Not looking for an investment, necessarily. IPOs are financing events for the company. They provide funds for expansion and allow large shareholders, such as venture capitalists and company founders or execs, to secure a return on their investments. With a few exceptions, such as eBay (Nasdaq: EBAY) or Amazon (Nasdaq: AMZN), IPOs are not opportunities for investors. 

In fact, it can be very fruitful to scour offering prospectuses (SEC filings S-1) for potential shorting opportunities. You may find companies rushing to get out the door as a last financing gasp for venture capitalists and execs before the business fades. Think Loudcloud, now Opsware (Nasdaq: OPSW)

[If you are interested in learning more about shorting, February is, uh, short month in The Motley Fool Select. Enjoy a free exclusive report -- "Betting Against the House: Shorting for Profit" -- and two free issues of Select today!]

Foreplay
New and used golf club and golf-related retailer Second Swing proposes to be listed on the AMEX as SSG, and to raise around $18 million after costs. The Minnetonka, Minn., (a very affluent suburb of Minneapolis) company plans to use the money to expand and repay short-term debt primarily held by its chairman, CEO, and majority stockholder, David Pomije. Pomije and a number of Second Swing's top execs came from Funcoland, the largest chain of used video game software and hardware at the time of its sale to Barnes & Noble (NYSE: BKS) in 2000.

Founded in 1997, the company's sales are 71% preowned (used, in my day) golf clubs and gear. While the company buys 80% of its inventory from its customers, it makes all pricing and inventory decisions centrally using a proprietary model. This leaves no discretion to store managers to balance supply with demand, and inventory is 50% managed via a central distribution center in Minnetonka. According to the prospectus, same-store sales increased 20% in 2001, and 9% in the year through Sept. 2002. Their slogan, "It's not you, it's your clubs," brings a knowing smile.

For the last three years, Second Swing hasn't been cash-flow positive from operations and doesn't expect it until 2005. Cash burn from operations was increasingly negative through 2001, and then dropped off markedly in the nine months through September last year:

     Cash From   Capital
     Operations  Expenditures
1999  $(1.3) mil. $0.5 mil.
2000   (2.7)       1.2
2001   (3.1)       1.3
2002   (0.05)      1.3

The company plans to use $4.3 million to repay debt, $12 million to expand from its current 30-store base by 20 in 2003, and then by 30-40 stores a year until it hits 200. It projects no positive cash flow from operations until 2005. And that will depend crucially on the efficiency of its proprietary inventory management system and distribution. We can see management's track record through growth in inventories versus growth in sales.

              (in mils. except %)
                  %            %     Gross 
Date    Inv'ies Change Sales Change Margins
12/2000  $2.4   --    $7.6*   --     38%*
12/2001   4.0   69%   16.3*   115%   37%*
9/2002    4.7   18%   22.9**   40%   37%**
*for year to date
**for nine months to date 

These numbers appear to support the idea that management is very efficiently managing inventory. The store base grew from 20 to 30 stores in 2002, each store requiring $160,000 in inventory investment, $105,000 for property equipment, one store manager, and two full-time sales managers. With the 50% growth in 2002, sales increased 40%, but inventories only 18%. Nice. And remember that all stores didn't open on Jan. 1, so the 40% sales increase looks quite good.

Still, repeat after me: The IPO is a financing event for the chairman and CEO to get a large part of his investment back and create a market for the rest and for the company to expand. Let's face it: This is not some hot, new thing. Even if you credit that golf demographics might be excellent, and the company's system creates at least some moat, it's hard to believe that any investor will miss any shiny, speeding train to future riches by waiting for a few quarters or years of SEC filings. And Second Swing is not an obvious short, either, even though it's not cash-flow positive from operations. If inventory management is any indication, the company may just find itself with a profitable niche as a publicly traded company.

Golfers probably know the answer to the question, "Why can't I get simply try my golf equipment in the store, and then buy it on eBay?" I suspect clubs are very, very personal, and you want the exact club you try. But what do I know? I gave up golf because of a rotator cuff condition years ago. Do you think there is a business niche for the most efficient inventory manager of used golf clubs? Let me know on the Rule Breaker - Strategy discussion board -- and whether you find any better future candidates for investment among the recent and coming IPOs.

I hope you enjoyed this look at where the high-risk venture capital and the currently shy-risk new public market financings are going. Have a most Foolish week!

Updated portfolio returns below -- a good year so far versus the major averages.

Tom Jacobs (TMF Tom9) is fiercely competitive at miniature golf. You can hear Tom with Bill Mann this evening on Online Tonight with David Lawrence (to listen to this or earlier shows, choose first hour, segment three). His stock holdings appear in his profileThe Motley Fool leads the known universe in its disclosure policy.

Rule Breaker Portfolio Returns as of 02/11/03 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week       -2.43%    -2.83%    --     -2.05%
Month      -1.52%    -2.31%    --     -1.83%
Year 1.08% -4.98% -- -2.91%
CAGR
using IRR** since 8/4/94*** 20.08% 7.30% 9.02% 7.14%
10/20/98***-0.53% -5.52% -5.13% -6.56%

*Dividends added. Or, danger ahead. Whatever.

**Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!

***What's this? The Rule Breaker Portfolio's precursor, the Fool Portfolio, was born Aug. 4, 1994. In a 10/20/98 column, David Gardner announced the name change of the Fool Portfolio to the Rule Breaker Portfolio. Here we provide returns as if the RB Port started on either date. Remember, don't mimic any online portfolio. Most individual investors should restrict any positions as risky as these to under 20% of their portfolio -- and could have a long and happy investing life with 0%.

Rule Breaker Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  AMZN AMAZON.COM, INC. (0.62) (2.9%) 20.78 
  AOL AOL TIME WARNER INC. (0.16) (1.54%) 10.20 
  TREE LENDINGTREE INC 0.23 2.02% 11.35 
  EBAY EBAY INC (0.16) (0.22%) 73.40 
  MLNM MILLENNIUM PHARMACEUTICALS INC (0.06) (0.89%) 6.68 
 SHORT  SIRI SIRIUS SATELLITE RADIO INC (0.03) (3.3%) 0.88 
  SBUX STARBUCKS CORP (0.03) (0.14%) 22.12 
  AMGN AMGEN INC 0.47 0.89% 53.45 
 SHORT  GTRC GUITAR CENTER INC (0.04) (0.22%) 18.51 
  SPY SPDR TRUST;1 (0.58) (0.69%) 83.43 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 09/09/97 1320 AMZN 3.20 20.78  556.73%
 08/05/94 4020 AOL 0.46 10.20  2,220.63%
 06/03/02 916 TREE 13.72 11.35  -17.21%
 02/26/99 1145 EBAY 46.54 73.40  57.74%
 09/27/01 2260 MLNM 14.69 6.68  -54.51%
 SHORT 01/24/02 2500 SIRI 6.90 0.88  87.25%
 07/02/98 940 SBUX 13.98 22.12  58.35%
 12/16/98 1160 AMGN 21.44 53.45  149.33%
 SHORT 08/21/02 1000 GTRC 16.49 18.51  -12.32%
 04/24/02 290 SPY 110.16 83.43  -24.22%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 09/09/97 1320 AMZN 4,220.20 27,429.60  23,209.40 
 08/05/94 4020 AOL 1,860.42 41,004.00  39,143.58 
 06/03/02 916 TREE 12,565.44 10,396.60  -2,168.84 
 02/26/99 1145 EBAY 53,294.44 84,043.00  30,748.56 
 09/27/01 2260 MLNM 33,207.00 15,096.80  -18,110.20 
 SHORT 01/24/02 2500 SIRI 17,258.26 2,200.00  15,041.74 
 07/02/98 940 SBUX 13,138.62 20,792.80  7,654.18 
 12/16/98 1160 AMGN 24,875.50 62,002.00  37,126.50 
 SHORT 08/21/02 1000 GTRC 16,488.00 18,510.00  -2,038.00 
 04/24/02 290 SPY 31,945.00 24,194.70  -7,750.30 
Cash:573.54 
Total:298,553.04 


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Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.