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Deconstructing the Harris & Harris Letter
Board: Harris & Harris Group, Inc.

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By spookysquid
April 20, 2007

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Well, as nilvest reminded me, the annual letter to shareholders is out. What follows is my rather sarcastic, and long, evaluation of the letter. (I justify that sarcasm with the simplistic thought that management works for you, so it is in your best interest to be as cynical and non-lovey-dovey as possible. You wouldn't do that with your employee, why would you do it with YOUR management team? Oh, and try and read it with an understanding that I was actually going for humor (low though it may be), rather than sniping.)

For me, with TINY specifically, there are really only one or two big things that you can get out of their annual letter.

1. What does the company think the immediate future look like
2. What does the company think you should find important to know

So, with that in mind, let's see what they had to say.

1. The Future

H+H has spent a lot of ink both here and in the past on giving their estimation of the market for IPO's. And why shouldn't they? This is after all what they target. It's where they make the big money. They know that even the weakest company in the world can make for a great IPO if there is enough speculation in the market. But still, fundamentally, this always gives me an uneasy feeling like we are hoping for another speculation bubble like the late 90's. Maybe TINY is a good contrarian indicator. When it doubles, jump out of US stocks and into something else? I don't know.

But here's the thing. Whenever they are spending time on the potential market and not on their portfolio, I turn cold. Why? Because they are saying that there is greater potential in a more easily duped market than in the great businesses that they are nurturing. Again, you may ask yourself, "Who cares". The answer is that you should. And you need look no further than NURO for the reason. NURO IPO'd at $8.15. But, TINY didn't just liquidate immediately. Instead, they held on, and didn't sell out till NURO hit the high $20's. This turned a 4 bagger into a 7 bagger just by waiting a year. What this means to you is that if TINY IPO's a good company and has the gumption to wait for an even better valuation, the profits could be even higher for them, and ultimately, for you.

In their defense, as I mentioned earlier, if they just pushed IPO's into a poor market, that would spell certain disaster, in the form of poor returns, for shareholders. What is ultimately needed is both a favorable market AND a strong company made stronger by new capital to fund its growing endeavors. Which leads us to our next section...

2. What They think is important for us to know

Well, there were four big things that management wanted to convey to us.

1. The market could maybe kinda sorta, if you squint and look at it sideways, begin to look like it might just be starting to be a bit like a more positive environment for IPO's. I've covered this one already, so I'll let it be.

2. That some of their companies are actually better suited than certain cherry picked examples of previous IPO's in terms of revenues. They are almost to the point of asking Mr. Market why he hasn't demanded that TINY start handing out IPO's. Yes, a full 17 are now generating more revenue than NANX did back in 1996. But there's so much more to this statement than meets the eye.

3. That while there may have been questions of their ability as management to pick the best investments for their port, given the right lens, certain metrics seem to indicate that there are in fact doing quite well. We shall examine this also.

4. It was a good idea for them to switch to stock based compensation. Or, to put it another way, it is better to dilute the shareholder any time they want than reduce the NAV only when they have a successful outcome. You can probably guess my thoughts on this issue.

Let's start by looking at the claims surrounding revenues:

"As time goes by, and the commercialization of nanotechnology progresses, the question of if and when a wave of nanotech IPOs will begin becomes less and less about nanotechnology-enabled companies themselves and more and more about the IPO market itself. When our first nanotech investment, Nanophase Technologies, Inc. (Nasdaq: NANX), went public in late November 1997, it was not yet profitable, had recorded revenues in 1996 of approximately $596,000 and would record revenues for all of 1997 of approximately $3.7 million. By comparison, in 2006, 17 of our current portfolio companies (including two microtech companies) generated revenues in excess of Nanophase's revenues in 1996, the last full year before it went public. Moreover, in 2006, eight of our portfolio companies (including two microtech companies) generated total revenues in excess of Nanophase's revenues in 1997, the year in which it went public. Altogether, in 2006, our 27 tiny-technology portfolio companies generated aggregate revenues of approximately $158 million, of which over half was generated by one company. Three of our portfolio companies were profitable in 2006, including two tiny-tech companies."

Let's see if we can pick this apart and then see what the reassembled mass looks like.

When our first nanotech investment, Nanophase Technologies, Inc. (Nasdaq: NANX), went public in late November 1997, it was not yet profitable, had recorded revenues in 1996 of approximately $596,000 and would record revenues for all of 1997 of approximately $3.7 million.

So, Mr. Market paid good money for an (still) unprofitable company...in the 90's...for a high-tech company. Are we getting the picture here? And note, no where in that paragraph to they discuss "Profitability".

By comparison, in 2006, 17 of our current portfolio companies (including two microtech companies) generated revenues in excess of Nanophase's revenues in 1996, the last full year before it went public.

First, adjusted for inflation we find that those companies that beat NANX's revenues were worth only $463,851.19 in 1996 dollars. Or, to flip it, NANX's revenue's are worth $765,797.32 in 2006 dollars. So the feat, on the face of it, is that much less impressive. The better question then is how many of the companies today are beating the inflation adjusted revenues?

(As a side note, there's a really neat calculator which I used for adjusting for consumer inflation at http://data.bls.gov/cgi-bin/cpicalc.pl. Brought to you by...The US Gov! Hey, they can do some things right in government.)

Moreover, in 2006, eight of our portfolio companies (including two microtech companies) generated total revenues in excess of Nanophase's revenues in 1997, the year in which it went public.

This is slightly more impressive since NANX saw rev growth from $.5 Million to over 3 mill in one year. 8 companies generating more revenue than that does seem promising, but again, we must adjust for inflation. I see no need to go through the motions, as you all get the idea now.

Altogether, in 2006, our 27 tiny-technology portfolio companies generated aggregate revenues of approximately $158 million, of which over half was generated by one company.

So, let's do some quick math. Over half came from one company, so that leaves 26 companies generating $79 Mill. 17 of those generated over $500K, meaning we can pretty much rule out 9 of the 26. 8 of those generated over 3 $Mill leaving 9 generating between 500K and 3Mill. That means, of the eight, they collectively had to generate between 52-74.5 Mill. This level of dissection is admittedly meaningless, but still interesting to see.

And now you're probably thinking "So what". Well, my response is "NAV". Remember that? The all important core metric? Well, with these numbers, we now have the ability to value TINY on a Price to Sales measurement! Yup, we get to add another metric to our toolbox of valuing TINY. And what do we see here? Well, we see a PS of...8.388 (or just 8.4 if you prefer). Wow, that's rich! By (really) rough (and random) comparison, Intel Corp goes for 3.34, while non-tech player Walmart goes for a mere .56. But, ultimately, this is relatively meaningless because this is a one time reporting and we don't know which companies were the main contributors or what went into those numbers.

Getting back to NANX, ultimately I'd have to register a big fat "Who cares" when evaluating the comparison with the current portfolio. It's really meaningless babble. The only important part is getting an understanding of what the current port is doing TODAY.

Next, on to the "Gross Write-Downs". On a Year over Year basis, it looks as if Write-downs, or what percent of the port they made a bad call on, has decreased. That would be true, save for one small detail: The secondary offering. Yup, they raised a little over $30 mill in that deal, so while the percentage of NAV may have decreased, the total value increased by a whopping 22% while NAV has grown 58% on NO REVENUE! Again, wow! Things are not quite as rosy as they would have you think.

But again, we should temper this with an understanding that as their deal flows increase (which they have by a full 50% since 05), the absolute dollar value of their write downs should also increase. It's just the nature of the business. And considering that NAV and deal flow went up by 50% while write down's only went up 22% undiluted, could there be some positive message to take out of this?

Consider this final fact first. The Write downs that they are experiencing are not a reflection of increased deal flow from last year. These write downs come from investments made multiple years ago. In other words, the two don't correlate. We won't truly know the value or worthiness of the deals made this year until a few years from now.

Last, let's look at the switch to stock based compensation. There were four reasons given:

1. Competitive pay and bonuses with Private venture-capital firms. You'll note that I emphasized private. Yet another selective comparison under their belt.

2. As we talked about before, they want to keep as much cash on hand as possible. This is perhaps the only reason that I somewhat agree with.


3. Third, they want to increase employee ownership. In theory, this is a reasonable goal.

4. I'll just quote them: "accruals for cash profit-sharing payments reduced our net asset value (NAV). Grants of stock options do not affect NAV (if and when options are exercised, NAV per share either increases or decreases depending on whether the exercise price is above or below NAV per share at the time of exercise)."

My take is that while some of this is valid, I think it changes the focus from focusing on specific goals like driving a port company towards IPO, to wealth generation on a smoother curve. Maybe it's a zero sum game, as they have suggested in number four, but I see it as a slightly net negative for the shareholder.

So there you go, Spooky's take on the annual letter. Any thoughts/comments?

-spooky


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