Venture capital discussion
GIBBS: Wall Street is salivating over the initial public offering of Google, the popular Internet search engine. But can one company's plans to go public repair the damage and change the fortunes of an entire industry? Or are we in for more '90s-style greed and envy?
The reality is most investors have no chance of getting in on the hottest IPO in years. That's traditionally been a game for insiders and venture capitalists, but there's a lot to be learned from watching where those people are putting their money. That's why Susan Woodward formed Sand Hill Econometrics, so she can follow the money. She joins us from Silicon Valley. Roger Novak's firm, Novak Biddle Venture Partners, has invested over $350 million trying to discover the next new thing. We're also joined by Wall $treet Week with FORTUNE contributor Michael Farr.
Well, Roger, let me start with you. We finally got it. Google has announced a $2.7 billion initial public offering. What does it mean for tech, and what's at stake here?
NOVAK: I look at Google as just a bellwether deal, maybe a once-in-a-lifetime type of deal.
GIBBS: Why?
NOVAK: Well, the rapidity with which that company has grown and the profitability is unlike almost any other company that's come to market in recent years. But I think that what you're seeing is not so much the return to health of a whole industry, but the result of very, very shrewd investing by (venture capital firms) Kleiner Perkins and also Sequoia.
GIBBS: Susan, there's been so much talk about this IPO. Can it turn around an industry that's faced with consolidation?
WOODWARD: Well, it can't turn around an industry. I think the most important news about the Google IPO is not the boring news of the last 10 days, which basically it was going to be bigger than a breadbasket. The important thing is this morning they announced they were going to do it through an auction. I think it's the right thing to do, and I think they're doing it for the right reason. It's the only fair way to run an IPO, and they acknowledge it's the only fair way and that's why they're doing it. I think the tech world needs less repairing than Wall Street does, and this is a huge step in the right direction for Wall Street.
GIBBS: Michael, what does this IPO activity -- particularly for the first quarter, which has been a nice pick up -- what is it saying to Wall Street?
FARR: I think it's saying a number of good things, that investors are back in the market willing to buy these earlier stage companies as they're coming public, and the appetite with which they are being absorbed into portfolios is also another encouraging sign. Investors are back. They're cautious, they're reading the numbers, they're not there willy-nilly, but investors are back and they're participating. I think it's good.
GIBBS: Roger, what's the difference between then and now? With the 1990s we saw broad-based opportunity and instant riches. Can we expect to see that again?
NOVAK: No, and that's healthy and that's a really good thing that's happened. We're getting back to a period now where companies have to show real earnings, real revenue growth, and real value. Back in the go-go days, it was, you could take a company public with $2 to $3 million, losing $10 million, going to a $20 million loss.
GIBBS: Susan, your venture capital index has pretty much followed the growth of the value of the industry. Can you talk about venture capital versus the Nasdaq and where you see the growth coming from?
WOODWARD: Well, the Sand Hill index is, as you point out, Karen, an index of value, and we saw it turn up in October of '02, and it's up 40 percent over 2003. So there's definitely been a profound recovery in venture values. Now that doesn't mean we're back to where we were, because when something falls 60 percent, if it rises 40 percent it's still a long, long way from where it was. But it's coming back.
GIBBS: Where do you see venture capital dollars finding a home?
WOODWARD: Well, information technology and biotechnology primarily, which is where it's mainly found a home.
Biotechnology, that would include pharmaceuticals and drug delivery systems and medical devices will be of interest. It will continue to be of interest. All you have to do is look at the demographic numbers to see how interesting it will be.
And in information technology, the areas of important activity are storage, data storage that is; security, as in keeping spam and viruses and worms out of your system; voice over Internet; and programmable chips.
FARR: Roger, there's more money now, though, going into venture. Is that right?
NOVAK: There's less money than there has been. I think the money in the system right now is manageable, but I think the amount of money that's being thrown toward venture capitalists right now is probably still too high.
GIBBS: What red flag does that raise for you, Roger?
NOVAK: Well, it says to me that potentially we could have additional years of losses in the industry until it shakes out. So I think we're probably looking for some additional shakeout over the next two to three years.
WOODWARD: Who's going to sue whom for what reason?
NOVAK: (laughs) That's not something I contemplate every day. I contemplate what's the next great opportunity.
WOODWARD: I mean the reason you guys make the big bucks is for making the big decisions, and one of the big decisions is restraint. So you don't have to invest just because all that big pile of money is there.
NOVAK: Well, Susan, I think it needs to be restraint on two sides. One is we've always decided that if you're going to do early stage, you need to have a manageable amount of money. But number two, we had three times as much commitments as we wanted to take, and that was after turning away a number of people who called us who we didn't even know. So that just said to me there's just way too much money.
GIBBS: Roger, you see a lot of companies in a lot of industries. What is really floating your boat? What's making you excited about the VC market?
NOVAK: We think information security is one of those industries where there will continue to be innovation because the threats change. And you're not under the same pricing power or the subscription model that you have in most of the rest of the software industry. If the threat's there, people have to buy it.
We like education, believe it or not. And the reason why we like it is that it's such a mess, and anytime there's chaos, there's opportunity.
We like RFID. We played that…
GIBBS: RFID is?
NOVAK: Radio frequency identification. We played that, though, two and a half years ago with an investment in a company which has become a leader by the name of Matrics. We're now seeing a lot of money move into that space, so we're hesitant there. We like anything in the mobile wireless industry.
FARR: Where would consumers see RFID in use?
NOVAK: I think in the future everywhere, from the grocery store to within various devices.
FARR: It'll be in food packages?
NOVAK: It could be in food packages. It's initially starting in the industrial area in the supply chain. But as (radio frequency) tags get down to a nickel or less, I think you can stick it on a lot of different items.
GIBBS: Conventional wisdom is that venture capital and IPO investing is not for the individual investor, and certainly it's very, very risky. So how can the individual investor get in on this game?
WOODWARD: Well, I don't think the individual investor can unless it's a very rich person. I mean for the average bear, venture capital just doesn't make very much sense. It's very risky, it's very illiquid, it only comes in great big chunks.
FARR: I think in many ways, too, the individual investor is probably already invested somehow, somewhat, in venture through many of their main stock holdings.
Pharmaceutical companies have, make investment in small biotechnology companies. It's a way that they spend their R&D dollars.
Cisco, the tech company, takes a lot of their enormous cash flow and does put it back in smaller tech, early stage tech sort of firms. Intel does the same thing.
Then there are companies like Silicon Valley Bancshares, which makes loans to the tech market and start up tech companies. They get warrants. It's a little bit riskier, but you end up with a fairly broad portfolio of warrants in a lot of tech companies, and it's been a very interesting company to watch.
Then you can look at the biotechs and some of the biotech indexes. There's an exchange-traded biotech fund. There's the BBH, which is Biotech Holders Trust.
These are riskier companies, but if you buy a diversified portfolio of them - don't put too much money in there - it is a way to gain some exposure to this earlier stage of investing.
GIBBS: Roger Novak, Susan Woodward, thanks for joining us.
Farr on the markets
GIBBS: Now, Michael, I want to ask you about the markets. It was not a good week for the Dow, the S&P was off as well, and the Nasdaq-inflicted some pain. You think investors are missing out don't you?
FARR: I think the market short term is probably behaving as short-term markets typically behave -- which is irrationally. They don't make sense.
If you look at the facts, earnings came in some 20-plus percent ahead of analyst expectations. That's a huge win. The economic numbers have been coming in equally strong. So if the earnings are gaining and the economy is improving, it ought to show up sooner or later, and it hasn't. Now I believe that it will. And if you look at the companies that haven't moved that still have good numbers, General Electric really hasn't moved much in the past year. Bank of America really hasn't shown much appreciation. All strong companies, I think, are worth a good look.
GIBBS: Well, Michael, okay, I agree with you earnings are improving and the economy does seem to be taking hold, that it is a solid recovery, and that of course is going to lead to higher interest rates that many people are worried about. Where is the threshold of pain? Is it a 1 percent increase over where rates are now? Is it 2 percent? What's going to be the magic number?
FARR: Don't know. In fact I think that some step towards higher rates will give investors confidence. We need to know that the Fed is going to be deliberate and delicate and determined -- all three Ds we need, Karen, out of the Federal Reserve. And once investors get a sense that they are going to control this and take action and meet this at the front line, meet inflation at the front line, I think share prices will do well. The real threat is inflation that gets away from them. So, as far as I'm concerned, the sooner the better.
GIBBS: You mentioned GE, Bank of America. Any other stocks that you particularly like?
FARR: Microsoft in tech world.
Microsoft has been, I think Microsoft's been $27 a share for two years, or maybe 10 years or 20 years. Every time I look at Microsoft, they have enormous amounts of cash on their balance sheet, billions of dollars in cash. The earnings growth, excluding that cash, is strong. I think Microsoft is one of those stocks that I think 10 years from now your children are going to kiss you for having bought.
GIBBS: But, again, you have to have this long-range view.
FARR: No question about it, because in these short-term markets, you think that you're doing everything right. I'm buying stocks with earnings, and I've done my homework, I've read my Value Line, and I think this company's going to beat their number. I think that the economy's improving. I think that they're going to see sales increases. I think IT demand is going to increase and capital expenditure is going to increase. And here we are in April, and all of those things are happening, and I'm sitting here as an investor going, "What did I miss?" This is supposed to work. It's not working, but remember, it's not working for the short term.
One other point: It doesn't feel good to commit new dollars to this market now. You're hearing it's expensive, you're hearing about the war and all of these things. If you're sitting home, as an institutional investor or as an individual investor, and you're thinking I don't feel good about this right now, reaching into my pocket and putting money into the market, I will tell you that that's the time to do it. My rule of investing, one of my many rules, is if it feels bad, do it. Forget everything you learned in the '70s. If it feels bad, do it. It will feel bad to sell as a stock is blowing through the roof. It feels bad to buy when they're dropping.
GIBBS: Michael, it's always a pleasure. Thanks for joining us.
FARR: The pleasure's mine. Thanks, Karen.
Cola wars
COLVIN: Two companies that badly want you to do what feels good - at least if you like soft drinks - are Coke and Pepsi.
Their rivalry has always been a great story, but lately it has taken some bizarre twists. Coca-Cola, owner of the most powerful brand name on planet Earth, can't find a CEO. And PepsiCo, whose product portfolio practically defines junk food -- Fritos, Cheetos, and Doritos, as well as Pepsi and other soft drinks - well, it wants to portray itself as a wellness company.
Is the world going nuts, or is it just me? And by the way, would you want to buy either stock? Caroline Levy analyzes the beverage industry for UBS; she joins us from New York. Pattie Sellers is a FORTUNE magazine editor at large who has written often about both companies; she's also in New York.
Pattie, CEO of the Coca-Cola Corporation -- it doesn't get much bigger than that in American business. And yet, Jim Kilts of the Gillette Company, CEO there, top candidate, said, "No, thank you." Carlos Gutierrez of Kellogg, another top candidate, said, "No, thank you." Who was the third one? Bob Eckert, CEO of Mattel, another top candidate, said, "Count me out."
What is going on? Why doesn't anybody want to run Coke?
SELLERS: Oh, Geoff, isn't it incredible? The world's biggest brand, the world's most powerful brand. You know, it's really a shame, and you know they're playing spin the bottle here, and nobody's accepting.
You know, it's down, among the candidates who have been named -- and you named three of them -- there are two left. One is Kerry Clark, who's one of the two vice chairman at P&G, and the other is Neville Isdell, who is a former Coke executive, used to run Coke Europe and then ran one of the big Coke bottlers. And obviously there are other candidates that we don't know about, but I'll tell you, the good ones have said no, and not that these two guys wouldn't be good, but…
COLVIN: But does this mean things are worse at Coke than they seem to be?
SELLERS: Yes, I think, although the bad news just keeps streaming out about every week. And, you know, the management ranks have been decimated, which is their biggest problem. And anybody who goes in there is going to have to go in and rebuild the management. And also, you know, the inside candidate is Steve Heyer, who is all but eliminated. I mean he is not going to get the job, and whoever comes in, Heyer will probably leave.
COLVIN: Will probably leave. Caroline, how bad is this whole CEO search saga for the company?
LEVY: It's terrible for morale within the company, not just at corporate in Atlanta, but across the globe for all the bottlers seeing their great company without clear leadership. I think it's really bad from that standpoint.
It's bad for investors. People don't want to step up to a stock where it's really unclear who the leadership is and what the strategy will be going forward. I might disagree a little bit with Pattie in terms of management ranks being decimated, in the sense that I do think amongst the regions, five major regions across the world, there is some very strong leadership. But that being said, I think it's critical to have a visionary at the top of the company that is very clear about what the strategy is.
And I think where the uncertainty is probably having the worst impact is on the marketing and advertising of this once great company in the consumer world really falling behind rival Pepsi, in my mind, in terms of its advertising and marketing.
COLVIN: Well, let's talk about Pepsi a bit, because in addition to the whole soft drink business, they own the Frito-Lay snack food business. I happen to have here a couple of bags of potato chips, Lays potato chips. One is Lays Classic, the other is Lays Baked potato chip. And they have a big seal on the front that tells how little fat is in it, and on the back they have the seal of the Cooper Aerobics Center -- this is Dr. Kenneth Cooper, the famous fitness expert. Now this is not just a little marketing plan. The CEO there, Steve Reinemund, wants to cast PepsiCo as a wellness company. Is he out of his mind? Is he on to something, or what?
SELLERS: You know, this is something they have to do, Geoff, when you consider that a couple of months ago the government came out and said that obesity is quickly closing in on smoking as the number one killer in America. PepsiCo is the biggest junk food company in the world. They have Frito-Lay. They've got to change their products. They've got to change their marketing. They're actually planning on coming out with a big, sort of overall marketing campaign this fall where they'll put a sort of green seal of approval on their healthy products, what they consider to be their healthy products. And you know this company is really good at rebranding, repositioning. They're probably the best marketers around. So, you know, it's a huge challenge for them, but there's no one else who is up to it as much as they are.
COLVIN: Caroline, is this going to work? Are consumers going to buy it? And should Coke be trying to do something similar?
LEVY: I think it is working. Pepsi had extraordinarily strong results in 2003 and in first quarter '04. It's just unbelievable given the low-carb trend. You might have expected the Lays business to be under terrible pressure. What in fact happened was their "Better for you" snacks, which are about 12 percent of the portfolio, grew very, very strongly, probably 20, 30 percent, and that's the Quaker, Tropicana brand names, etc.
But the more indulgent food, which is a nice way of saying rather unhealthy, also grew incredibly strongly. They've relaunched the Lays brand and it's crispier and packaged better, and I can tell you my addiction has only increased to those products. So I think what they've figured out is a lot of people are talking about low-carb, 15 million people may be on a low-carb diet. That leaves, you know, 240 million who are not, and it's still big business.
COLVIN: It is very big business, and those are still the biggest products they have, the old-fashioned, high-calorie ones.
Now Coke versus Pepsi, it is one of the all-time classic rivalries. Let's look at the big picture. Company versus company: who's winning?
LEVY: Well, if I may take that, I think Pepsi has clearly been winning over the last seven years.
Coke's stock peaked in about 1998, and it coincided actually with the low point in the dollar, and they've been very hard hit by the fact 70 percent of their business is outside the U.S., and so they've had currency hurting them really badly.
But at the same time, their management teams really got hard hit due to a succession of CEOs. And Pepsi, meanwhile, was executing at full strength, just very clear leadership, very, very strong team in place: Steve Reinemund, Indra Yooyi combination, and then all the operators. And then this fabulously-transforming Quaker Oats acquisition, which gave them the leading sports drink as well as the healthier brand names, as Pattie mentioned. So there is no doubt with, if you just look at the straight financial results, Pepsi has been a home run over the last five years.
COLVIN: Pattie, you agree company versus company Pepsi's winning?
SELLERS: I agree. You know, Coke used to be a great company and now it's a good company, and PepsiCo used to be a good company and now it's a great company. It's amazing to see this turnaround. You know, so much of this is about management and the strength of management, and I think that's the sort of most important way to compare the two companies right now. I mean they both have great brands, but in terms of management quality, PepsiCo's got it right now.
COLVIN: Caroline, I've noticed that you have recommended the Coca-Cola bottlers. Now traditionally, or at least in years past, they really got squeezed because Coca-Cola would charge them a whole lot for that Coke syrup, but they were out there in the marketplace fighting price wars on the other end. Now you like them. How come?
LEVY: Well, Coca-Cola Enterprises we think is going to be a great stock over the next 12 months, really because they are getting pricing from the retailers.
Finally, they took something like 4 percent pricing in the first quarter, which is about two times the rate we've had over the last five years, and pricing is the most profitable growth you can get. Not only that, though, they have some great innovation coming, a new mid-calorie cola from Coke called C2 that we think is going to drive volume growth. We also think they have some great purchasing strategies to reduce costs. So we think CCE is going to have very strong earnings this year.
COLVIN: Coke itself is one of those stocks that Warren Buffett says is in his permanent portfolio. He intends to hold it forever. In the current environment at today's price, would you tell investors to buy Coke with an eye towards holding it forever?
LEVY: Forever, possibly. I mean I do believe with good leadership, this is absolutely a company that can be turned around. It has multiple brands. While the name on the door is Coca-Cola, there's of course Diet Coke, which is growing because it's on trend with low carbs and no calories. And they have innovation coming. They obviously have Sprite. They have multiple water brands, juices around the world. So this company can win.
But in terms of a six-to-12 month recommendation, we do not have a buy on the stock, and that does have to do with leadership. I am just a huge believer that one person can change the destiny of a company, and I think we still have to find that person and to get the board to back off and let whomever they put in place really run this business as they see fit.
COLVIN: And what's your recommendation on Pepsi?
LEVY: My recommendation is a "buy" on Pepsi. It's my favorite of the big-cap consumer companies. I follow Anheuser-Busch, Coke and Pepsi, and I would definitely be putting my money into Pepsi, based on both the growing snack business, really it's not just in the U.S., but huge successful snack businesses all throughout Europe and Latin America and even now in Asia, and then I think their non-carbonated beverage strategy is very successful, and I think they're great marketers. So all those things coupled with good leadership, you know, really high quality leadership, make me bullish on Pepsi.
(Note: UBS and/or Caroline Levy has a position in PepsiCo stock. UBS has an investment banking relationship with or has received compensation from Coca-Cola Enterprises, Coca-Cola Co. and PepsiCo)
COLVIN: Pattie, what's your favorite snack food?
SELLERS: You know, I went to Frito-Lay a month or so ago, and they forced all these potato chips on me. I love Rold Gold Honey Wheat twists, which is a fairly new PepsiCo Frito-Lay product. I don't like the chips, but I love these pretzels.
COLVIN: Yeah, but Pattie, I think your favorite snack food is probably apples or carrots or something like that, right? You can't fool me.
SELLERS: No, pretzels are better than apples.
COLVIN: Caroline, how about you? Your favorite snack food?
LEVY: Well, I'm ashamed to say it's Lays Sour Cream and Onion, and I don't just buy a small bag. I buy a big bag. And my children see me doing it, so it's very hard to say, "Hey, guys, cut back on the snacking" when they're seeing their mum do it.
COLVIN: Well, it explains a lot about where these old businesses are going. Caroline Levy, thank you very much.
LEVY: Goodbye, Geoff. Thank you.
COLVIN: Pattie Sellers, thanks for being with us.
SELLERS: Thank you, Geoff.
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