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04/23/04Oracle / PeopleSoft #

Melanie Hollands


Apparently Ellison thinks the Department of Justice ruling was bad law and is hell bent to overturn it because it's bad precedent. As I have previously mentioned, I agree with this point of view (that it's a bad law). But in the particular case of the Oracle / PeopleSoft merger, I still think the DoJ made a good decision - for both companies (only Larry doesn't realize it).

All this means is that Larry's got enough money to invest in making his point and will continue to press it until there is no further avenue for appeal.

I still think the odds are very much against the Oracle / PeopleSoft deal closing because of the numerous roadblocks that are not going to go away quickly.

Cheers

Melanie Hollands

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04/22/04re: VXO and P/C Ratio suggest a rally could be close # #

Melanie Hollands


Steve,

You totally got the 1126 level right!

Actually, the numbers are fascinating on this. During the 2000-2002 bear, if you bought the market only when it was 105% of the 50 DMA and sold when it dropped back below, you were in the mkt 256 days and had a positive return
of 6.28%. However, if you waited for 110% of the 50 DMA then you were in for 186 days and made 12.79%.

From this 1124 level, I think we rally up to around 1140 (maybe 1150) and then it putters out. I doubt that we break 1150. A move above there would break the downtrend line - a very important battle. As for what happens from 1140, it depends how it behaves at that level. I think it bounces off and we sell off again.

Cheers

Melanie

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04/14/04re: VXO and P/C Ratio suggest a rally could be close #

Steven Poser


Melanie - Using a 50-day m.a. to signal oversold on VXO is relevant if this is still a bull market. If a major top is in, then this would be a major sell signal. I am not suggesting that it is a major sell signal, but it is definitely something one must be aware of. Personally, I have been looking for a drop to 1126.66 in the S&P 500 and then expect a small new high. However, the odds are far greater for a move below 1,000 in the next six months in the S&P 500 than a move above 1,200 in my opinion.

Steven Poser, http://www.poserglobal.com

> Melanie Hollands wrote:
> Looking at the VXO and the Put / Call ratio suggests that we could be close to a rally.
>
>Once again the VXO has just signaled a buy signal by trading back above the 50 day MA. It might be a few days early, but a tradeable rally is coming. The track record of the VXO is nothing short of amazing.
>
>The Put/Call ratio also suggests that selling exhaustion coming - range of 83- 1.19 today.
>
>On top of the spiking VXO and high Put/Call, we're getting very close to another oversold indicator. We're currently having a > 87% down day. I understand that 90% down days are rare and signal an oversold market.
>
>Trin at 1.24 also confirming... I think I'm getting ready to do some buying.
>
>Cheers
>
>Melanie

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04/14/04VXO and P/C Ratio suggest a rally could be close #

Melanie Hollands


Looking at the VXO and the Put / Call ratio suggests that we could be close to a rally.

Once again the VXO has just signaled a buy signal by trading back above the 50 day MA. It might be a few days early, but a tradeable rally is coming. The track record of the VXO is nothing short of amazing.

The Put/Call ratio also suggests that selling exhaustion coming - range of 83- 1.19 today.

On top of the spiking VXO and high Put/Call, we're getting very close to another oversold indicator. We're currently having a > 87% down day. I understand that 90% down days are rare and signal an oversold market.

Trin at 1.24 also confirming... I think I'm getting ready to do some buying.

Cheers

Melanie

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04/09/04re: Rupee v/s Sensex #

Shamil Chotai




In an export driven economy, the exchange rate is bound to affect the secondary markets. However, as your analysis indicates, the sensex and exchange rate have no correlation which means that the sensex is well balanced with equal number of companies benefitting from the rise in the rupee, and those facing adverse effects due to this rise.

However, we find that the overall weightage of companies that would suffer from the rising rupee is quite high compared to those that benefit from it.

This seems to indicate that the markets may not be considering the long term impact of the rising rupee. Given that software and new economy stocks (which depend heavily on exports) have seen rising valuations, there appears to be a willful disregard to facing the consequences of a rising rupee.

Whatsay?

> Haresh Soneji wrote:
> Off late and rather so during the previous few days, players in the market are throwing tantrums about the impact of the depreciation of the dollar against the rupee. And why not? Barring the previous few trading sessions where the equity market rose sharply, the rise in the value of the rupee against the dollar was at a much faster rate than the surge in the equity market. Consider this: in the ten consecutive trading sessions during March 18-31, markets appreciated by nearly 1% but the dollar depreciated against the rupee by nearly 3.9%. this caused worries among players that when the equity market will fall, the dollar rise against the rupee will be at the same pace. But, the markets have already laid to rest those fears.
>
>Several players in the market still seem to be sceptic about this fact, but we don’t think so. We studied the movement of the rupee against the dollar with the movement of the equity market to find their correlation in the long run. The Bombay Stock Exchange’s (BSE) premier index – sensex was taken as a benchmark to calculate movement in the equity market. The result was not surprising and proved that the fears of many market players are all hyped. Here’s the result: the depreciation of the dollar against the rupee and the movement in the market has virtually no correlation.
>
>The correlation coefficient between the two variables calculated for the previous one year was as low as 0.06. Squaring the correlation coefficient makes it easier to understand. The square of the coefficient is equal to the percent of the variation in one variable that is related to the variation in the other. Here the square is a negligible 0.35%, indicating no correlation. Further, the number of times both the rupee and the sensex moved in the same direction was 54%. Even this suggests that the movements between the two are not correlated as there is almost an equal chance of either way movement between the two. So, investors need not worry whether there will be any direct impact on the stock markets, if the dollar continues to depreciate against the rupee.
>
>Correlation is a statistical technique, which can show whether, and how strongly pairs of variables are related. In order to calculate the correlation coefficient, daily closing levels of the rupee and the sensex for the previous one-year were taken into consideration. Daily percentage changes were tabulated and yearly data was then correlated to arrive at the correlation coefficient.
>The main result of a correlation is called the correlation coefficient. It ranges from -1 to +1. The closer the correlation coefficient is to +1 or -1, the more closely the two variables are related. If the correlation coefficient is close to zero, it means there is no relationship between the variables. If the correlation coefficient is positive, it means that as one variable gets larger the other gets larger. If the correlation coefficient is negative it means that as one gets larger, the other gets smaller (often called an "inverse" correlation).
>

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04/07/04Rupee v/s Sensex #

Haresh Soneji


Off late and rather so during the previous few days, players in the market are throwing tantrums about the impact of the depreciation of the dollar against the rupee. And why not? Barring the previous few trading sessions where the equity market rose sharply, the rise in the value of the rupee against the dollar was at a much faster rate than the surge in the equity market. Consider this: in the ten consecutive trading sessions during March 18-31, markets appreciated by nearly 1% but the dollar depreciated against the rupee by nearly 3.9%. this caused worries among players that when the equity market will fall, the dollar rise against the rupee will be at the same pace. But, the markets have already laid to rest those fears.

Several players in the market still seem to be sceptic about this fact, but we don’t think so. We studied the movement of the rupee against the dollar with the movement of the equity market to find their correlation in the long run. The Bombay Stock Exchange’s (BSE) premier index – sensex was taken as a benchmark to calculate movement in the equity market. The result was not surprising and proved that the fears of many market players are all hyped. Here’s the result: the depreciation of the dollar against the rupee and the movement in the market has virtually no correlation.

The correlation coefficient between the two variables calculated for the previous one year was as low as 0.06. Squaring the correlation coefficient makes it easier to understand. The square of the coefficient is equal to the percent of the variation in one variable that is related to the variation in the other. Here the square is a negligible 0.35%, indicating no correlation. Further, the number of times both the rupee and the sensex moved in the same direction was 54%. Even this suggests that the movements between the two are not correlated as there is almost an equal chance of either way movement between the two. So, investors need not worry whether there will be any direct impact on the stock markets, if the dollar continues to depreciate against the rupee.

Correlation is a statistical technique, which can show whether, and how strongly pairs of variables are related. In order to calculate the correlation coefficient, daily closing levels of the rupee and the sensex for the previous one-year were taken into consideration. Daily percentage changes were tabulated and yearly data was then correlated to arrive at the correlation coefficient.
The main result of a correlation is called the correlation coefficient. It ranges from -1 to +1. The closer the correlation coefficient is to +1 or -1, the more closely the two variables are related. If the correlation coefficient is close to zero, it means there is no relationship between the variables. If the correlation coefficient is positive, it means that as one variable gets larger the other gets larger. If the correlation coefficient is negative it means that as one gets larger, the other gets smaller (often called an "inverse" correlation).

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03/30/04Indian Equity Markets #

Haresh Soneji


Look at Beta

Players in the equity market are throwing words of caution, after looking at the rising volatility in the market. Volatility seems to have become a very common feature in the equity markets. And if you are a close tracker of the market, you might have seen how markets move with a bang towards the close of the session, on any given day, of late. While long-term investor might just shrug this off as a normal happening there are several others who would like to understand what exactly is going on. A proper understanding would also enable one to understand the situation better rather than just be afraid of volatility.

Before going on to what volatility is one has to remember that a measure which one can refer to is that of beta. But, since the subject of volatility has been thrown open, lets understand it very briefly. Volatility is calculated by dividing the difference between the index’s or stocks high and low points by its closing value on that day, and multiplying it by 100, to express the result in percentage terms. For example, if the difference between the intra-day high and intra-day low value of the sensex was 400 and the sensex settled at 5800 levels for the day, volatility for the given day would be 6.9% ((400/5800)*100)).

When the Indian markets were on a one-way ride, daily volatility in the Indian markets was around 1-2%. This was a healthy sign for the Indian markets since most of the time, markets opened with a significant gap in the positive and remained there or move upwards. There were very few occasions when market actually moved in the red or closed negative. So, volatility at that point in time was marginal and good for the all the players, including small and long-term investors.

But, of late (the last 4-5 weeks) things have changed. Daily volatility in the Indian markets has perked up to around 6%. This kind of volatility brings us back to the old days, where daily volatility was in the range of 5-9%. Now this could be a tough ask for a day trader and chances are that the day trader may catch the market on the wrong side leading to heavy losses.

Now let us understand what is beta of a stock. Also known as beta coefficient, beta is a measure of volatility, or systematic risk of a company’s stock as compared to the market as a whole. In a simple sense beta shows how a particular stock moves in relation to the market. Beta is dependant upon the time period used to calculate it and therefore it makes more sense to use long-term returns to calculate it. Usually, beta is calculated using several years returns. The reason is simple, an assumption that five years generally covers different sets of market conditions.

Beta is calculated using regression analysis. Investors need not get into the intricacies about the calculation of the beta but should be more concerned with its interpretations. To start with the beta of a stock will be between 1- and 1.

A beta of 1 indicates point-to-point movement with the broad market. A beta of less than one indicates that the stock is less volatile than the market and a beta of more than one indicates that the stock is more volatile than the market. So, basically beta of a stock measures the tendency of the stock to respond to the swings in the market. For example, Zee’s beta is 1.6 to BSE 100, so theoretically, the stock price of Zee is 60% more volatile than the market.

A negative beta means that the stock moves in an opposite direction when compared with the general markets. One has to remember that while this might not be true on all days on an average such a situation will be witnessed.

We calculated beta with data as far as 1998 of the BSE 100 stocks and compared it with the index to get a broader picture. About 63 stocks had a beta of less than 1, indicating that they moved in lesser proportion to the market and were less volatile. So, why do we consider them? Investors who are slightly risk averse would like to hold stocks with low beta as they might not be able to stomach so much volatility in their holdings.

This brings us back to the point as to what contributes to volatility? There are multiple reasons for the same – the expected rise of interest rates in the US may see money being pulled out of Indian markets, the recent bird flu in Asia causing panic in FII community and restricting inflow of funds into India, expiry of contracts in the derivative markets in India, the upcoming assembly elections, huge P-notes outstanding positions in India, existing of quick money by way of hedge funds and other such reasons. Most of the reasons, if you see are external in nature and cornering around FIIs and some of them are recurring. FIIs have become an integral part of Indian capital markets and the market reacts accordingly.

The investor on their part need to look at the betas carefully and these are usually made available by brokerage houses and other research outfits. Some financial publications also give details of beta but the key to the whole process is understanding them properly.

Regards,
Haresh

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03/24/04EU Ruling Against Microsoft #

Melanie Hollands


The European Union's ruling (leaked Monday, and officially announced today) against Microsoft -- a fine of €497 million for antitrust violations -- is a joke.

Even if Microsoft has to end up unbundling the audio and video from this version of Windows -- which is not a technical problem whatsoever -- the company will find somw way to justify a reason to bundle it all back together again the way it was planned - possibly in Longhorn (the next version of Windows, due out in 2006). It could also reassemble the pieces in some other product. Alternatively, the company still could reach a compromise with the EU.




The hope appears to be that the ruling would prevent rebundling the audio and video in Longhorn or some other package. But I don't think it sticks. Microsoft's point is that integration makes the user experience better - that its audio and video programs will still work the best with the Microsoft product. In addition, the company argues that (me paraphrasing) it is being unfairly treated in a "free market". Yeah, whatever.

Anyway, as a result of this ruling, the company may have to let in competitors on its API code. Now, I think there are many customers who would welcome buying an unbundled product, for thomw these video and audio apps add little (if any) value. And my guess is that if Microsoft charges the same price for "bundled (Windows + Apps)" versus "unbundled "Windows" + "unbundled apps" (and I don't see why they wouldn't), then it's all the same to its bottom line. Now, other companies can make an interface between Microsoft and these other programs to simulate an integrated user experience. But it seems these programs don't run as fast or as well.

Anyway, these are come of the claims being made by the Microsoft camp.

The EU ruling potentially opens up the door for other organizations to sue Microsoft. And over time, it's possible this could erode Microsoft's credibility. But I doubt that erosion to its credibility will be quick, due to its way dominant market position and the substantial financial resources it has at its disposal to defend itself.

I don't see a major or immediate impact on the MSFT stock price as a result of the EU ruling (perhaps a small "relief rally" after the official announcement). But I do think that the stock progressively and gradually will continue to weaken over the long-term (say, 1-2 years). For now, I see support for the stock in the $23.50 to $24 range. MSFT is in the process of forming a substantial bottom pattern, so I would hold off going long until that bottoming process is more complete, and so long as the broader market continues to soften.

Looking out longer term, say in 12 months' time, I believe that MSFT will be trading at lower levels than it is currently, even if the market is marginally higher. It's a rough period for a share price when a company goes from being a growth stock to a value stock and the ownership constituency shifts from growth- to income-oriented. Then discount the risk of being declared a monopoly at Microsoft, as well as the threat of a substitute technology such as Linux, which is a substantial longer-term threat in my opinion.

The basic problem I see for Microsoft (and to reiterate some of what I have written previously in this column) is that IT budgets are not going to grow very fast over the next several years, and the company already owns large chunks of the market. So there is limited ability to increase revenues from the Office business, because Microsoft risks ticking people off and driving more people off license.

Growth in new PCs, and therefore operating system sales, is likely to be constrained to three to four upgrades for laptops and four- to six-year cycles for desktops. Creation of new markets for other sorts of operating systems will probably be constrained by the reluctance of many potential partners to get into bed with Microsoft. That said, Microsoft does have some areas where it can grow, such as databases and analytical services, as well as growth opportunities in the small business end-user segment.

Weighing up these factors, my view is that MSFT stock trading at nine times sales seems a bit high. I think five to six times sales is more reasonable, considering its growth opportunities for the next couple of years. However, mutual funds often own MSFT as a proxy to the NASDAQ Index (of which MSFT contributes around 12% on a weighted basis) or the tech sector. So, I doubt that the stock would sink to such lower valuations any time soon. Going forward, I think MSFT can continue to trade in a $24 - $28 range for a while.

Cheers

Melanie Hollands
President
Koala Capital, LLC

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03/10/04re: Reply to Rakesh - Market Direction #

Jacob Kaldenbaugh


Melanie,
If you're saying we're in a correction, I'm inclined to agree with you. I think we'll see some volatility as it hashes out, but I am strongly biased for continued declines. I'm always negative the market when gas prices get this high, and they're close to record highs right now. I believe that gas prices remove such a great deal of capital from business and consumer accounts, that it stunts economic growth. I've been asserting for some time now that the Fed would sit tight on rates. While I never felt that the economy was rebounding as much as the market believed, I think that recent comments by Greenspan indicate that he may be considering an increase now. Especially if you believe, like some do, that the increase in commodity prices presages extensive inflation. It's almost a chaos type of analysis because if gas prices also continue to rise, then we could see a real dampening of the economy as consumers get hit in the pocketbook. Should be interesting to watch. Regardless, the only sector I'm a fan of at the moment are select international plays.
Tech is somewhat of an anomaly. Tech continues to show fundamental strength, but it's pretty fully valued right now. We won't have a replay of 2000 because most tech companies are better run and capitalized than they were then. What we are seeing is that valuations are getting stretched as investor expectations have gotten ahead of the reality of growth (it's coming, just not *that* fast).
I still like media companies that are trying to put together a digital model. It's still early, but I don't see anything that discourages me from the sector. I am, however, being very picky about valuation. That being said, it's good to see Apple continue to rise, especially in this market. Wait until the market figures out its retail+small biz strategy! I think it'll see $30 by the end of the year, easy.
Hope all is well.
Best,
Jake


> Melanie Hollands wrote:
> Rakesh,
>
>Your interpretation of my market note below is not correct.
>
>My note refers to the process of correction that began in mit-to-late January, 2004: 1) on January 13 for the SOX (January 13 being the date that Index peaked), and 2) on Janaury 26 for the Dow, S&P 500 and NASDAQ (January 26 being the date those Indexes peaked).
>
>I don't belive that tech is "about to tank" and did not write that.
>
>However, I did write that I believe this correction is not over.
>
>I belive that the correction will continue with the market moving sidewaye with a downward bias for another month or more (possibly, stress POSSIBLY, as long as anotehr four months but there are a number of factors that could influence how much longer the market corrects.) I will take it as it comes; but for now I don't believe that the correction, which has been underway for 6 weeks or more now, is over. That said, today was a weak day across the board and if this continues, and we get sufficiently oversold, then we should bounce a bit at some point.
>
>I hope this clarifies my views.
>
>Cheers
>
>Melanie

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03/09/04re: Reply to Rakesh - Market Direction #

Steven Poser


Stocks have been moving mostly sideways to lower (depending on what part of the market you look at) for a bit of time now, as Ms. Hollands noted. Several areas made new s-t lows on Monday. I have a letter that recommended sales for SMH, the semi-conductor HOLDR at $43.70. We are still short and looking for $38.40 on that, but barring a strong move below there, our view is that this is still just a correction. The S&P can slip to 1122 or so. IF the markets get much lower than that level, we might very well be in a deeper correction of 10-15% off the highs. Our preferred view is for that correction to start from a new high, and not now. Long-term is much more bearish, but I do not see major problems until Q3 or Q4. But, deflation will be coming back around again in the press real soon. Not saying we will get it, just that talk of it will return.

Steven W. Poser

> Melanie Hollands wrote:
> Rakesh,
>
>Your interpretation of my market note below is not correct.
>
>My note refers to the process of correction that began in mit-to-late January, 2004: 1) on January 13 for the SOX (January 13 being the date that Index peaked), and 2) on Janaury 26 for the Dow, S&P 500 and NASDAQ (January 26 being the date those Indexes peaked).
>
>I don't belive that tech is "about to tank" and did not write that.
>
>However, I did write that I believe this correction is not over.
>
>I belive that the correction will continue with the market moving sidewaye with a downward bias for another month or more (possibly, stress POSSIBLY, as long as anotehr four months but there are a number of factors that could influence how much longer the market corrects.) I will take it as it comes; but for now I don't believe that the correction, which has been underway for 6 weeks or more now, is over. That said, today was a weak day across the board and if this continues, and we get sufficiently oversold, then we should bounce a bit at some point.
>
>I hope this clarifies my views.
>
>Cheers
>
>Melanie

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03/09/04Reply to Rakesh - Market Direction #

Melanie Hollands


Rakesh,

Your interpretation of my market note below is not correct.

My note refers to the process of correction that began in mit-to-late January, 2004: 1) on January 13 for the SOX (January 13 being the date that Index peaked), and 2) on Janaury 26 for the Dow, S&P 500 and NASDAQ (January 26 being the date those Indexes peaked).

I don't belive that tech is "about to tank" and did not write that.

However, I did write that I believe this correction is not over.

I belive that the correction will continue with the market moving sidewaye with a downward bias for another month or more (possibly, stress POSSIBLY, as long as anotehr four months but there are a number of factors that could influence how much longer the market corrects.) I will take it as it comes; but for now I don't believe that the correction, which has been underway for 6 weeks or more now, is over. That said, today was a weak day across the board and if this continues, and we get sufficiently oversold, then we should bounce a bit at some point.

I hope this clarifies my views.

Cheers

Melanie

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03/08/04re: Market Direction #

Rakesh Sahgal


Hi Melanie,

Re. your contention that the markets esp. the tech part of it is about to tank, I would like to submit that the process of a correction was initiated around the 23rd of Jan, '04 - in terms of the NDX. Matter of fact the market has by today corrected the rise commencing 11/21/03 to 01/20/04, by approx 62%. I am unaware of your views on technical analysis. However I would like to think this appears to be the final stages of the shakeout and again the market (in NDX terms) should find support around the 1420 regions on the weekly charts and around 1380 on the monthly charts. Will any of the suport levels hold? Your guess is as good as mine. If they dont I wont hesitate in changing my perception of the market. However in the interrignum I would like to keep an eye out for an end of the present correction given the close proximity of the NDX to underlying support levels on the weekly and monthly charts. This is again loud thinking and no more. The markets have this nasty habit of making all wannabe gurus like me look foolish. So I for one would like to play it by the ear and see how the cookie crumbles, as they say in your country.

> Melanie Hollands wrote:
> I write a weekly market column and / or technology column at various investment sites. On January 14, 2004, I wrote that I thought the market "felt" like it could be due for a correction. At that time a number of elements that caught my attention. First, the put/call ratio, which was they are almost even, whereas usually puts are a multiple of calls. Second, stock newsletters in general were very bullish (often, but not always, a bearish sign). Third, stocks in general, and technology stocks in particular, had run from their 50-day moving averages with no pullback in ten months. Fourth, the weakness in the US dollar; and I don’t yet see the US economy in a self-sustaining recovery. Fifth, we were in the throes of earnings season. Tech stocks in particular looked unlikely to hold onto their lofty valuations - it seemed unlikely that underlying growth rates at technology companies would, for the most part, match expectations that were baked into stock prices.
>
>Since January 14, 2004, the market has corrected a bit. But before I describe the market action over the last six-to-seven weeks, I must point out that while in this case I was right that things had started to “feel” different I don't always get it right; I don’t know anyone in this business who does although some are better at it than others. “Predicting” market direction is not my specialty (I’m a stock analyst, not a market technician) and often one gets the timing of a change in market direction wrong a few times before getting it right. This is one of the reasons I rarely trade the "ends" of a trend. Often, I have ended up spinning my wheels trying to “predict” a change in direction and this has lead to friction loss from entering and unwinding positions. I know some who do trade these “ends” well but I am not one of them. In general, I prefer to enter a trend once it has started although there have been exceptions.
>
>First, taking a look at the SOX, the Philadelphia Semiconductor Index, this has been a leader in this market correction. This index reached what was, in hindsight, a roughly 21 month high of 560.65 on January 13, 2004; around 21 months earlier, on April 22, 2002, the SOX had closed at around 573. On January 14, 2004, the SOX has fallen back around 10% to close Friday March 504.25.
>
>Second, taking a look at the NASDAQ this has also corrected although it has lagged the SOX by nearly two weeks. The NASDAQ closed at 2153.83 on January 26, 2004; the Index had not traded at around these levels for around two and a half years when, on June 12, 2001, it closed at 2169.95. Since January 26, however, the NASDAQ has traded down almost 5% to close Friday March 5, 2004, at 2047.63.
>
>This correction could potentially last another one to four months (although if the market gets more oversold then it should bounce a bit). Notice that merger news gets no traction; rather, it gets a one-day pop on low volume followed by a slide back. In addition, many economic numbers have been disappointing. The Chicago Purchasing Managers’ index (PMI) was positive in February, but it’s more of a “gut check survey rather than empirical data. Recent economic releases based on “actual” numbers – such as Durable Goods, Capacity Utilization, Consumer Spending, Industrial Capital Equipment Spending, and Unemployment – have all been weaker than expected. Contrast this with the Department of Commerce comments that 2003 federal spending was +8.7% in the third calendar quarter of 2003 - the highest since being up 9.9% in 1967. And furthermore, the economy has not indicated it is in a self-sustaining recovery - yet.
>
>Following a substantial influx of cash at the beginning of 2004 - $40.8 billion in January - the market continued to rally until January 26 when both the NASDAQ and the Dow Jones Industrial Average (DJIA) peaked (although as mentioned above the SOX had peaked nearly two weeks earlier on January 13). At that point, the NASDAQ Index topped and reversed, while the DJIA and the S&P 500 Indexes each formed a temporary top. Since then, neither the DJIA nor the S&P 500 have pulled back as aggressively as the NASDAQ, and both have remained within striking distance of their 52-week highs. While these larger cap indexes have stalled or pulled back, mid-to-smaller cap indexes such as the S&P MidCap 400 Index and the S&P Small Cap 600 Index have continued to make new 52-week highs.
>
>This suggests a market consolidation period that could last anywhere from one to four months. However, consolidation does not mean that the primary rally is over; just that it is “resting” and pulling back a bit. The DJIA and S&P 500 have yet to experience a 5% pullback from their January 26 highs of 10,702.51 and 1,155.37 respectively. As of March 5, the Dow had pulled back 1% and the S&P closed all but flat with its January 26 high – up 0.13% to 1,156.86. (The S&P includes more mid-cap stocks, which, given the continued run up in mid-to-small cap stocks, probably accounts for its recent relative strength versus the large-cap DJIA and NASDAQ Indexes.) Until we get a 5% pullback or more in these indexes, then my view is that an endpoint in the primary rally of the last 12 months is not yet in sight despite this secondary (correcting) trend. Once the market gets that level of correction, then I’d be on the look out for another run-up. But that begs the question “What is the next catalyst to propel the market higher again?” One will emerge, but at this stage I don’t yet see one and see the market trading in a range for a while longer.
>
>Cheers
>
>Melanie Hollands
>President
>Koala Capital, LLC

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03/08/04Market Direction #

Melanie Hollands


I write a weekly market column and / or technology column at various investment sites. On January 14, 2004, I wrote that I thought the market "felt" like it could be due for a correction. At that time a number of elements that caught my attention. First, the put/call ratio, which was they are almost even, whereas usually puts are a multiple of calls. Second, stock newsletters in general were very bullish (often, but not always, a bearish sign). Third, stocks in general, and technology stocks in particular, had run from their 50-day moving averages with no pullback in ten months. Fourth, the weakness in the US dollar; and I don’t yet see the US economy in a self-sustaining recovery. Fifth, we were in the throes of earnings season. Tech stocks in particular looked unlikely to hold onto their lofty valuations - it seemed unlikely that underlying growth rates at technology companies would, for the most part, match expectations that were baked into stock prices.

Since January 14, 2004, the market has corrected a bit. But before I describe the market action over the last six-to-seven weeks, I must point out that while in this case I was right that things had started to “feel” different I don't always get it right; I don’t know anyone in this business who does although some are better at it than others. “Predicting” market direction is not my specialty (I’m a stock analyst, not a market technician) and often one gets the timing of a change in market direction wrong a few times before getting it right. This is one of the reasons I rarely trade the "ends" of a trend. Often, I have ended up spinning my wheels trying to “predict” a change in direction and this has lead to friction loss from entering and unwinding positions. I know some who do trade these “ends” well but I am not one of them. In general, I prefer to enter a trend once it has started although there have been exceptions.

First, taking a look at the SOX, the Philadelphia Semiconductor Index, this has been a leader in this market correction. This index reached what was, in hindsight, a roughly 21 month high of 560.65 on January 13, 2004; around 21 months earlier, on April 22, 2002, the SOX had closed at around 573. On January 14, 2004, the SOX has fallen back around 10% to close Friday March 504.25.

Second, taking a look at the NASDAQ this has also corrected although it has lagged the SOX by nearly two weeks. The NASDAQ closed at 2153.83 on January 26, 2004; the Index had not traded at around these levels for around two and a half years when, on June 12, 2001, it closed at 2169.95. Since January 26, however, the NASDAQ has traded down almost 5% to close Friday March 5, 2004, at 2047.63.

This correction could potentially last another one to four months (although if the market gets more oversold then it should bounce a bit). Notice that merger news gets no traction; rather, it gets a one-day pop on low volume followed by a slide back. In addition, many economic numbers have been disappointing. The Chicago Purchasing Managers’ index (PMI) was positive in February, but it’s more of a “gut check survey rather than empirical data. Recent economic releases based on “actual” numbers – such as Durable Goods, Capacity Utilization, Consumer Spending, Industrial Capital Equipment Spending, and Unemployment – have all been weaker than expected. Contrast this with the Department of Commerce comments that 2003 federal spending was +8.7% in the third calendar quarter of 2003 - the highest since being up 9.9% in 1967. And furthermore, the economy has not indicated it is in a self-sustaining recovery - yet.

Following a substantial influx of cash at the beginning of 2004 - $40.8 billion in January - the market continued to rally until January 26 when both the NASDAQ and the Dow Jones Industrial Average (DJIA) peaked (although as mentioned above the SOX had peaked nearly two weeks earlier on January 13). At that point, the NASDAQ Index topped and reversed, while the DJIA and the S&P 500 Indexes each formed a temporary top. Since then, neither the DJIA nor the S&P 500 have pulled back as aggressively as the NASDAQ, and both have remained within striking distance of their 52-week highs. While these larger cap indexes have stalled or pulled back, mid-to-smaller cap indexes such as the S&P MidCap 400 Index and the S&P Small Cap 600 Index have continued to make new 52-week highs.

This suggests a market consolidation period that could last anywhere from one to four months. However, consolidation does not mean that the primary rally is over; just that it is “resting” and pulling back a bit. The DJIA and S&P 500 have yet to experience a 5% pullback from their January 26 highs of 10,702.51 and 1,155.37 respectively. As of March 5, the Dow had pulled back 1% and the S&P closed all but flat with its January 26 high – up 0.13% to 1,156.86. (The S&P includes more mid-cap stocks, which, given the continued run up in mid-to-small cap stocks, probably accounts for its recent relative strength versus the large-cap DJIA and NASDAQ Indexes.) Until we get a 5% pullback or more in these indexes, then my view is that an endpoint in the primary rally of the last 12 months is not yet in sight despite this secondary (correcting) trend. Once the market gets that level of correction, then I’d be on the look out for another run-up. But that begs the question “What is the next catalyst to propel the market higher again?” One will emerge, but at this stage I don’t yet see one and see the market trading in a range for a while longer.

Cheers

Melanie Hollands
President
Koala Capital, LLC

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03/05/04USD / Euro #

Melanie Hollands


There's some really interesting stuff going on with the US dollar. In particular, an interesting development looks like its about to unfold in the USD / Euro.

Easy Al (Greenspan) was harping all last week that a weaker dollar is good for the US so long as depreciation has been gradual. Now, in hindsight he probably had good information in advance on market positioning and, hence the washout in the Euro/USD over the past week. Greenspan was trying to stall the dollar bounce from happening.

Now, think of what happens as an end result: even if there are equity inflows into the US, a stronger dollar means that Asian central banks won't need to be buying as much dollars to support the USD. Therefore, they need to buy less treasuries; which, in turn, means that interest rates will rise in the bond markets. That is defintiely something Easy Al doesn't want right now.

See the irony?

The scenario I just sketched out is a real possibility, so Easy Al and his gang can't afford to let it unfold. I would expect Snow & Co. and Easy Al to comment more on the dollar in the next week or two. Rememebr, Al has NEVER commented on forex prior to last week. In fact, he took pains to remind questioners that FX policy belonged to Treasury and wasn't the domain of the Fed.

As I said above, interesting developments on a more macro scale that the deal folks at the Fed need to keep under control.

Cheers

Melanie Hollands
President
Koala Capital, LLC

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03/05/04Oracle 4 PeopleSoft #

Melanie Hollands


The anti-trust issue with Oracle / PeopleSfot does not apply to ALL of Oracle's lines of business and is, therefore, a bit harder to see from the outside.

The crux of the anti-trust issue is with the apps business - both ERP and CRM. Removing PeopleSoft from the ERP business (particularly now that it bought JD Edwards) leaves SAP with a likely more dominant share of the business than today. Looking at the high-end of the market, Oracle has about 35-40% right now and this would increase to >50% market share of the high-end if Oracle succeeds at buying PeopleSoft.

There are many that will not buy the PeopleSoft product from "Oracle / PeopleSoft", even if Oracle swears it will continue to "support" it. Folks will assume that Oracle will underinvest in the further development of the app - and no one wants to invest in ERP software that is bound to become obsolete in 4-5 years.

Oracle buying PeopleSoft means death to the CRM portion of the business and concentrates the call center software market squarely in the hands of Siebel. Same reason. If the market is defined a bit more broadly to include the upper mid-market for ERP and to a lesser extent CRM, then the concentration picture is a little bit less bad - but not that much. Oracle would most likely benefit from this.

The Clayton Act doesn't require a market become a monopoly to act to bar a merger. It only has to have a bad impact on the competitive dynamics. And this is an important reason why the anti-trust issues will (in my opinion) prevail in the case of Oracle / PeopleSoft.

Cheers

Melanie Hollands
President
Koala Capital, LLC

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02/27/04re: Oracle 4 PeopleSoft #

Jay Swartz


Melanie,

You called it; the SEC is working to block the deal.

BTW, anyone watch the Larry interview on 60 minutes?

Regards,

J


> Melanie Hollands wrote:
> The real issue in this merger is not the offering price that Oracle may (stress MAY) be able to have approved by PeopleSoft, but rather the liklihood of the deal passing muster with anti-trust issues. Getting Regulatory approval will be, in my view, central to whether or not the deal gets done - not the actual bid price. I doubt the deal gets regulatory approval.
>
>Cheers
>
>Melanie

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02/19/04Oracle 4 PeopleSoft #

Melanie Hollands


The real issue in this merger is not the offering price that Oracle may (stress MAY) be able to have approved by PeopleSoft, but rather the liklihood of the deal passing muster with anti-trust issues. Getting Regulatory approval will be, in my view, central to whether or not the deal gets done - not the actual bid price. I doubt the deal gets regulatory approval.

Cheers

Melanie

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02/17/04re: Oracle4 PeopleSoft #

Ananda Chakravarty



Melanie,

Your comments on Oracle's takeover bid for Peoplesoft is mostly on the mark. But I still am a believer in Peoplesoft products. It's a company that is worth more than the $16-$20 you suggested. Not just for the incoming cash flow but because of the customer loyalty they have generated - an intangible that is rarely reflected on an income statement or balance sheet. They have a strong customer support team and have consistently upsold and crosssold products to existing customers.

The viability of Oracle buying out PeopleSoft does focus on the regulatory authorities. But I would venture to say that if ORCL purchases PSFT, PSFT is dead. Their assets will dwindle and they will suffer the same fate as those miniature companies that MSFT swallowed up one by one. From ORCL's perspective, this is just removing a major competitive threat. Even if it's a financial loss, Ellison has an incentive to take PSFT out of the market. Too much of ORCL's business has been siphoned out to PSFT and Siebel in the past couple of years, and I can see how this will impact the market as a whole. SAP will be a survivor, but on the fringes only. The CRM/ERP efforts over the last two years have been so dismal that PSFT just can't show it's stuff and bring out a strong sales cycle.

I think ORCL will continue bidding on PSFT until it either replaces a majority of the board (unlikely) or is able to present such a high bid (stock & cash) that it will cause PSFT shareholders to crumble. Hostile takeovers are fun to watch (but not participate in - especially as the acquiree!!!). I'd like to see a poison pill get enforced in this kind of a battle. I doubt there would be any white knights to save PSFT in this fight though - except maybe the government.

Ananda Chakravarty

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02/14/04Oracle4 PeopleSoft #

Melanie Hollands


I still think this deal has a snowflake's chance in hell of getting done.

Ellison is certainly determined not to give up on acquiring PeopleSoft. But not at $26 per share, since PeopleSoft rejected the new bid earlier this week. The point of raising the bid, in my opinion, was to offset the negative of an obviously ridiculous bid that was on the table. Oracle is trying to get institutions to vote for its slate of directors. Candidly, if I were a PM at Fidelity I would laugh in Oracle's face if management tried to get my proxy with a below-market bid on the table. That's all this really meant, I think.

That said, perhaps there is an even higher price at which PeopleSoft might sell to Oracle. Craig Conway, PeopleSoft’s chairman and CEO, has made his point and might potentially give in if the price is right. His golden parachute, coupled with the moving up of the shareholders meeting, just gives me the feeling that something could be going on. Or maybe this is just more tactics in defense ... hard to say.

I thought this deal highly unlikely to succeed since the day the deal was announced in early June 2003, and I'm still of that view. Larry's ability to hit the right price for PeopleSoft is one aspect of this saga, but getting regulatory approval for this deal is a whole different can of worms. On this basis, it’s still hard to predict the outcome of Oracle's hostile bid for PeopleSoft, but I’m inclined to believe that Oracle is unlikely to succeed. Given the discount to the bid on Friday, I think the market shared my view. So, I'm not that surprised that PeopleSoft rejected the bid.

The real issue in this hostile takeover is whether the Justice Department, state attorneys general and EU authorities rule against the merger. If so, it's not necessarily legally dead, but I can't see Oracle persisting. Time was the enemy when Oracle was thinking of preventing the J.D. Edwards deal. The Oracle bid for PeopleSoft probably ends if there is an anti-trust finding against Oracle. Although this one is still close to call right now, I'm still inclined to think the bid fails.

I know a bunch of folks who argue that this should NOT be an anti-trust issue. But in my opinion, it is and the anti-trust issue is with the apps business - both ERP and CRM. Removing PeopleSoft from the ERP business (particularly now that it bought JD Edwards) leaves SAP with a likely more dominant share of the business than today. If you look at the high end of the market they have about 35-40% right now and it would be >50% if Oracle buys PeopleSoft. There are many that will not buy the PeopleSoft product even if Oracle swears it will continue to "support" it. Folks will assume that Oracle will underinvest in the further development of the app - and no one wants to invest in ERP software that is bound to become obsolete in 4-5 years. Oracle buying PeopleSoft means death to the CRM portion of the business and concentrates the call center software market squarely in the hands of Siebel. Same reason. If you define the market a bit more broadly to include the upper mid market for ERP and to a lesser extent CRM, the concentration picture is a little less bad - but not that much. Oracle would most likely benefit from this. The Clayton Act doesn't require a market become a monopoly to act to bar a merger. It only has to have a bad impact on the competitive dynamics.

As far as I’m concerned, the Oracle bid for PeopleSoft only makes sense within the orbit of the Ellison ego. But Oracle didn't play its cards right. Management’s attempt to talk down PeopleSoft's product line by saying it was going to discontinue the products was a misstep. It made a lot of people angry. And made a hostile takeover that much more hostile. Maintenance of Oracle's customer base, that's what it was about. Oracle was going to take the PeopleSoft products it liked and leave the rest while keeping the maintenance revenue stream. Even if that was Oracle's intention the company never should have made it public. Big mistake.

However, from a shareholder value perspective it could be argued that the deal should get done. For example, take the most recent bid of $26. On the basis of company fundamentals, I just don't think PSFT is worth that much. Maybe $16, $17 ... $18 tops, but not $26. So, a 44% premium to (what I estimate as) fair value would be very attractive. Perhaps PSFT shareholders will see the greatest value to themselves lying with approving the Oracle acquisition at an even higher price. I think if you are a major shareholder and you don't go for the Oracle deal, from a purely financial perspective you should have your head examined. I’m not saying that I think the deal will get done; I’ve already stated I believe it will get blocked due to regulatory matters. I'm just saying that is one scenario whereby this deal could get done since, financially speaking, it really is in the shareholders interest. Take the cash now and buy ORCL or SAP stock. Holding PSFT at around $22 (roughly it's current levels) is not the best financial choice available for a shareholder when there is a bid for $26, or perhaps even more, on the table.

PS: I see in Wednesday's (or was it Thursday's) WSJ that Oracle is "soliciting support for a possible court battle with the Justice Department to defend the company's hostile bid for PeopleSoft". This is not surprising; and as I've said before, the outcome of this takeover bid will more than likely hinge on anti-trust issues.

That said, I don't think the DOJ should be futzing around in these matters - it's bad law. On the other hand, if Oracle buys PeopleSoft, then it's bad for PeopleSoft users and the apps business generally because it will wind up concentrating more of the business in SAP's hands when a bunch of customers flee from Oracle.

Cheers

Melanie Hollands
President
Koala Capital, LLC

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02/08/04An In-Depth Look at Red Hat (RHAT) #

Melanie Hollands


I like RHAT stock long and think it can move up to around the $22 price target within the next few months. However, I expect a volatile ride on the way to $22. This price target represents a cash flow multiple of 24x consensus' fiscal 2006 Operating Cash Flow (OCF) per share of $0.93. I would be inclined to build a position in RHAT from here down to around $15 (the gap close) for a couple weeks. Then, if the broader market gets more positive the upside coming into the Spring I would add to the position. My guess is that if the stock turns up again, then $30 (or 32x 2006 OCF) is possible in the next 12-18 months. But for now, I am keeping a 3-month price level of $22 in mind.

However for a short-term trade rather than a position, there is another way to play RHAT depending on how the stock trades over the next few days. RHAT is close to the 50 day moving average (DMA) and it appears poised to bounce off of that level ($17.02). If it does bounce off the 50 DMA, then the stock could potentially move up to the $21-$22 area; and if we got a real “whoosh” down to the 50 DMA then it could potentially rebound in as short a time frame as the next few weeks. The stock just appears to be getting oversold, although I would still want to see it trade down to around the $17.20 level before I would commit. And if, under this scenario, it does trade down to the $17.20 area, I might put some short-term money to work there.

Bear in mind that the Street is not uniformly bullish on RHAT. In particular, Barron’s recently published a quite negative piece on the company and the stock's prospects. However, I remain bullish longer-term on this particular Linux play but I do expect a lot of volatility along the way. So, buckle up and be prepared for a bumpy ride in a long-term position in this name.

Red Hat's business momentum continues to be strong, and the company looks to be hitting its sweet spot in growth. Some of you may recall that I used to cover Red Hat when I was an analyst at Merrill Lynch, although in 2000 I was not particularly bullish on the name. However, both the times and Red Hat’s business outlook are different and part of my current thesis, is that as long as consumer resistance continues to build against Microsoft's relatively weaker products, then Red Hat will continue to grow. I understand that many of Red Hat’s hardware partners are likely to pre-load a higher-end version of Red Hat's Linux and this could potentially boost Red Hat’s revenues and, consequently, it’s sequential growth rates during the summer months. Red Hat's biggest opportunity for revenue growth and market share expansion lies with improving the attach rates of “paid Linux” versus “free Linux”. In its third fiscal quarter, Red Hat's attach rate of “paid-for” Linux unit shipments for servers was 15%. This left the remaining 85% to potentially migrate from “free Linux” to “paid Linux” or Linux support.

Competition in the Linux space has increased quite significantly. In particular, despite increased competition from Novell, growth rates of 25% to 30% are widely expected for Linux adoption, and this should provide allow at two (or perhaps three) primary Linux operating system distributions to thrive during 2004. Red Hat's dominant position in enterprise Linux servers continues to overshadow any available packaged Linux operating system.

Unique to the software industry, Red Hat's business momentum is led by a demand-driven product line that has high levels of awareness in it’s end-user market, and as a result Red Hat’s products require relatively little marketing to its customers. Over 2,500 new customers signed up in third fiscal quarter, up from 1,500 new customers the previous quarter and 1,000 in the previous, first fiscal quarter. From what I hear, it’s quite possible that new quarterly subscription contracts could reach around 40,000 new subscriptions, which would be up 21% sequentially from 33,000 new subscriptions in the previous quarter.

Red Hat’s competes in a high-growth software market that longer-term can deliver perhaps as much as $10 billion in annual revenue – representing, roughly speaking, $4.0 billion associated with the server, and another $5-$7 billion associated with the other layers of the operating system, such as application server, applications, database, and storage. I believe Red Hat's strategy to build its business foundation on providing a superior operating system running on the server will deliver substantial benefits in the future to the company and its network of business partners. Even competitors that I have recently spoken with -- including Novell -- acknowledge that the bulk of the profits in the initial Linux movement during the next two to three years will likely be derived from the server business, not the desktop. Although the unit volume of desktop applications is larger desktop unit prices are much lower, whereas the dollar volume associated with the server business is much higher.

Over time, I expect the basic operating system on the server to become a commodity, and therefore as unit sales volumes increase pricing of the core product will fall. Hopefully, Red Hat will be able to hold software pricing at around $500 per server per year and offset the dynamics of commoditization by adding incremental features at the edge of the server. This can be achieved by moving into adjacent layers of the server such as application server, applications, database, and / or storage. It is possible that both gross margin per server and the unit volume of servers sold should increase over time, partially or even largely offsetting the likely price decline in the core server operating system.

Another sting in Red Hat’s bow is the $585 million (ex financing costs) of newly raised capital during the last month with a convertible debenture. This war chest of new cash increases Red Hat’s balance sheet to around $913 million in total cash, up from $328 million at the end of the third fiscal quarter. Wisely and prudently spent, this can help leverage Red Hat's market leadership position beyond its core server operating system and into tangential areas.

As it moves beyond its core business, Red Hat will potentially face competition with many of its current business partners (e.g. BEA Systems). Red Hat claims that the end-markets are segmented into low- and high-end user needs, however I see potential for risk if the company becomes overly “granular” with its market segmentation. Strategically speaking, Red Hat will need to be careful, and somewhat selective, in the sub-markets it chooses to enter. Otherwise, the company could risk being “de-supported” from some of its business partners such as Oracle and BEA Systems that have enabled Red Hat to achieve the success it has achieved to date. That said, for the foreseeable future Red Hat should continue to enjoy substantial business leverage and tactical latitude on the server before management likely has to be concerned about seriously stepping on any of its partners’ toes.

Consistent with Red Hat's strategy to expand beyond its server operating system, the company is expect to introduce its own version of an open-source application server sometime during the Summer of 2004. This new server product will be based on JonAS, a pure Java open source implementation of the EJB (Enterprise JavaBeans) specification. (The current stable release is version 3.3.5.) JonAS has already been downloaded by over 150,000 people and is used in hundreds of operational applications, including e-commerce, e-portal, management systems, intranet applications, document processing, inventory systems, reservation systems, and banking applications, with various operating systems (including AIX, HP-UX, Linux, Solaris, Windows) different JVMs, and a variety of databases (including Access, DB2, Informix, Interbase, MySQL, ObjectStore, Oracle, PostgreSQL, and SQL server).

I understand that Red Hat has already advised BEA Systems, a current business partner, that this move will largely focus on more departmental needs than on enterprise deployments. Red Hat's move further validates BEA's presence inside the application server market, although in general I prefer not to think of the desirability of one company’s move as being measured by imitators but rather the desirability of the overall market segment. That said, Red Hat's application server product offering is in its infancy.

Red Hat’s biggest opportunity for continued revenue growth and market share expansion appears to be in improving attach rates of “paid Linux” versus “free Linux”. In the third fiscal quarter, Red Hat's attach rate of “paid-for” Linux running on the server was 15%, up from around 12% in the previous, second fiscal quarter. Red Hat management had originally thought the overall potential for “paid-for” Linux was 55% of the unit shipments (the other 45% would use some type of free Linux). However, that figure now is closer to 75%, based on the initial success Red Hat is having with its customers. For example, I understand that one major hosting company that originally piloted a free version of Red Hat Linux is now deploying around 12,000 “paid-for” copies of Red Hat Enterprise Linux (RHEL).

Another major driver pushing customers to deploy RHEL is the phasing out of Red Hat's older retail product. I believe there is a significant opportunity to move lower-cost users to full “paid-for” versions of RHEL. Red Hat has had strong success in late 2003 because Red Hat sold over 3,000 paid-for subscriptions to customer migrating off a lower-cost retail version. I believe there is potentially another upgrade wave as Red Hat phases out support for its retail version at the end of April 2004.


Hardware and Software Partners

In addition to the powerful resources of the open source development community, Red Hat's product line is being endorsed by a sterling roster marquee partners such BEA Systems, Dell, HP, IBM, and Oracle. Many of Red Hat's partners have yet to resell the current RHEL 3 product line. However the company’s hardware partners should begin to preload RHEL 3 in the February/March 2004 time frame. This is likely to provide yet another revenue catalyst since RHEL 3 now addresses over 80% of the available hardware devices - more than double what the earlier version RHEL 2 covered. Approximately 90% of the enhancements in RHEL 3 were generated around improvements in hardware support, with the remaining 10% of the enhancements to the new software were made based on end-user requests.

Dell Computer. Dell is Red Hat's leading business partner. Dell has also been a Red Hat reseller since early 1999, and currently resells a low-cost version of Red Hat software called R2. Toward the end of the first quarter this year, Dell is expected to start preloading RHEL 3, and over time Dell is also expected to offer Novell/SuSE as an alternative solution to Red Hat. This serves to reaffirm Dell’s commitment to Linux in general.

Fujitsu/NEC/Hitachi. From what I understand from industry sources, they are all just beginning to preload Red Hat RHEL 3.

Hewlett-Packard. HP is another marquis win for Red Hat, became a business partner only eight months ago, so it's a little early to assess progress on this front.

IBM, another Red Hat Partner, recently started preloading its X-series hardware with Red Hat 2 software in November 2003. IBMs commitment to Linux is also evident in the company's $50 million investment in Novell. This will offer IBMs customers a choice of Linux operating systems -- one from market leader Red Hat as well as Novell.

Oracle. CEO Larry Ellison recently referred to Red Hat as a "key partner." Allied to this, I understand that Red Hat has made a significant number of enhancements to its RHEL 3 software (I've heard up to as many as 40 to 50 enhancements) that are directly in support of Oracle's database and applications.

That said, in my view Larry calling any company a "key partner" plus two bucks gets you on the Manhattan subway these days. But it does point to Oracle's heavy push into the Linux world as a way of countering IBMs push in this front (Oracle versus DB2), and as a way of getting parity with Microsoft SQL Server pricing for cheapo implementations. (I'm not all that sure whether after paying Red Hat whether you're as cheap as Windows, though.)

Oracle continues to hammer away at the part of the market that's got a relatively simple set of requirements, a simple business system, and no desire to do anything fancy. I'm guessing that 25% of the enterprise market is in this category. For the upper mid-market, they're probably going to stop losing as much share to Microsoft because they've figured out a way to make a plain vanilla implementation easy to deploy and (maybe) maintain.

On the other hand, Oracle continues to have a real gap between the story management talks about and the reality of what it’s doing. In the apps business it appeals to the "I-don't-give-a-crap-just-make-it-simple" buyer, and there's nothing wrong with that. But Oracle thinks/claims its stuff is better than anyone else's, which is such a laugh. I tell ya, software marketing executives…


Success in Vertical Markets Beyond Financial Services

Red Hat is steadily gaining customer acceptance in market segments beyond its traditional and core strength in financial services. I am hearing about early customer migrations in other vertical industry markets such as consumer, government, manufacturing, media, retail and telecom; and even better, I understand that migrations to Red Hat Linux are becoming more frequent in companies operating in these, and potentially other, verticals. For example, in media industry, Red Hat seems to be gaining traction. Word around the traps is that a quite large and well-known media company will be moving perhaps as many as 6,000 Unix-based servers to Linux over the next two to three years. I am not sure whether this will be Red Hat business; I would hope so. I also understand that consumer packaged goods leader Unilever has plans to migrate its entire internal Unix installed base to Linux by the end of 2006. I have no information as to whether Unilever will deploy Red Hat, but there seems little doubt as to its commitment to Linux. Companies’ increasing levels of interest in Linux serve as additional validation of the attractiveness of Linux in the corporate environment in general.


Increasing Competition in the Linux Space

Red Hat currently estimates its market share of the server business at around 80%. The company also estimates its share of all users of Linux across all user platforms at around 67%. I love companies with dominant market share. However, as the popularity of Linux continues to grow Red Hat’s dominant position will be eroded as strong competitors such as Novell (with its acquisition of SUSE) and Ximian enter and consolidate in the space. That said, Red Hat appears clearly focused on maintaining and growing its current Linux leadership. I understand that the company is currently the dominant player in almost all the industrial countries in which it offers its products. However, in terms of dollar sales Red Hat believes Germany is the only major industrial country in which it doesn’t have dominant market share. But this makes sense given that competitor SuSE's headquarters is located in Germany. Another serious competitor in the European market is Mandrake in France. In Asia, larger competitors include TurboLinux in Japan, and Red Flag in China.

Clearly, the competition is increasing. However Red Hat's expected $125 million revenues (based on consensus’ estimates) in fiscal 2004 overshadows the reported dollar figures from Mandrake, TurboLinux, and Red Flag combined, as measured on the basis of subscriptions/license fees. For now, Red Hat is leaps and bounds ahead of the emerging and growing competition. To provide some relative color, the number two Linux player SUSE (now owned by Novell) reported around $40 million in revenue last year – approximately equal to one quarter of Red Hat’s revenues.

But market leaders invariably lose some (and sometimes all) of their dominant share position over time. Based on past and projected future Linux-based unit server shipments, the market can easily sustain more than one competitor; and I think near-term the market can support two to even three solid competitors. In fiscal 2003, Red Hat management has estimated that around 800,000 Linux servers were shipped, up a substantial 32% from 600,000 servers shipped during fiscal 2002. Management’s estimates that around 2.1 million Linux servers will likely ship in 2007 (although I personally don’t like to forecast more than 1-2 years ahead). That said, management is projecting annual unit shipment growth of around 25% from 2004 to 2007.

Novell recently closed its acquisition of German-based SuSE, globally the second-largest distributor of Linux. Novell paid $210 million in cash for the company, and as a result has added 399 additional employees as well as significant Linux expertise to augment Novell's already solid engineering staff. IBM has agreed to buy a $50 million convertible debenture from Novell in conjunction with the acquisition, with terms and pricing of the debenture to be set soon. IBM is also a Red Hat partner. However, I don’t expect any significant changes to the relationship between Red Hat and IBM as a result of IBMs investment in Novell. Rather, I see IBMs investment in Novell as complementary, not threatening, to its relationship with Red Hat. IBMs relationship with Novell seems to be more a form of validation of it’s own Linux strategy and to be in a position to offer multiple Linux solutions.

Acquiring SuSE allows Novell to be significantly more competitive in the Linux market. The acquisition will also allow Novell to penetrate different sub-segments of the market since SuSE has specific expertise in Linux for mainframes and in Linux for the desktop. Compare this with Red Hat, whose core strength is in enterprise computing, i.e. Linux-on-Intel servers running corporate applications and data center infrastructure. However, Red Hat is actively competing with Novell/SuSE to provide IBM with (I understand) Linux software for 300,000 - 400,000 desktops. But this is early days, since the initial supply deal is for pilot-sized projects. That said, Red Hat’s competition for this and other contracts is heating up.

Novell is expected to announce a software protection program for its Linux customers. I understand that the terms of the program will provide customers of SuSE Linux, who sign a licensing agreement with Novell and keep their its support contract current, will receive protection from copyright infringement lawsuits up to $1.5 million, or 125% of the software purchase price. This could make the value proposition of Novell’s Linux incrementally more attractive versus other Linux providers such as Red Hat. This could advantage Novell with respect to the outstanding IBM contract. IT could also pressure Red Hat to provide similar purchase protection for its existing and potential Linux customers. However, given the range and quality of Linux offered by Red Hat I doubt that there would be any near-term impact on Red Hat’s new and renewal contract sales.


Linux vs. Linux

Red Hat vs. SCO. Red Hat filed a lawsuit against SCO in August. The Red Hat claim is based on allegations of unfair business practices against SCO. The suit is slowly grinding its way through the legal system. Colleagues in the legal business inform me that the claim is now in front of the federal judge in Delaware awaiting a ruling on a motion to dismiss.

SCO vs. IBM. SCO has a copyright infringement legal action currently being brought, and which could threaten the broad adoption of Linux. SCO’s legal suit claims that the 2.4 kernel of Linux contains source code that infringes upon SCO’s own copyrighted version of Unix code.

Last year, IBM requested discovery and in fact won both of its motions for SCO to be compelled to provide discovery at the last court hearing, which I believe was on December 5th, 2003. Consequently, SCO was legally obligated to provide discovery to IBM. SCO recently faced (and, if I understand correctly, may have missed) its deadline to submit its discovery response to the US District Court in Utah. Lawyer colleagues of mine tell me that such discovery documents would need to detail specific copyright infringements alleged to have been made to SCO’s Linux code, since SCO owns the licensing rights to Unix System V (USV). So, discovery would need to include at least two things. Fist, specifics of the USV source code that SCO believes is protected by its copyright. Second, it should detail the specific infringements that SCO alleges IBM has made on this “copyright protected” code, and which SCO claims IBM improperly derived from SCOs Unix System V. Legal colleagues of mine doubt that the offending code -- or even pieces of it -- will be made publicly available, although there is always the possibility that some of the offending code could “leak” out during the legal proceedings. If this happens, then the code could then be rewritten by developers in the Linux community.

In return for its discovery documents, SCO has asked IBM for a bewildering amount of information. First, SCO has asked for the source code to all versions of the operating systems AIX and Dynix, two Unix versions created and distributed by IBM. Second, SCO wants details of all modifications IBM has made since 1985 to the present (yep… that’s 19 years of R&D history) together with all of IBM’s R&D records and notes pertaining to the development of the software. Third, SCO also wants a detailed and itemized list of all contributions IBM has ever made to Linux, irrespective of whether the contributed code ever made it into the Linux kernel. Fourth, SCO has asked for the names of over 7,200 current and former IBM employees who did have (or who even might have had) access to code that SCO claims infringes its copyright. Yeah, right. Absent a settlement, this treasure hunt should keep the folks at IBM busy scurrying around and delay any productive or sensible resolution to the SCO suit for a long while.

But moving back to practical business matters. I doubt that SCO's legal threats against IBM and, by extension, Linux and its developers, have had a negative impact on Red Hat's business so far.

A number of companies supporting the adoption of Linux have stepped up the plate to provide financial support for Linux users. With the last few weeks, IBM and Intel have agreed to contribute to a small fund founded by the Open Source Development Labs (OSDL) consortium to help provide legal protection for current and future Linux users. ODSLs fund is currently a small $3 million, with a goal of growing the fund to $10 million. The fund can be used for legal actions threatened against Linux users by SCO and others. Both Red Hat and Hewlett-Packard have previously contributed funds to help provide some measure of protection for Linux users against SCOs legal actions. Perhaps the protective instinct among these and other hardware companies will gain momentum, and allow the OSDL fund to become sufficiently large that it can provide a more substantial level of financial assistance.

Red Hat's Cash War Chest Boosted by a Recent Convertible Offering

Red Hat recently raised $585 million net proceeds from an offering of convertible debentures. The terms of the offering are 1) a 0.5% coupon, and 2) debt convertible into RHAT stock at $25.59 per share (priced at a 37% premium to the stock’s closing price the day before the offering). The company’s original filing was for $400 million, significantly less than the $585 net proceeds eventually raised. I believe that this serves as yet another indication of the growing level of investor bullishness on Red Hat in particular, and on the longer-term growth potential from investments in the Linux market in general.

Red Hat’s prospectus states that the cash raised is intended to fund international expansion and growth through acquisitions. By all accounts, the market for Linux outside the United States is booming. I expect new business partnerships to form the cornerstone of Red Hat’s brand building strategy. Countries such as China, India, Korea and possibly Japan seem likely places for the company to forge new partnerships.

In terms of growth through acquisitions I expect Red Hat to pursue a two-pronged strategy. First, I see Red Hat maintaining its focus on some open source technology companies. Second, I expect it will also focus on leading closed source companies in the key areas of infrastructure – such as application server, database, grid computing, security, storage, and technical workstation markets. (It is possible that Red Hat will "open," i.e. make public, any closed-source IP that it purchases. ) Focus on these closed source areas will help Red Hat build a solid revenue stream from subscription-based offerings that run on top of its core operating system business. This will help meet Red Hat’s objective of increasing revenue per server.

Red Hat’s additional cash also makes it a more formidable competitor with Novell/SuSE, which as a combined entity has over $500 million on the balance sheet.


Valuation

I like RHAT stock long and think the stock can move up to around the $22 price target by the mid-2004. However, I expect a volatile ride on the way to $22. The $22 price target is based on a projected cash flow multiple of 24x fiscal year 2006 Operating Cash Flow (OCF) per share of $0.93. Like many software companies, Red Hat's subscription model causes its income statement to understate cash flow generated from new sales of its enterprise products. Consequently, Operating Cash Flow (OCF) can serve as a proxy for operating earnings since OCF captures changes in deferred revenue. (Readers may recall my piece on Microsoft in this column late in 2003, where I used OCF as to measure Microsoft’s operations and stock valuation.) In addition, the trajectory of Red Hat's growth far exceeds any other comparable company. Red Hat's revenue growth over the next 12 months could be in the 35% to 40% area versus other comparable companies with expected revenue growth in the high single-digit to low double-digit growth.

I would be inclined to build a position in RHAT from here down to around $15 (the gap close) for a couple weeks. Then, if the market gets jiggy to the upside coming into the Spring I would add to the position. That’s one way to trade RHAT. Another is to have the stock price hold the 50-day moving average (DMA), depending on how the stock trades over the next few days. RHAT is close to the 50 day moving average (DMA) and it appears poised to bounce off of that level ($17.02). If it does bounce off the 50 DMA, then the stock could potentially move up to the $21-$22 area; and if we got a real “whoosh” down to the 50 DMA then it could potentially rebound in as short a time frame as the next few weeks. The stock just appears to be getting oversold, although I would still want to see it trade down to around the $17.20 level before I would commit. And if, under this scenario, it does trade down to the $17.20 area, I might put some short-term money to work there.

The stock has come off the recent top fairly hard. But in the process, it has made new channels. When a new channel is "formed", that is usually the most powerful move. A few weeks ago in this column, I referred to RHAT breaking $8.5 earlier in 2003, and at that time the stock had formed a new channel at that time. Shortly after the break of $8.5 the stock went on a massive tear. (Usually, it is a matter of a stock “banging" up against the top of the channel, then finally cracking it in order to enjoy a substantial up move.) My guess is that if /when RHAT turns up again, then $30 (or 32x 2006 OCF) is possible sometime in the next 18 months. But for now, I am keeping a 12-month price level of $22 in mind.


Risks to the RHAT Stock Price

Dependence on the Growth of Linux. Red Hat’s growth largely relies on the overall growth and acceptance of Linux as a viable and attractive operating system for enterprise computing applications. As enterprises and governments continue change their perception of, and increase their or acceptance and adoption of Linux and other open source software then this would continue positively impact Red Hat's business.

Intellectual Property. Red Hat contributes its source code to the open-source community. Consequently, there are no intellectual property barriers to competitors to copy and potentially improve upon Red Hat’s software model. Some of these competitors are armed with larger capital and human resources, and could potentially erode the company’s dominant market share position.

Legal Issues Present Some Uncertainty. Some level of uncertainty revolves around the copyright infringement legal action currently being brought by the SCO Group. This lawsuit potentially threatens the broad adoption of Linux in the enterprise and other markets. SCO’s legal suit claims that the 2.4 kernel of Linux contains source code that infringes upon SCO’s own copyrighted version of Unix code. (I think SCO’s claim is largely a form of “commercial brinksmanship” that will be a royal pain in the neck for everyone involved, will end up costing a ton of money in legal bills, and ultimately allow more lawyers to buy Gulfstream jets, but whatever – it’s SCO’s claim nonetheless.) The folks at SCO are a truculent bunch; they have also filed a lawsuit against IBM and, in addition, have threatened to file additional lawsuits against the users and distributors of Linux. The risk here is that a successful SCO lawsuit could limit the acceptance and deployment of Linux in the enterprise. If this happened, to some extent this would slow Red Hat’s revenue growth outlook.

Strategic Business Partners. Red Hat currently has business partnerships with other software technology companies and distribution partnerships with some major hardware vendors. Red Hat is pursuing a strategy to broaden its product offerings and, as a result, will likely offer competing products with these vendors. Consequently, one or more of Red Hat’s strategic relationships could end up being negatively affected as it competes against some its partners. This could curtail revenues that Red Hat hopes to derive from these strategic relationships.

This comment is not a recommendation to buy or sell any security. It is only intended as food for thought and to stimulate debate among like-minded Ryze members.

Cheers

Melanie Hollands
President
Koala Capital

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