Andrew Main, The Australian Financial Review, 13 June 2000
Australia is familiar with the speculative mining stock that has a brief life but, today, the Australian Stock Exchange is awash with cheap tech stocks that have, in some respects, an even more dubious future, as Andrew Main reports.
Two months ago, the sharemarket was running so hot that any stock with a claimed connection to the internet was climbing several per cent a day and every new technology float was besieged by frantic retail investors. Last week, Worldschool Ltd, a small internet learning float, saw its $1 shares finish their first day's trading at 28.5¢, which means that any subscriber who sold at that price lost 71.5¢ of every dollar invested. They have since recovered slightly but, for technology stocks at least, the boom is well and truly over.
What is worse is that the Australian sharemarket is once again about to become home to a bombed-out underclass of financially strapped but illiquid stocks. But it will be a different market to those that followed share busts in 1972 and 1987. In those cases, most of the tiddlers left gasping on the beach were "NL" mining stocks, which then went into financial hibernation that lasted years.
This time, the confetti of dot com stocks that find themselves out of favour will have to merge or die, because the lifeblood of small technology stocks is the expensive marketing of technological ideas.
"If you're a mining company with a resource under the ground that you can't afford to exploit, you can sit on it until you find someone who can," says Warren Lee, a former chief executive of LibertyOne Ltd who is now executive director of venture capital group GS Technology Capital. "In the technology area, ideas are wasting assets and if you can't turn one into reality quickly, there's a good chance it will be overtaken by another product.
And if you try to protect intellectual property, it's an expensive and difficult business."
The Australian sharemarket has always had more than its share of small stocks, often called "penny dreadfuls", that have historically been mineral exploration stocks down on their luck because of a metal price slump.
Buying them has always been something of a risk, but when the next boom comes, as it inevitably does, a share you bought for 5¢ can suddenly rise to 50¢. Which is why the small miners survive, like lottery tickets with no expiry date and a draw every four or five years.
One mining veteran says small mining companies that amalgamate their offices and pool resources can survive on as little as $100,000 a year, which would offer a nominal 30 years of penny-pinching hibernation to a company with $3 million in the till.
Australia has 1,233 listed companies with a total market capitalisation of $667.2 billion - but the top five, including News Corp and National Australia Bank, make up 33 per cent of the total value. And the 500 stocks that now make up the All Ordinaries Index represent well under half the stocks on the board despite making up 96.5 per cent of the value (see graphic).
The painful arithmetic is that the smallest 733 companies - roughly half miners and half industrials - have a total market value of $13.3 billion, or an average market capitalisation of $18 million each. Hundreds are worth less than $10 million each, despite the collective wisdom that even $50 million is too small to be viable.
When the technology boom started last October, some people were saying "this time it's different", but the hardheads were saying that nine out of 10 new technology stocks would fail or merge - and nothing has happened since to suggest the latter were wrong.
The only thing that has turned out to be significantly different is that soldiering on, as small mining companies often have done, is not an option for companies with technology assets.
Fortunately for their founders, merging is an option, and a good one for two reasons: the recent changes to capital gains tax legislation have made scrip-for-scrip bids among cash-strapped minnows a viable proposition, and accepting a takeover bid is the only legitimate way in which those founders will be able to get their shares out of escrow and sell them before the normal 18-month escrow period expires.
"Escrow" is the term used to describe the limbo in which company founders have to put their shares for a period after listing them, to avoid the obvious temptation to dump the lot on the market and leave the company floundering. ASX listing rules say the only way that shares can be brought out of escrow early is in the case of a takeover.
As long as it is a bid for all the stock and nets more than 50 per cent of the target company, there is nothing to stop the founding shareholder selling as many shares as the bidder wishes to accept.
Well and good, but the small end of the sharemarket is a brutal place to be, even after the merger of two $10 million companies to form a $20 million entity.
While some new technology companies have good ideas and little money, "so many of these tech companies have no business and a lot of money", says Paul Evans of AMP Private Equity. "The bizarre thing is that our business is to look at fundamentals, to buy cheap and sell high, and a lot of these hastily assembled tech stocks have been put together in a way that is absolutely anathema to us."
It is clear that the cash-rich stocks will be quick to snap up small companies that do have good ideas.
Andrew Rothery, managing director GS Private Equity and a colleague of Lee, says: "Those companies are in a perverse situation where they're supposedly in a public market but they have no access to capital. The only basis on which they have been able to raise capital has been on completely outrageous terms."
The private equity industry is enjoying some discreet Schadenfreude at the near-death experience suffered by the founders of most small technology stocks since the "tech wreck" of April 17, when a negative court verdict on Microsoft Corp in the US triggered a long-awaited rout on Nasdaq, the US sharemarket that has the lion's share of technology stocks.
Only a few months ago those founders were in the venture capitalists' offices struggling to put up a business model that would merit the venture capitalists risking their investors' money on the new ideas.
"Suddenly, when the tech market took off last November, retail investors were scrambling for product and a number of stockbrokers muscled in by offering those people what was effectively free money," said one corporate adviser with a bigger broking house, who preferred to remain anonymous.
"They were raising $20 million, $40 million and $60 million for companies and allowing the founders to keep a major share of the equity, but they were bringing new companies to the market that were frankly not ready to fly on their own, because the brokers were interested more in their fee than the long-term viability of the company."
In a more "normal" market, venture capitalists usually put a few million dollars of seed capital into start-ups and then, between five and 10 years later, those companies gain enough momentum to reach the sharemarket as $50 million floats or bigger.
One thing appears certain: the private equity brigade may have been piqued at being trumped by brokers in floating small tech stocks, but it is in no hurry at all to buy the wreckage.
"Privatising a listed company, even a bombed-out one, is a bit like buying a block of units that's already been strata titled," says another insider.
Les Fallick, director of Gresham Partners' $200 million technology fund, believes the boom has scotched the chances of a lot of small stocks - some of which could have ended up performing well - because money was thrown at them before they were ready to use it properly, and now they are too big to buy back privately but too small to make an impact.
"We are saying that listing anything under a value of about $100 million in Australia is not a wonderfully good idea - we would prefer to see $200 million to $300 million," he says.
"A lot of these small companies are in an absolute catch 22 - that they have to merge with other companies, but if they want to make a bid they have to have not only a story to tell but also an earnings record."
"Earnings" has been something of a dirty word in recent months, since technology floats have to expect at least a couple of years of losses before earnings take off.Daniel Petre, the chairman of ecorp, the float of Publishing and Broadcasting Ltd's online businesses that went to market in mid-1999, will live to regret one exchange he had with a reporter about earnings. "In what year do you expect your company to become profitable?" asked the reporter - to which Petre replied: "That question is not relevant."
It may not have been then, but it is now. After running up from $1.20 to $8.60, ecorp shares have caught the same cold as the rest of the market and have come back to $2.56 - double most shareholders' original investment, but a more subdued proposition entirely.
Ecorp, 80 per cent owned by PBL, is one of the likely predators in the new technology regime, having access to the parent company's cash plus its own secret weapon, Ticketek, the cut-price ticket business that was slipped into ecorp in more cavalier times to provide some cash flow.
Roger Allen, the founder of 1980s success story Computer Power Ltd and now the manager of three major venture capital funds with partner Roger Buckeridge, recently told investors at a fund launch that there was a high casualty rate among technology companies that went straight to the sharemarket without first going through the "incubator" of a venture capital environment.
Frank Forster, who works with Allen, quoted a recent article in Forbes magazine that said in the US, initial public offerings that had been backed by venture capitalists showed an average gain of 120 per cent compared with 31 per cent for stocks that had not had VC backing.
Venture capitalists have their own barrow to push, but they sound a better bet than the small end of the sharemarket. One technology company director made this forecast: "It's going to be a Darwinian experience out there, eat or be eaten, and the fact that a lot of people have lost their financial teeth just means it's going to take a lot longer, and be a lot messier, to sort out."