Milestone Matters - Spring 2003 Newsletter

"We're moving from an era of killer apps . . . to killer businesses.  Just spending money on IT never creates any value.  It's what you do differently in terms of business processes that matters."  Bruce Harreld, chief strategist at IBM, Fortune, May 12, 2003

Editor's Corner

Dear Friends, Investors and Associates:

In the wake of the Iraq conflict, the world at large is stunned and trying to figure out the implications within a new geopolitical context.  Hawks in the US are giddy and contemplating how to leverage their success.  Doves are disoriented and trying to gain a foothold from which point they can mount an attack on administration policies.  One approach adopted by many dissenting politicians has simply been to hide while troops are in the field.  Another tactic has been to keep moving the goal posts.  We won the battle but there are no greetings and flowers.  Now there are greetings and flowers but shocking looting.  Now the looting is abating but there is insufficient humanitarian assistance.  I suspect the next chapter will recognize that assistance is building favorably and civil order is being restored but bickering Iraqis portend that there is no hope for "democracy" and a swift US exit.  So this debate will continue for some time and neither hawks nor doves are likely to give ground on the fundamental question of preemptive attacks in the name of national security and, in turn, the threshold question of the war's legitimacy.

The indisputable good news for business people in the US is that the specter of uncertainty, attendant to the build up to the war and during its execution, is no more.  This represents a huge psychological lift and there is some anecdotal evidence that economic decisions of all kinds, heretofore held in abeyance, will be made.  Of comparable importance, is that the administration, eager to take advantage of the President's current popularity and chary of a repeat of the George Bush I 1992 scenario, will press ahead with its tax cut proposals and other economic stimulus initiatives.  Some argue these policies are ill-conceived and will prove ineffective, but we are more comfortable with the FDR approach.  Rather than not acting for want of the perfect solution, the Federal government must push forward on a number of fronts to stimulate growth.  It is unlikely that whatever policy mix is adopted will hurt and the initiatives may help to boost second half 2003 and 2004 GDP growth above the current tepid 1.6%.

Within this brightening picture, we noted an article in the Wall St. Journal the other day which reflected our sentiments.  The thrust of the message was that most technology innovations (e-mail) insinuate themselves into our lives and quietly become pervasive over time. They seldom are launched, rocket-like and soar to success.

The fact is, the application of technology solutions will continue to advance but in its own unpredictable way and along a timeline that defies easy forecasting.  In the latter half of the 90's, the Internet was naively viewed by many as the panacea technology.  Many paid dearly for their optimism-without-analysis in the debacle of 2000 and the attendant stock market retreat.  Subsequently, the naysayers have been abundant and with the benefit of hindsight, have denounced these excesses.

What has gone little noticed is that innovations enabled or facilitated by the Web have continued to proliferate.  In the May 12th issue of BusinessWeek, the editors noted that, among other things:  40% of publicly listed Internet companies are profitable and more are becoming so with each quarter; E-business spending continues to rise and now constitutes 27% of all technology spending; US subscribers to broadband service have doubled since 2001 and are growing at 56%; Productivity growth has doubled, predominantly in technology-heavy industries like autos, in the course of the Net's proliferation; Online advertising will total $6.6 billion this year; If one had invested $1000 in each and every e-tail IPO, one's portfolio (including all the losers) would be up circa 35%; Businesses will conduct $3.9 trillion worth of e-commerce this year; More than 80% of post-1995 Internet applications and growth are occurring within non-technology industries. 

Four of the five investments MVP made in 2002 would not have been possible without the Internet.  We did not set out to invest in "Internet" companies but rather in companies that offered software, information or services that improved the productivity of their customers.  Not surprisingly, these companies used the Internet as an enabling technology; it was simply a given that this was the best means of collecting and distributing information.  We continue to look for and see companies with innovative businesses made possible by the Internet, and at valuations where it is also possible to make reasonable investments.

Milestone II Portfolio News

Derivatives Portfolio Management, LLC  (DPM, LLC) a hedge fund administrator, announced that Catherine Banat, formerly of Goldman Sachs, was recently appointed as Executive Vice President in charge of Sales and Client Services.  Catherine joins DPM as sales are accelerating (Q1 2003 revenues jumped 29% vs. Q1 2002).

The Seven Cs

Kronos Incorporated (Nasdaq:KRON, $900 million market cap) reported that for its fiscal second quarter ending March 2003, net income rose 26% to $7.3 million and revenue grew 20% to $96.5 million. The earnings releases of very few software companies are starting off this way today.  Ed Goodman and I invested in Kronos over 20 years ago, when we were at different firms. (I am still a director.)  It had just introduced the world's first electronic time clock which cost many times more than a mechanical clock.  Revenues were less than $2 million and it was not yet profitable.

Kronos was then not unlike the companies in which Milestone is investing today.  In addition to small size and lack of profitability, it was aimed at a niche market (the market for mechanical time clocks was then less than $80 million annually and dominated by one competitor, Simplex, a company Kronos acquired last year).  Management was young and untested.  In short, there were lots of reasons not to invest, but Kronos' CEO, Mark Ain, had a compelling vision: by using electronics, Kronos was not replacing the time clock, but rather it was creating a new system by which businesses could control and reduce their labor costs.  This would justify the higher price and expand the market.

This vision has come to be realized.  Kronos today is a $300 million plus software, services and solutions company and is the dominant provider in what is now called the "front line labor management" market.  It is one of only 6 software companies that have increased revenues in each of the last 10 years and yet always remained profitable each year.  Its record of increasing revenue over 93 consecutive quarters and 64 consecutive quarters of operating profit is a remarkable achievement.  How has Kronos done this and what lessons can be learned?

Management attributed its performance last quarter to the fact that in difficult times businesses look for ways to save money and Kronos' solutions do this.  Analysts might cite its broad markets, large customer base, and the reasonable price of their products, but these characteristics are not that unique. Certainly then, brilliant management and a sagacious Board of Directors must be the reason for its long-term performance.  Management says the board has been helpful, but I believe its main contribution has been to encourage management's best instincts. And management hasn't really been brilliant (nor has it tried to be), unless you consider sticking by a set of core values and common sense, brilliant.  Given the results, this may be a very good definition!

So what are Kronos' business values?  What follows is my opinion.  For mnemonic purposes, I will call them the 7 Cs.  In addition to Common Sense, they are Conservative, Commitment and Continuity, Customers, Complete, and Change.

Common Sense is perhaps the hardest to explain.  Everyone knows what it is but every once in a while people and organizations seem to take leave of it.  I think it has been pervasive at Kronos because things get discussed, openly and vigorously.  And there has been enough struggle and scares in its corporate history such that no one has developed an infallibility complex.

Conservative is a fellow traveler with common sense.  The accounting, compensation, new product initiatives and overall management of the business all tend toward the conservative.

Commitment explains much of Kronos' success.  Nothing came fast or easy; Kronos' time and attendance application has never been a must have fad, like CRM or e-commerce.  It's always had to be sold; consequently the company has become really good at selling.  This required real commitment; management at Kronos really believes in the value of what they are doing.

Continuity is also key.  For some of the top managers, their Kronos job has been their only job.  By the standards of high technology companies, senior management overall has remarkably long tenure.  This has given them deep and intimate knowledge of the business and its customers, an invaluable asset.

Customer focus is not a unique value to Kronos, but it certainly is a necessary one.  And this focus applies to all customers, regardless of size. Kronos was built selling to smaller and medium size customers, so there is not the disdain too often seen in software companies for customers who are not big-ticket buyers.  This focus also had the very beneficial effect of forcing Kronos to make its products easy to install and become productive rapidly.  Smaller customers simply didn't have the staff or budget to endure long and costly integration cycles.  This has not hurt with large companies either; 60 of the Fortune 100 are Kronos customers.

Complete distinguishes Kronos' commitment not only to selling software but also to insuring that it works for the customer by installing it as well.  When Wall Street was extolling the financial virtues and scalability of pure software companies and decreed that integration services must be outsourced, Kronos resisted and continued to provide its customers complete solutions. 

Change, ever present in the computer business, has been embraced by Kronos enabling the company to prosper through waves of new technology from the PC to the Internet.  At times, it has meant a painful need to change people or business partners.  But there is no choice if the business is to prosper.  Indeed, Kronos' founder and still CEO, Mark Ain says one of the corporate maxims is, "If it ain't broke, break it," meaning that change has to be almost an institutionalized part of the business.

Certainly, there are lessons to be learned from Kronos.  The ultimate one is the simplest: that the companies we invest in are, at the end of the day, a reflection of the values of the entrepreneurs and management teams we back.  It is their commitment to their vision and their customers, and their ability to handle change that are the ultimate determinants of the success of our investments.  It's also watching people like Mark Ain grow that makes our business so interesting and gratifying.
----Richard J. Dumler, General Partner

SIGNS OF LIFE

Source:  BusinessWeek

Milestone Venture Partners 

Investing in early Stage Enterprise Information Technology Companies in the New York 

Metropolitan Area

551 Madison Avenue, 7th Floor, New York, NY 10022 V: [212] 223 7400 F: [212] 223 0315

www.milestonevp.com