Risk & Compliance

Can Comdisco Ventures Escape Incubator Hell?

The company insists it isn't an incubator, but is anybody listening?
Craig SchneiderNovember 20, 2000

Sometimes hanging with the wrong crowd can brand you for life. Just don’t tell that to Comdisco Inc., which hopes to convince the investing public that its profitable Ventures business is not an incubator.

But the company is going to have to challenge some preconceived notions among investors, who still lump the Ventures unit in the same money- losing category as CMGI and Internet Capital Group. From its standpoint, Comdisco argues that there are substantial differences between its venture business and those of the other firms.

Ironically, it was only a year ago that the technology leasing and services firm was considerably less insistent about drawing such fine distinctions. Granted, that was a time when companies as well known as Microsoft, Intel and Chase Manhattan were seeing already strong earnings lifted further into the stratosphere from their venture capital investments.

Back then, the tech market was on a roll, and the sky was the limit. Comdisco had every reason to want the markets to give its stock a premium for its venture portfolio.

What a difference a year makes. CMGI and ICG shares are both off more than 90 percent, and Comdisco’s stock closed at $14 on Thursday, more than 75 percent off its 52-week high.

It wasn’t supposed to be that way. Comdisco filed for an initial public offering of the Ventures unit earlier this year, and the company should have begun trading months ago. Now, the offering won’t happen until next year at the earliest.

Unfortunately, investor sentiment for incubators shows no signs of recovering any time soon, and that doesn’t bode well for any IPO with overtones of an incubator business. CMGI said on Tuesday it will “exit” its iCast entertainment site, sell its 1stUp.com Web- access operation and write off as much as $90 million for the six-month period ending January 31. Last Friday, ICG announced a 35 percent staff cut and fourth-quarter charge as high as $30 million, citing weakness in its B2B portfolio.

Even Comdisco Ventures hasn’t been unscathed. It wrote off some $34 million in its fiscal year ended September 30, most of which it used to “clean up” the portfolio. But the unit has been profitable for 13 years of its 14-year history. And over that time, it’s only written off $54 million, including this year’s amount.

Still, Comdisco’s management is determined to emphasize the differences between its Ventures unit and the incubators. While the companies all have investments in young startups with a heavy Internet flavor, Ventures comes about its holdings in a manner that is not wholly in tune with a traditional VC or incubator.

The Ventures unit operates much as an extension to the parent company. Whereas Comdisco leases computer equipment and disaster recovery services to established firms, Ventures extends these services to cash- starved tech start-ups. It typically finds them through arrangements it makes with other VCs.

Comdisco’s management knows it has its work cut out for itself if it is going to get its message across.

“There’s obviously a lot of uncertainty both in the equity and the debt markets of what that business is,” said CEO Nicholas Pontikes on Comdisco’s fiscal fourth quarter conference call last week. “We have to do a better job of communicating what that business is, and frankly what it is not.”

The analysts who follow the firm would like to see the company correct its mistaken identity.

“They have to spell out and show investors how different Comdisco Ventures is from a regular incubator,” says Andrew Sidoti, senior analyst at W. M. Smith & Co.

Comdisco’s CFO John Vosicky addressed some of the market’s misconceptions on the conference call. For starters, Ventures deals with the top 20 venture capitalists in the country, but is not a VC itself. “They’re bringing the deals to us,” he said. “We are not investing equity capital into these deals.”

Ventures provides lease and debt financing to VC-backed startups, and a typical client is a company that needs computer equipment to get up and running but can’t necessarily afford to use cash to purchase the goods. Typically, they’ll lease the equipment from Comdisco Ventures and as part of the contract will hand over some warrants and an equity interest in the company.

These deals don’t require Comdisco to spend any more than what it normally shells out on computer equipment.

Vosicky said, “We provide a credit line where we lend money, and in those cases we’re typically getting three times the warrant coverage for taking that risk.” The leases and loans are generally three-year deals.

Therefore, if a company pays back a lease and then goes bankrupt, Ventures’ financial exposure is minimal because it hasn’t directly used cash to acquire its equity stake. That’s in sharp contrast to other incubators that are almost solely dependent upon a successful IPO. It’s also a big reason why Ventures has been consistently profitable.

Ventures posted pre-tax earnings of $246 million for fiscal 2000, ended Sept. 30, which was more than triple last year’s pre-tax income. Approximately $40 million came from the warrants portfolio.

Overall profitability for Ventures was actually higher, according to Mark Jordan, an A.G. Edwards analyst. But Ventures added about $60 million to the portfolio’s reserve. “In my opinion it’s a more conservative balance sheet,” he says.

In fiscal 2001, the parent company conservatively expects Ventures to generate $300 million in cash flow, $50 million from the loan and lease, and the balance from warrant profits. The figure accounts for commissions and planned additions to reserves. Ventures represents nearly two-thirds of its parent company’s overall profits.

And would you believe that Ventures actually does well in this weak IPO market? Some of its high profile holdings with recent IPOs include Corvis Corp., Avici Systems, ONI Systems, Handspring Inc., and high-flying Transmeta Corp., which more than doubled last week on its first day of trading. Ventures’ stakes in the five firms collectively amounts to a market value close to $500 million.

The mark-to-market valuation for publicly traded securities within the portfolio that Ventures plans to sell in its fiscal 2001 year is over $847 million, some of which is still in six-month lockup periods mandated by the Securities and Exchange Commission for pre-IPO investors.

The portfolio also has over 450 companies that are private and $95 million in reserves, which is plenty to cover any foreseeable write-offs. Incubators generally tend to focus on one market sector, but Ventures’ portfolio is diversified across several industries including communication and networking, B2C and B2B e-commerce, software and computer services, life sciences, computer hardware and semiconductors.

As a whole, Comdisco has invested about $1.2 billion in Ventures in fiscal 2000, but plans to drop the investment to $500 million in 2001. To the extent that venture capital companies are slowing down investments, so goes Ventures. “We do not have a budget of how much we put into this space,” says Pontikes, who calls the business opportunistic. “If we see that the deals don’t make sense or the valuations are screwy, we’re going to back off quite a bit.”

Still, the stigma that comes along with being labeled incubator is hard to shake.

Will the investing public be open to a re- education of Comdisco Ventures? Maybe, but first things first; Comdisco has been waiting nine months for the SEC to clear Ventures’ registration statement. And even if the IPO gets cleared in the next few days, the SEC still requires an additional 25-day quiet period before the IPO can take place.

“We’re in the process of responding to the SEC’s most recent comments, and we believe we have resolved any remaining issues,” said Vosicky, reading from a prepared statement on the call. “Before we proceed with the offer, however, we have to include our year-end numbers in our prospectus and continue to evaluate market conditions.”

“If we were effective immediately, we could not take this public today,” Pontikes added. “But our goal is to be ready so there’s nothing stopping it except market conditions.”

“I think over the next six months, as the classical incubators continue to struggle, [Ventures] will continue to be profitable,” adds Jordan of A.G. Edwards. “That absolute performance will help it differentiate from the incubators.”

Click here for Comdisco’s latest 10-Q (released Nov. 13).