Tech Downturn 2001

Business India, May 14-27, 2001

Clouds over the Valley

The causes and effects of the slowdown in the US economy can be most vividly seen in the frenetic hi-tech industry
Shivanand Kanavi

A new spectre has risen in front of Indian investors, right on the heels of the shenanigans of highflying bulls, highly cooperative banks and the bear cartels. It is called the "downturn in the US". It initially looked a distant phenomenon and many tried to discount its effects on Indian IT industry and economy. However, when the darling of Indian tech investors Infosys - lowered its growth target in the coming year to 30 per cent, after having grown at 100 per cent plus this year, the impact of the US slowdown finally hit the Indian shores. Com­mentators are now changing the description of the state of US econ­omy from a 'slowdown' to a 'reces­sion'. Many predict a 12-24 month period for recovery. Obviously, it is better to come to grips with the situ­ation than wish it away or panic. A Business India team visited various hi-tech centres in the US in March-April, 2001 and talked to VCS, entrepreneurs, executives and ordinary folks to get a picture of the depth and extent of the clouds over the Valley.

The gloom hits you as soon as you arrive at San Jose airport. Our favourite cab driver in the Valley, Iqbal Singh, lamented that all his plans of growing from one cab to four and starting his own cab company have come to a naught. "Business is down saabji," he says. "Yeh dotcom shotcom, it screwed up everything." Even the Indian grocer in Bharat Bazaar, a department store in Silicon Valley, says that the slowdown and the mass lay-offs of H1-B Visa holders have reduced his sales of pickles, pappadams, sambhar powder and such.

We had visited the Valley in the October of 2000, much after the dot­com meltdown in April 2000, but we saw none of the panic and fear that we saw this time around. People cracked jokes about the dotcom madness and wrote short stories on how smart Indi­ans saw the crazed US market and made a fast buck out of dotcoms. One even claimed that the original dot in the dotcom was the kumkum bindi on an Indian forehead, in spite of the gadzillions being spent by Sun Microsystems too claim the contrary. Everyone made the dotcom mania sound like a black comedy by Monty Python enacted in some distant land. "The real tech companies backed by products, customers, revenues and profits will not be affected," they said. In fact, stocks of companies like Sycamore and Juniper Networks reached their peaks in September 2000 - five months after the Nasdaq crash of April 2000.

Today, however, they are trading at a much lower value (see table). In the first week of April, Sycamore not only lowered its earnings expectation from $165 million in the previous quarter to $50 million in the last quarter, but even laid off 120 people - nearly 10 per cent of its work force. On April 5, Desh Deshpande, chairman Sycamore Networks, was felicitated by an organ­isation in Cambridge, Massachusetts. The citation read: "The Golden Door Award symbolises the positive influence that immigrants have had on this country by honouring a distinguished American of for­eign birth." Despite the fact that he is the first Indian to be hon­oured thus, he was in no celebra­tory mood. When congratulated, he said: "I have just had to lay off 120 people who believed in me and came to work for me. Ups and downs are part of business and I have seen them before. But at the moment, it really makes me sad."



BILLION DOLLAR BABIES
Sycamore Networks $ 12.25 billion Market Capitalisation as on 12 Jan’ 2001
$ 3.04 billion Market Capitalisation as on 7May’ 01
Strong in Soft Optics-a fusion of hard optics (DWDM)with software. Strong management team with credibility. A billion dollars in the bank.

Infospace $ 2.85 billion 12 Jan’ 2001 $1.58 billion as on 7May' 01

Early mover into wireless web content (has over80% of the US market). Expertise in merchant services. Entering broadband content. Over $500 million in the bank

Tibco $8.01 billion, (as on 12 Jan 2001) $ 2.64 billion (as on 7 May 2001)

Unrivalled in online data mining and services. A must for all financial markets and financial portals

Juniper Networks $41.76 billion (as on 12 Jan 2001) $18.24 billion (as on 7 May 2001)

Undisputed king of the high-end router market. Vinod Khosla –Scott Kriens team has built excellent relations with carriers and has delivered.

I2 Technologies $19.71 billion (as on 12 Jan 2001) $9.37 billion (as on 7 May 2001)

12 products have much broader applications than the ERP software. Stress on cast savings rather than flashy technology appeals to CEOs and CFOs. Good results achieved in manufacturing, retailing sectors.

Even the ebullient Naveen Jain, chairman, Infospace, is mel­low these days. While his com­pany Infospace keeps acquiring new companies and is taking major initiatives in broadband and wireless fields, Infospace's market cap has fallen from about $40 billion in March 2000 to $1.5 billion today. A fall-out of this crash is that in several companies stockholders are blaming the CEOS and founders for the loss in share- holder value. Earlier this year, Jain went out of his way to show his faith in the fundamentals of the company by buying half a million of its shares.

Of course, everything in the US is taken to the extremes. And so is share­holder wrath. According to Ed Hill, a former police officer, who now pro­vides bodyguards to the rich and famous: "There are so many crazies out there, no threat should be taken lightly." As an officer of DEA (Drug Enforcement Agency) he battled drug lords in Columbia, Panama and even South Asia. Today, he provides teams of bodyguards to the CEOs of Internet companies. Obviously, it is a lucra­tive, and growing, business.

Along with the dotcoms, some of their CEOs have also vanished. When we mentioned the success of Indians in hi-tech and the stockmarket crash, another Indian cab driver, this time in Seattle, waved a copy of Seattle Times in front of us. The newspaper had front-paged the story of Ravi Desai, who promised about '$5 million to the poetry departments of three uni­versities, including the University of Washington, Seattle. Poets and poetry lovers, startled by this munifi­cence of a patron of arts, got an ode composed for Desai by the US poet laureate. Alas, after the initial cheque of $6,700 came in, the dotcoms crashed and the poets are still waiting to hear from the gentleman.

Meanwhile, several entrepreneurs who made money through IPOS, mergers and acquisitions have defi­nitely lost a whole lot of their wealth, as Nasdaq slid from 5,000 in March 2000 to below 2,000 in March 2001. Billionaires have become millionaires and some millionaires have even become paupers. Those who built houses or put the money into fairly unexciting assets like old economy stocks or bonds are relatively better off, whereas most people who recy­cled their wealth into other tech stocks have lost heavily. "l don't even want to talk about it," says Naveen Jain, shaking his head. He, like many others, holds on to the belief that the tech sector will come back. In any case, they see no point in liquidating their portfolios in the current market.

The months March and April 2001, were nightmares to all those who made money in the tech boom. April 15, being the deadline for filing taxes, most people were scrounging around for money to pay taxes. We found sev­eral techies burning the midnight oil to bring their income statements to order and making frequent trips to their CPAS. Since taxes are calculated on the basis of the deals they made earlier and since many of them did not make provision for the taxes when they received the money, it was a double whammy. On the one hand their notional wealth has really come down. And on top of it they are being taxed at the higher levels of paper wealth that existed several months earlier.

Those who ventured to become angel investors with the expectation of their seed money multiplying sev­eral fold, are seeing start-ups fold up in front of their eyes. Aware of the problem, a few Valley politicians have begun discussing a scheme whereby taxes can be paid in instalments over the next few years. Obviously, any front-loaded tax cut by the Bush Administration would be most welcome by the normally pro-Democ­ratic techies.

The worst-affected are those who never saw the money but got only stock options. They were taxed on the basis of the value at which the stock was vested with them - though the current value is only a fraction of that. Points out Sashi Pundarika, a financial consultant: "There are many compa­nies where this has happened. Qtera, bought by Nortel for $3.5 billion, was a classic case. On acquisition, VCS got 85 per cent and walked away with the money. The employees and founders could not cash in right away due to the vesting schedule. Many of them are stuck with AMT (alternate mini­mum tax) greater than the current value of their Nortel stock, which, went down to $15 from about $80".

The tech companies which went public before the crash are well capi­talised and have money in the bank. This can be used for acquisitions or for R&D even in this lean period and they can ride out the downturn. "Down­turns and upturns are part of business. However, both these get exaggerated in the Valley. We have a billion dollars in the bank and we can ride out the downturn without cutting back on R&D," says Desh Deshpande. Clearly, companies like Sycamore, Infospace, Juniper, Tibco and 12 have no cause to worry on that account (see table). But those companies, which were on the verge of an IPO or were in the pre-IPO stage with one or two rounds of ven­ture financing, are in deep trouble. Suddenly, the valuations they com­manded before the crash look ridiculous and new money can come in at much lower valuations. That, of course, will mean squeezing the exist­ing investors' stake. Yet, the only other alternative is death by starva­tion for these companies. All hype has vanished from technology compa­nies, be they into optical networking, wireless or enterprise software. Natu­rally, VCS who were chasing deals ear­lier are looking at all the traditional parameters of customers, revenues, profits and so on.

Darwinism has suddenly become the hot favourite among VCS. "Slow­downs, downturns, recessions are a part and parcel of free market economies. They come with certain regularity, except that this one has been long overdue. They are good for the economy, as they stress every body to squeeze out the silly excesses of the good times. Weaker players crumble, freeing up the resources for strong sur­vivors. This downturn was bound to happen as a whole lot of capital was being misallocated and wasted. I have not seen innovation slowdown. It will come back stronger than ever. I have lived through several of these in my 34 years here and things always come back with great gusto," says Kanwal Rekhi, President, TiE.

Amit Shah built two start-ups earlier and sold them - ZeitNet to Cabletron and. Pipe Links to Cisco. Subsequently, he became part of the high-powered charmed circle around John Chambers, chairman Cisco. Amit resigned recently to become a venture capitalist and has several interesting observations to make on the boom and bust. "Whenever a revolutionary product appears and a 'paradigm shift' occurs, such as introduction of TV, autos, computers, there cannot be a 50-70 per cent growth rate for more than two to three years. The commu­nications and computer industry had been growing at 20-30 per cent year on year for eight straight years (roughly 1990 to 1998) before the dotcoms. Then the dotcoms took this growth rate to 30-50 per cent. At this point everybody began jumping in, which resulted in overbuilding, overcapacity, overspending. This final stage took the growth rates to 50-70 per cent year on year in an industry, which was already spending $500 billion a year. The result is a house of cards".

For instance, nearly 300 start-ups were funded at fantastic valuations in optical networking. Obviously, there is no room for all of them. The plug will be pulled for many. One estimate is that nearly 80 per cent might die due to lack of the next round of funding. Only the real technology innovators who have customers and revenues have any chance of getting acquired. A recent example from the chip sector is Vxtel headed by Atiq Raza. Raza is a chip pioneer in the Val­ley who earlier founded Nexgen and later headed AMD, a company that is now challenging even the giant Intel. Intel acquired Vxtel for $550 million in cash in February, 2001. ''It shows that if you have technology, if you have the right industry partnerships, then you are highly valued even in these market conditions," says Arjun Gupta of Telesoft Ventures who funded Vxtel.

For the time being, it is curtains for people like Rohit Chandra (founder eCode). Despite it being a good idea, VCS have pulled the plug on eCode, since there was not enough revenue. In the general downturn, even listed companies are filing for bankruptcies, and not all of them are tech compa­nies either. One man's meat is another's poison. According to New York Times' April 19 issue, law firms that specialise in Chapter 11 (a stage in bankruptcy process in US) are recruiting heavily.

"Not many startups are closed yet, though they are having a hard time raising the next round of financing. The next few months will be decisive. Companies are financially distressed though. Lots of those who can't meet expectations will fail, and the sur­vivors will have a good time," says Rajvir Singh of Redwood Ventures and a distinguished entrepreneur who founded Cerent, StratumOne and Sierra Networks.

As for causes in the downturn in networking and telecom sector, Rajvir Singh says: "DSL (Digital Subscriber Line) is the main culprit. Installation costs are high and revenue is low. Equipment vendors did not see that coming and did not factor that into their revenue forecast. Many CLECS (Competitive Local Exchange Carri­ers), the main service providers, are closed down. They were buying equipment on borrowed money from vendors. There is an over-supply of components and equipment, and buyers have run out of money. This should ease out in a year or so. There will be consolidation at the very top, including major organisational changes. Large companies would buy less of new startups, essentially pay­ing attention to the bottomline."

How did the industry get here? Sanjay Subhedar of Storm Ventures explains: "There were too many ser­vice providers - over 1,300 by last count. Cheap capital, both equity and high-yield debt, helped create them. Flush with capital, these new service providers helped create the boom we saw over the last three years, as they bought equipment and software to build out next generation networks to handle the needs of the bandwidth hungry Internet. U.S. TeIco spending grew from $60 billion in 1998 to $115 billion in 2000, changing the revenue ramp profiles for anyone in commu­nications - Corning, Nortel, Lucent, Cisco, as well as their suppliers - JDS Uniphase, Altera, Xilinx and Vitesse. Demand outstripped supply, lead times stretched out, and the equity markets reacted as one would expect. The markets gave huge premiums to the market leaders in the belief that the excess of demand over supply would continue ad infinitum. P/E mul­tiples skyrocketed to over 300 and, as that metric became ridiculous, the industry began using sales multiples as a substitute."

Though the downturn started with the telecom and communication net­working sector, but with the loss of shareholder wealth, a large number of ordinary people who had followed the tech pied pipers, saw their savings vanish. The money which was kept for the next car, home, college educa­tion was no longer there. "We put all our money in tech stocks after seeing our acquaintances buy a big house with the money they made in the stock market. Today it is not worth the paper," lamented a schoolteacher of Indian origin in California. Similarly, several people who put their 401(k) money (US version of the provident fund) into tech funds, have seen it vapourise. This has led to a drop in sales of old economy goods as well. Clearly, the excessive greed fuelled by a eight-year bull run in tech stocks has led to an aftermath of trillions of dollars lost. This in turn has led to a loss of purchasing power. The over­supply in tech sectors is being com­pounded by demand contraction in other sectors.

The lay offs in the tech industry have been well publicised as cutbacks in expenditure by big companies. However, others give a different per­spective. Rajeev Madhavan of Magma, a start-up creating chip design tools which had been on the verge of an IPO, says: "Some of these lay offs had to happen. When people were hired during the boom, they came with two or three offers in hand. They came to negotiate stock options rather than be interviewed. The downturn has helped companies to get rid of those that did not deliver." Sabeer Bhatia, founder Hotmail and Arzoo, agrees: "The phenomenal growth caused technology companies to hire 'less than ideal' people. Now, forced to become leaner and more profitable, they are shedding this excess weight by laying off people in the thousands. This creates a vicious cycle of rapid decline in con­sumption, which affects the entire economy - the results of which we are witnessing today."

However, this is more of a Valley phenomenon. In places like Boston or Dallas, it is not getting rid of dross but actual concerns on costs that has led to lay offs. Says a senior executive in Texas Instruments: "It has been the saddest exercise in my career. Having been forced to approve a list of people to be sacked is tortu­ous. Some of them are going to lose all their options, even though they are hardly six months away from the deadline (employees can carry all their options after 50 years of age in some corporations). It has taken so much out of me emotionally that I am going to take voluntary retirement in a month or two and start teaching, pre-school kids."

Does all this have anything to teach the Indian IT companies? 'Move up the value chain,' has become a cliche. But Amit Shah has a contrarian recipe: "Before moving up the value chain, consolidate your position as the premier outsourcing centre. There is a chance at taking out the EDS, IBM, Arthur Andersens of the world in turnkey outsourcing. This is where Wipro, Infosys, TCS should be headed. The myriad smaller companies, spe­cialise even to get 'bodyshopping' jobs. For venture capital to flow in, intellectual property will have to be created and market partnerships with US and European companies should be formed. No Indian startup, at this stage, can look to develop products for US or European markets, without hav­ing these partnerships. As for a long­term prognosis, it is excellent. You need a downturn to create an uptick."

The present gloom in the Valley has naturally led to tremendous stress. Bill Osmer, part of the well-known eco-system in the Valley, tries to reduce the prevalent tension by teach­ing yoga and pranayam to techies. Osmer learnt yoga from his guru in Mysore and is a regular visitor to India. He currently teaches yoga dur­ing lunch hours at several corpora­tions in the Valley -' Cisco, Intel, Applied Materials, Netscape, Hewlett­Packard, AMD, KLA-Tencore- as well as at many start-ups. There are other yoga teachers in the Valley today, but Bill was one of the first. Today he is a personal yoga trainer to entrepre­neurs like Rajvir Singh. "The current slowdown has definitely increased stress but the response is split. Some feel they need yoga more than ever to help and some feel they need to work harder than ever to secure their job and don't have as much time for these things. I have a vantage point, because I was already teaching at these companies during the boom years and am now watching the response during the bust. People, as always, have to find a balance in life," says Bill. However, finding balance is a tall order in the frenetic Silicon Valley.

Meanwhile, companies like 12 which started their marketing cam­paign several years ago saying, 'We will save our customers $ 50 billion by year 2005', have upped the figure to $75 billion. Sanjiv Sidhu's pitch may be more soothing to CEOs and CFOs in various old and new economy giants than Bill Osmer's yoga.

Vani Kola, who told us in October 2000 after having sold her company RightWorks, that she would be spend­ing her time climbing mountains like Kilimanjaro and helping her children grow up, has once again launched a start-up called Nth Orbit. And so the cycle continues.