TSC: Tech Stocks' Secret Sauce

There is a great lesson in the flame-out of Ciena over the past six weeks.

While the dense wave-division multiplexing Ciena pioneered really is a huge market opportunity, the company is just selling hardware. And that hardware, while technically complex, was not hard to duplicate.

Ciena’s so-called strength was that it could claim “first mover” status, a great buzzword that scares the hell out of me, as it often means the company will be the first to be run over by others. Ciena lacked a strong enough patent portfolio to slow down others, making it easy for competitors to poach. Pirelli in Italy rolled tire profits into optics and actually sued Ciena for patent infringement. Lucent (LU:NYSE) came late to the game, but it sells technology made by Hitachi (HIT:NYSE ADR) to jump-start its involvement. Ciena quickly became one of several undifferentiated vendors. Put another way, they had no secret sauce.

It’s that secret sauce that is the foundation of real franchise companies. Add a great management team that can execute growth and you have the underpinnings of a stock that can double and then double again and again, a stock you truly buy and hold.

How do you find these franchises? To borrow liberally from the great venture capitalist Don Valentine of Sequoia Capital, the backer of such franchises as Cisco (CSCO:Nasdaq), Apple (AAPL:Nasdaq) and maybe Yahoo! (YHOO:Nasdaq), there are three things that you must make sure exist:

• A monster market;
• Proprietary advantage in that market;
• A business model to leverage that proprietary advantage.

It is the second item on the list that is the secret sauce. And proprietary means a truly proprietary secret sauce, not just a combo of ketchup and mayonnaise.

What is it that a company can do to have an unfair competitive advantage over everyone else? What is it that allows a company to command a premium for their product or service? What makes customers come to them, very often exclusively?

These are big questions with no easy answers, but here are a number of things that we at Velocity consider when we try to figure out what a company’s secret sauce is.

Architecture

This is typically a hardware system that is recognized as enough of a standard that software developers write applications specifically for it. The IBM (IBM:NYSE) 360 was an architecture, and the Intel (INTC:Nasdaq) x86 is an architecture.

Operating System

The guts of a computer or a network. DOS or Windows comes to mind, as does Solaris, Sun’s (SUNW:Nasdaq) implementation of UNIX. But one of the most successful operating systems is IOS from Cisco, the code that runs its routers.

API or Application Programming Interface

This may be redundant to an operating system, but an API is how outside developers interface with your system. Application software can have an API to allow third parties to have access to the resources of an application, say SAP R/3. The more robust this interface, the better.

Language

An API is usually accessed via a software subroutine, like a piece of C++ code doing a system call into Windows. But nonprogrammers can access features via a scripting language or other logical interface and this can be enough to lock in users. The macros in Lotus 1-2-3, and now Excel, are a classic example.

User Interface

Perhaps repetitive with OS, API or language, but a good user interface can lock users in for years. Ask Apple about that. The Palm Pilot may be the latest example of a user interface locking in customers.

Algorithms

A mathematical code to implement some unique process. Compression algorithms, search algorithms, signal processing algorithms. What is especially nice about algorithms that is not true of software is that they can be patented.

Protocols

Also patentable, a protocol might be a defined set of signaling between two communications systems. Most protocols, like TCP/IP, are public domain and not owned by anyone. There are some patented protocols, like Token Ring, but the more proliferated a protocol is, the more likely it is open. Still, finding a company with a widely used but protected protocol is like discovering gold.

Semiconductor Process

There are occasionally unique processes to manufacturing semiconductors that are unique and secret. These are usually analog processes or some funky memory process that allows for smaller cells. This component of a secret sauce is the quickest to deteriorate in value, but one nonetheless.

Brand

This is the touchy-feely secret sauce. It is fraught with danger. On the online services side, a lot of money is being deployed to establish brands, such as Yahoo and @Home (ATHM:Nasdaq). It can work if done well, but the long-term staying power of the brand had better be more than paying for banner ads and distribution, the brand must stand on its own like Coke and Yoohoo.

Recurring Contracts

In communications services, such as selling broadband access or Web hosting, contracts are executed for some span of time. Ex-complete buffoonery, those contracts are almost always renewed since it is a pain to disconnect fiber lines or move Web servers. Not as valuable a secret sauce as others, it still points to interesting value at a variety of companies such as the competitive local access carriers, or CLECs.

Installed Base

Perhaps the most overlooked of sauces, Netscape (NSCP:Nasdaq) proved the value of an installed base. Get to a million users quickly and a business model will follow. RealNetworks (RNWK:Nasdaq) is on that path today, with 30-million-plus users of its player, and a business model that consists of selling server-side software.

Here are some things that do not qualify as secret sauce:

Manufacturing

The entire Japanese consumer electronics business was built on the premise that they were the world’s greatest manufacturers, but the Koreans and now the mainland Chinese have gone a long way to show it is a combination of know-how, currency and labor costs, not just manufacturing prowess.

Channel

A distribution channel for products and services is certainly valuable but is by no means a lock on value. Compaq (CPQ:NYSE) owned the dealer channel and then Dell (DELL:Nasdaq) went around it, going directly to consumers. Now Dell’s hold on the both the direct channel and the Web channel might be precarious as other entrants crowd in.

Pricing

Having the lowest price is just plain dumb in technology and communications. It means you have nothing else of value. Enough said.

A Lead

Having a lead as your only claim to fame is even dumber than having the lowest price.

Remember, a secret sauce is just a foundation of a franchise. A truly great company is one that has a management team that knows how to turn that secret sauce into profitable growth.