3 Contents Chairman s letter to shareholders 5 Profile, Aim, Policy 6 Corporate Governance 7 The Board 8 Key facts 11 Investment Report 12 3 Investment performance 12 Market overview 14 Sector developments 15 Portfolio 22 Holdings at June 30th, Portfolio composition: by sector 23 by country 23 by stock market 23 Company profiles: Unquoted 24 Venture capital funds 27 Quoted companies 28 Financial Data 36 Balance sheet 36 Statement of income 36 Profit distribution 37 Off balance sheet positions 37 Notes to the financial statements 38 Valuation rules 40 Report of the Board Members 41 Report of the Independent Board Members 43 Report of the Statutory Auditors 44 Glossary 45 Key Information 47
5 Dear Shareholder, It is my pleasure to present the second Annual Report of Quest for Growth which shows excellent progress in all areas of our business. The 1999/2000 financial year was outstanding in many ways. First, of course, was the remarkable volatility of the public markets for growth stocks. The company profited from the extraordinary rise in technology share prices between October 1999 and March 2000, a gain which the investment team successfully protected from the subsequent market declines by timely stock sales and hedging activity. Secondly, the year saw the first tangible returns from our investments in unquoted companies with the initial public offerings of Tanox and Orchestream. At June 30th, these showed gains respectively of 3x and 5x our original invested capital. Our investments in Venture Funds have produced an early contribution with the substantial gain in the value of our holding in the Kiwi Ventura Serviços Fund following the successful IPO of its Tiscali investment. 5 The result of these investment activities was to increase the net asset value per share during the year from to Adjusting for the gross dividend of 1.14 paid on 1st October 1999, this represents a total return of 80.3%, which exceeds the gains of the main growth stock indices (EASDAQ, NASDAQ and EuroNM). In accordance with the Privak regulations, the board proposes to pay a dividend of per ordinary share after withholding tax ( gross). The proposed dividend represents a return of cash to ordinary investors equal to 30% of the company s net asset value and 55% of the original subscribed capital. Many shareholders wish to maintain or increase their investment rather than reduce it, so the board is asking shareholders to approve the offer of a tradeable warrant to purchase one additional share for every share held on the dividend payment date. Details are given elsewhere in this report. We believe that these actions will add still further value for ordinary shareholders, who have benefited from the 83.6% increase in the share price of Quest for Growth during the year and the 1.09 (net) dividend paid in October I am encouraged that after just seven quarters the company is already close to achieving the levels of investment required by the Privak legislation after 5 years, excluding the cash held to pay the dividend. An innovation last year by Philip Fearnhead and his staff was the Quest Investor Club. These presentations, at 6 different locations around Belgium, were attended by over 700 people. Quest also presented at several other meetings. Together with the web site (www.questforgrowth.com) and our regular quarterly reports and monthly publication of net asset value, we aim to keep you fully informed of the company s activities. I am sure that you will join me in thanking the management and staff of Quest Management for their skill and effort in achieving the excellent results for the 1999/2000 year. I look forward to the coming year with confidence. Dr Jos B Peeters Chairman
6 PROFILE, AIM, POLICY : Quest for Growth focuses on European technology-based growth companies in sectors such as biotechnology, medical, health care, information technology, software, electronics, new materials, and special situations in other growth sectors. Funds under management amounted to 123 million, on June 30th, Quest for Growth has been listed on the Brussels Stock Exchange since September 23rd, The Privak, created by Royal Decree of April 18th, 1997, is an investment vehicle, specially t a i l o red to provide a suitable framework for investments in private equity and in gro w t h c o m p a n i e s. The Privak is a closed-end fund under the regulation of the Belgian Banking Commission and subject to specific investment and dividend pay-out rules : Investment rules : - A minimum of 50 % of the portfolio must be invested in equity ; - A minimum of 70 % of the portfolio (qualified investments) must be invested in : Unquoted companies ; Companies quoted on a growth market 1 o r Ve n t u re Funds with a similar investment policy to the Privak. H o w e v e r, investments in quoted companies on a growth market can never exceed 50 % of the qualified investments. - The company is not allowed to invest over 20 % of the portfolio in one company, nor invest over 6,2 million in one year, in one company. Tax Benefits: The Privak benefits from important tax advantages. These benefits only apply as long as the investment rules are adhered to and : - All investments are made in companies, subject to a normal tax regime ; - Over 80 % of the realised benefits of the fiscal year are paid out as dividend (Quest for Growth states in its bylaws that at least 90 % of the realised benefits will be paid o u t ). Dividends : The part of the dividend resulting from capital gains will be exempt from withholding tax. The remaining part of the dividend will be subject to a withholding tax of 15 %. Individuals : withholding tax is considered as final tax ; Companies : 95 % of the gross dividend income resulting f rom capital gains can be deducted from taxable profit (Dividend Received Deduction) ; withholding taxes can be credited against corporate taxes. Capital gains : Exempt from taxation. INVESTMENT POLICY : Quest for Growth invests in growth companies with the objective of converting capital gains into tax free income through the Privak stru c t u re. The largest part of the portfolio is invested in companies listed on growth markets (EASDAQ, EuroNM, NASDAQ, AIM) and other regulated markets. Under Privak rules this part may not exceed 65% of the assets from June The balance will be invested in unquoted companies intending to seek an introduction to a stock exchange within 18 months. Investments in start-ups or early stage companies are allowed, but will be exceptional. Up to 15% of the assets can be invested in venture or private equity funds having an investment policy compatible with that of Quest for Growth. 1 Defined by the Belgian Banking Commission as Easdaq, Nasdaq, Nieuwe Markt (Belgium), Le Nouveau M a rché (France), Neuer Markt (Germany), Nuevo Mercato (Italy), NMAX-New Market (The Netherlands) and Alternative Investment Market (U.K.)
7 CORPORATE GOVERNANCE Quest for Growth is governed by a set of rules imposed by corporate law, by the Privak legislation in particular, and by a set of rules laid out in the Ethical Code that applies to the directors of the Privak, of Quest Management nv and its personnel, the depositary bank and the investment advisers. Quest Management nv is the investment manager for Quest for Growth nv. The 11 member Board of Quest for Growth may include up to four Board members of Quest Management, the others being independent of Quest Management. Two of Quest for Growth s independent board members monitor the daily management of the company by its managing director, Quest Management. They verify, in particular, any situations where one of the following persons has a direct or indirect interest in a transaction by the company : the depository bank or the management company, or persons with whom the company, the management company or the depository bank are linked or board members, directors, persons who are responsible for the daily management of the Privak, the Management Company or the depository bank. 7 The annual report must justify these transactions, especially with regard to the benefit the Privak could draw from the transactions and compliance with its investment policy. The auditor, in his general responsibility for the control of the accounts, has also the duty to report specifically about such situations in the annual report. The daily management of the company has to abide by the general principle in the Privak legislation that the company is to be managed in the sole interest of the shareholders (Art. 24, Royal Decree 18 April 1997). In addition, the company has to act according to Articles 60 and 60bis of the co-ordinated laws on commercial companies. These articles contain a set of special rules, which apply in the case where a company represented by a board member has a commercial interest in a decision to be taken by the Board. BOARD MEMBERS Board of Directors : Jos B. Peeters, Chairman, Quest Management NV, Managing Director, represented by Mr Philip Fearnhead, Managing Director, Quest Management NV Comte Diego du Monceau de Bergendal, Vice Chairman Philippe Haspeslagh BVBA, Board member, represented by Mr Philippe Haspeslagh Joedheco NV, Board member, represented by Mr Leo Claeys Patrick Millecam, Board member René Avonts, Board member Joseph McNay, Board member Rudi Mariën, Board member Koen Debackere, Board member John Boeckmann, Board member
8 THE BOARD Jos B. Peeters, Chairman, Jos B. Peeters is the founder and managing director of Capricorn Venture Partners Ltd. For seven years he was managing director of BeneVent Management, a Belgian based venture capital operation associated with the Kredietbank-Almanij Group. Previously he worked for the international technology based consulting group PA Technology and for the Bell Telephone Manufacturing Company, now part of Alcatel. He was a senior partner with Baring Private Equity Partners and non-executive-chairman of Quartz Capital Partners Ltd. Dr. Peeters has the Belgian nationality and holds a Ph.D. in Physics from the University of Leuven. He has also been chairman of the European Venture Capital Association (EVCA) and of the working group which founded the European Association of Securities Dealers (EASD) and developed the concept of EASDAQ, where he is vice chairman. Comte Diego du Monceau de Bergendal, Vice Chairman Diego du Monceau brings with him a wealth of senior management experience. After a successful career in corporate finance with Merrill Lynch and Swiss Bank International Corporation, he joined GB-Inno-BM where he rose to become Managing Director and subsequently Chief Executive Officer of GIB Group. Today he is Vice Chairman of GIB Group, Chairman of Continental Bakeries (Netherlands), Vice Chairman of Quick and an independent director of Banque Bruxelles Lambert and JP Morgan Investment Funds (Europe), as well as being on the boards of several non-profit organisations. Quest Management NV, Managing Director, represented by Mr Philip Fearnhead, Managing Director Quest Management NV Quest Management, the investment manager for Quest for Growth, was founded in March It carries out due diligence investigations, recommends investment and divestment decisions, and monitors and produces valuations of the portfolio. The management team seeks to identify companies which offer potential for exceptional returns based on market research and company analysis. Philip Grant Fearnhead was elected Managing Director of Quest Management NV on 1 September Mr Fearnhead holds a B.Sc.degree in Physics from Imperial College in London, and an M.Sc. degree from the University of Wales. He spent nearly ten years in sales and marketing posts with IBM before joining Kleinwort Benson (now Dresdner Kleinwort Benson) as their computer industry analyst and has worked as a consultant to international IT and Telecommunications vendors. In 1993 he joined London insurer NPI (National Provident Institution) where he was responsible for international investments in both quoted and unquoted companies, with a particular focus on technology investments.
9 Philippe Haspeslagh BVBA, Board member, represented by Mr Philippe Haspeslagh Philippe Haspeslagh is a professor at the international business school INSEAD in Fontainebleau and at the Vlerick School for Management in Gent. He studied commercial engineering at the University of Leuven and received his MBA at the Harvard Business School. After his Ph.D. at Harvard he joined INSEAD. Philippe Haspeslagh has worked as a consultant for PA Management Consultants and McKinsey & Co and was Chief of Cabinet of Minister of Agriculture and S.M.E.'s, Karel Pinxten, in the former Belgian Government. His academic work is in the area of corporate governance, corporate strategy and merger and acquisition management. Professor Haspeslagh is a director of Capricorn Venture Partners and of the Kinepolis Group and is chairman of Pieters Visbedrijf and Unifrost. Joedheco NV, Board member, represented by Mr Leo Claeys 9 Since 1972, Mr. Claeys is shareholder and Director of the Roularta Media Group. He built up the internal structure of the media group, has a seat in the Direction Committee and is Vice-Chairman of the Board of Directors. Mr. Claeys is also active in the Boards of Directors of Covatel, Artwork, Accentis and various family partnerships. Furthermore he is President of the Mercator Printing Group. Patrick Millecam, Board member Patrick Millecam obtained a degree in Economic Sciences at the University of Gent (RUG) in In 1992 he also obtained an additional degree in informatics at the University of Brussels (VUB). In the beginning of 1993 Mr. Millecam joined Corluy as a financial analyst. As a portfolio manager he won a lot of recognitions ands awards for Bank Corluy : the Tijd Award for the highest return in 1 year in the pension funds category in 1996 and 1997, the Tijd Award for highest return in 1 year for the Belgian stocks category in 1997, the Tijd Award for the highest return in 3 years in the pension funds category in 1997 and 1998 and the Sicav de Cristal for the highest return in 1 year for the Belgian stocks category in Mr. Millecam is currently responsible for the investments in Flemish stocks (VLAM21) and the pension fund (Top Global Pension) of the Bank Corluy. René Avonts, Board member Graduated in commercial engineering at the University of Leuven in 1970 and started his career in the IT-division of Paribas Belgique. He joined the International Division in 1972 and became head of this Department in After several promotions, he was elected member of the Board of Directors in Since 1998 he is member of the Executive Committee of Artesia BC and BACOB in charge of Financial Markets and Investment Banking as well as for Artesia Securities, the equity subsidiary. Other mandates include : Member of the Board of Directors of Banque Artesia Nederland and Parfibank since 1997 ; Member of the Board of Artesia Holding Ireland and President of AMCC, Seattle since 1998 ; Director of Group Crédit Agricole since He is also member of "Le Conseil de Surveillance" of Banque Vernes Artesia since May Joseph McNay, Board member After getting a BA at the Yale Univestity of New Haven and an MBA at the Wharton School of Finance in Philadelphia, Mr. McNay started his career in 1967 as an Investment Advisor and Director of the Company Endowment Management & Research in Boston. From 1976 till the present day, he is Investment Advisor and Chairman of Essex Investment Management Company LLc, also based in Boston.
10 Rudi Mariën, Board member Rudi M. Mariën, born in 1945, is co-founder of INNOGENETICS, has been Chairman of the Board of Directors and is major shareholder since the foundation of the company. Mr. Mariën is also the founder, shareholder and Representative Director of several medical laboratories. He is the President of BARC NV, an accredited international leading central clinical laboratory, specialised in pharmaceutical studies and in performing analyses within the framework of occupational medicine. He has a degree in pharmaceutical sciences at the State University of Gent and a specialisation in clinical biology. Koen Debackere, Board member Koenraad Debackere holds M.Sc. and Ph.D. degrees in Electrical Engineering and Management. He studied at the University of Gent and MIT, Cambridge, U.S. He is a full professor in Technology and Innovation Management at the University of Leuven. He has been a visiting professor at Nijmegen Business School and is a faculty member at the Vlerick Leuven Gent Management School. He has been a guest lecturer at various European business schools (Manchester, Kiel, Tilburg, Insead). He is the head of the research division INCENTIM at the University of Leuven. This division has developed extensive experience in doing fundamental and applied research in the area of technology and innovation management. Koenraad Debackere has received several international awards and nominations for his research activities in the area of technology and innovation management. He obtained Best Research Paper Awards from the American Academy of Management and the Decisions Sciences Institute. He has authored over 70 articles and book chapters in this field. He has been involved in projects for the European Commission, the Belgian and Dutch government and multinationals. Koenraad Debackere is the Managing Director of K.U.Leuven Research & Development and Chairman of Gemma Frisius-Fonds K.U.Leuven nv, the Venture Fund of the University. In November 1999 he was nominated Chairman of Leuven.Inc (Leuven Innovation Networking Circle). John Boeckmann, Board member After his training as a stockbroker, John Boeckmann joined M&G in 1967 as an Investment Manager for the UK based assets. Between 1971 and 1978 he was director of two listed public companies, specialising in asset realignment, which were both successfully sold. Until he left M&G in 1997, he managed a wide range of M&G funds such as equities, bonds, for retail and charity accounts, UK mutual funds, pension funds and special accounts including US accounts. In 1997 he joined Compagnie Monagasque de Gestion in Monaco as a consultant director; and in 1998 he joined the Board of Banco Privato Portugues in Lisbon. Thanks to this rich curriculum of activities he has gained extensive experience of the financial markets connected with equity investment in the UK and Continental Europe.
11 KEY FACTS 1/7/ /6/ /9/ /06/1999 Net profit : 56,426,078 3,126,851 Net profit / Share : Ordinary dividend : 37,363,457 2,762,185 Performance dividend to A and B shares : 7,053,266 nil Profit carried forward : 12,029,460 20,105 Ordinary Dividend per share (before withholding taxes) : Ordinary Dividend per share (after withholding taxes) : June 30th, 2000 June 30th, 1999 N.A.V. : 123,575,750 70,256,418 N.A.V. / share : Stock Price / share : Number of Shares : 2,708,000 2,708,000 Stock price Volume
12 INVESTMENT REPORT Investment performance The 1999/2000 financial year has been very successful for Quest for Growth, with excellent results achieved in all of the company s investment areas. The chart below shows the changes in net asset value per share and the share price of Quest for Growth during the year ended 30th June The overall increase in net asset value was 80.3%, including the gross dividend of 1.14 ( 1.09 net) paid in October Reflecting this performance, the share price increased by 83.3%. Share Price and Net Asset Value History Net Asset Value, net dividends reinvested Net Asset Value Share Price During the year new investments totalling 6.76m were made in six private companies. In addition, 1.15m was committed to NetFund Europe, of which 550,000 was drawn down, and follow-on investments were made in the Kiwi and Schroder Life Sciences Fund II totalling 1.64m against previous commitments. The total additional investment in private equity was 8.95m. Two of our unquoted company investments, Tanox and Orchestream, made successful initial public offerings on the NASDAQ and London stock exchanges respectively. At the end of June our investments were worth approximately 3x and 5x their original cost. Quest (along with the other venture investors) is prohibited from selling these shares until October 2000 and June 2001 respectively by the terms of the public offering. The year end valuations are therefore discounted from the public market prices by 20% for Tanox and 25% for Orchestream in accordance with European Venture Capital Association rules to allow for the risk of a share price decline before the "lock-up" period ends. Under the Privak legislation, private companies like Tanox and Orchestream remain classified as "unquoted" in the portfolio for five years after their IPO, unless previously sold. In our venture fund investments, Kiwi achieved a very successful early IPO with Tiscali, the leading internet service provider in Italy, which allowed it to repay 1.6m to Quest and still increase its value by approximately 3x.
13 In the quoted stocks we had a similarly successful year. Both asset allocation and stock selection added significant value to the portfolio. Liquidity was reduced from 33% to 3% during the last months of 1999, capturing much of the strong increase in growth stock valuations during the period. Starting in February, stocks were sold to increase liquidity, thereby avoiding much of the general decline in market values of technology stocks that occurred between March and June We also started to hedge the portfolio against a general market downturn from the end of December by purchasing NASDAQ 100 put options, which also mitigated the effects of the subsequent market correction. Stock selection was favourable. If taken in isolation, the quoted stock portfolio would have exceeded the returns from the main indices which we monitor (EASDAQ, Euro.NM and NASDAQ). During the year there was a policy of moving the portfolio to more liquid stocks as many stocks rose to what we considered unsustainable levels. The chart below shows the returns achieved by the fund compared with the major growth stock indices. 1 3 Performance of Quest for Growth and market indices to 30th June months 6 months
14 Market overview The sharp increase in prices of growth stocks that took place in late 1999 and early 2000 was followed by a similarly sharp correction. Much of the price correction in the first half of 2000 took place in the Internet space, with the median stock down 67% from the high. Some stocks are down more than 90%, with investors doing a better job in distinguishing profitable companies from those with high cash burn rates. While valuations are certainly more reasonable now, we expect continued volatility as investors continue their reappraisal of company earnings prospects and valuations. Quest for Growth s management expects evidence of slowing economic growth to become apparent over the next several quarters as there is typically a time lag of 9-18 months from the time that central banks start to raise interest rates to a reduction in economic growth. The consensus estimate is for real US GDP growth to slow to 3%-4% by year-end and European real GDP growth to stabilise in the 2-3% range. This would extend the long- running economic cycle with low inflation and create a favorable climate for technology companies. Risks to these forecasts are probably in the direction of slower growth and higher inflation. If these materialised, companies would report lower earnings and the market would trade on lower multiples of earnings. Quest for Growth is well placed for both scenarios. Strong public equity markets obviously help our quoted stocks directly and our private companies indirectly (by making IPOs easier and at higher prices). Lower prices in public stock markets create important opportunities to increase our private equity investments at lower cost and build a store of value for the future. To reduce any short term impact on our quoted stocks, we will continue to hedge those investments when we feel it is appropriate. Quest for Growth will continue to seek opportunities for sustained long term growth in value irrespective of market conditions. Quest for Growth remains confident that the adoption of new technologies in communications, materials, computing and life sciences will continue to be a global feature for the foreseeable future. Whatever happens to market valuations in the short term, those companies which produce or deploy advanced technologies have the opportunity to prosper as they are, quite literally, building the future of our world. While the US has historically provided important technology leadership, Quest for Growth sees strong European leadership in many areas. Mobile communications, new semiconductor materials, and software technologies all present strong opportunities for European companies which have demonstrated that they have world class technologies. Meanwhile, European markets are less developed in their use of new technologies, with the result that deployment is still at an early stage compared to the US.
15 Sector developments In IT Services focusing on IT Internet Service Market Globalisation is a theme that persists throughout the technology and especially the IT services space. As enterprises become increasingly integrated and solutions and services are rolled out by large enterprises across the globe, they will seek global solutions providers. Accordingly, many IT services companies are now firmly focused on increasing their international presence. While there remain a number of purely regional players, the market is increasingly beginning to penalise those IT services companies that lack a developed internationalisation strategy. Finland 1.60% Denmark 2.60% Spain 3.10% Switzerland 3.50% Sweden 5.10% Other 8.10% Germany 22.30% 1 5 RELATIVE EUROPEAN IT SPENDING (1999) Netherlands 5.90% Italy 8.90% France 17.10% UK 20.80% Denmark 2.80% Spain 2.80% Switzerland 3.00% Sweden 5.80% Finland 1.70% Other 7.80% Germany 22.40% RELATIVE EUROPEAN IT SPENDING (e2003) Netherlands 5.80% Italy 10.50% France 13.50% UK 23.90% The pie charts indicate that while Germany has historically been the highest spender in the European IT market this is set to change. By 2003, it is estimated that the UK will overtake Germany in this regard, accounting for 24% of IT spending in Europe, with the French and Italian markets also set to grow in importance. This is reflected in the portfolio of Quest for Growth. It is also important to remember that the European market is a long way behind the US in terms of total spending on IT services. Indeed, estimates suggest that by 2003, Europe will account for only 28% of global IT spending with the US remaining the largest market at 48% of the total. According to IDC, the world Internet services market was worth 16.2 billion USD in 1999, up 108% on As a comparison, the IT services market was worth billion USD in 1999, up 10%. Over the next four years, the Internet services market should continue to expand strongly and IDC forecasts annual growth of 44% over the next four years. At this rate, the world Internet service market will be worth 99.1 billion USD in 2004, compared with 500 billion USD for IT services. QUEST FOR GROWTH will continue to look for new opportunities in both the traditional IT services and the internet services markets.
16 Telecom and Equipment also driven by consolidation In Telecommunications, the evolution to 3rd generation wireless networks (3G, UMTS) will produce a major revolution in both consumer and business use of technology. UMTS combines high speed mobile access with Internet Protocol (IP)- based services. However, UMTS is not just about high speed Internet access. The combination of mobility and the Internet will bring about whole new ways of communication, the access of information, the manner of conducting business, learning methods and entertainment services. For example, it will be possible to purchase a recording heard on the radio by instantly downloading it to a storage device whilst driving along the highway. The main limit on the range of applications will be the imagination of the service providers, not the technology. Consolidation is likely to be both horizontal (between existing operators) and vertical (between operators and media/internet companies and between operators and service providers). Horizontal consolidation creates significant synergies from owning networks in several countries. These include cost synergies through the pooling of purchasing (of new infrastructure) and R&D (in mobile applications) and revenue synergies, e.g. roaming. However, consolidation is likely to be vertical as well. Revenues will be increasingly influenced by content and commerce as well as the provision of mobile access. This will lead to joint ventures and mergers between operators and media/internet companies. The U.K. auction for UMTS licenses has prompted a re-evaluation of the costs of development of third generation networks as levels of license fees far exceeded even the most optimistic hopes of the U.K. government. The amount of money raised in excess of 22 billion GBP has prompted a reassessment in a number of countries, most notably Italy and France, of the methods to be used to award 3G licences, with an increased bias toward auctions and away from beauty contests. For the industry as a whole it has also raised the cost of providing 3G services at a time when the revenue streams from basic data services are just beginning to materialise. Based upon a fairly simplistic extrapolation of the cost of licences in the U.K. market, expenditure by operators on the 56 licences to be made available in the whole of Europe could be in excess of 132 billion USD. In that context we see the level of uncertainty surrounding the costs of a UMTS license in Germany, Europe s largest market, to be a key driver of sentiment and a potential short-term brake on performance.
17 Over the next few years, the demands put on communications systems will be considerable. Assuming Internet traffic continues to double every 3.5 months, a yottabit (or one million billion billion bits) of bandwidth will be required by Future networks will have to offer not only unprecedented speeds, but also reliability, backward compatibility with existing equipment, interoperability and cost efficiency. Major progress in micro-electronics, opto-electronics, digital signal processing (DSP) and software will be required to make this vision a reality. Companies with strong presence in optical systems or an extensive customer base of established and emerging carriers will be best positioned to engineer a revolution in telecom infrastructure. IT and mobile Security The Internet is a pervasive organisation: extending a company s network reach across the Internet can enhance revenue growth - and expose a company to potential "data damage". The explosive increase in mobile communications, together with technological advances in mobile systems, networks, interfaces, and applications, offers tremendous leverage to individuals and businesses and reinforces the issues of confidentiality and security. The basic requirements are essentially the same for fixed or wireless services: authentication and encryption. The particular difference arises at the point at which the two worlds meet and data must cross or be converted as it crosses. 1 7 According to Datamonitor, the global market for IT security products was 2.3 billion USD in 1998 and is expected to grow to 8 billion USD by The specialised nature of IT security products involving immensely complex calculations and algorithms creates natural barriers to entry. However, producing software is a potentially compelling value proposition. It resembles the manufacture of medicines, where the vendor s revenue comes from the licensing income of the medicine. As the cost of reproducing software is almost zero and distribution is global in scale, this can result in a highly leveraged business model. IT security products can be implemented in hardware or software, or both. The smart card industry is rapidly evolving to provide the advanced authentication and encryption facilities needed for electronic commerce transactions and is an example of how new technologies can create complete new industries from very modest beginnings. Accelerating Growth in Smart Cards
18 The semiconductor industry The semiconductor industry is the hidden core of the entire electronics industry. Although the semiconductor market is smaller than the overall electronics industry (129 billion USD versus 910 billion USD for the overall industry in 1998), it is outgrowing it by a factor of two to one, as semiconductors represent an increasing proportion of the content in electronic systems. The semiconductor industry is considered to be among the most cyclical of industries. The cyclicality in the semiconductor industry is due to its high fixed costs. When commodity semiconductor prices are high, IC manufacturers invest massively (currently at 1-2 billion USD per plant) to reap profits until the resulting oversupply causes prices to drop below the point where further investments are economic. While the industry has made significant progress in quickly ramping and stabilising production, it still takes around months to build today s $2 billion factories (fabs). By the time a fab has come online, the demand in the market which it was intended to serve may have changed considerably. Capital intensity, long lead-times for new capacity, and fast-moving markets make semiconductor supply-demand parity difficult to achieve. In 1999 the global semiconductor industry began to come out of a "double dip" (referring to two years of declining year-on-year revenues in close proximity, 1996 and 1998). Following three years of very strong industry growth, 1995 represented the peak of the last cycle. Analysts estimate that the semiconductor industry will have grown by 17.6% in The recovery has been broad in nature, and actually began in July 1998, as the DRAM sector bottomed out. The recovery has followed the typical recovery pattern: slowdown in capital spending in the prior 12 months leaving insufficient capacity for demand growth. The demand growth was the actual factor which really changed in mid-1998; unit volume in the industry had been basically flat over the prior twelve months as the Asia-led global economic slowdown affected electronic equipment purchasing, a factor which had been accentuated by excess inventory in the PC channel in the first half of With the worst of the Asian Financial Crisis over by the summer of 1998, economies were on the up, as was semiconductor unit demand. This was helped by newer applications such as mobile communications, digital consumer electronics and Internet access reaching critical mass. Analysts are forecasting that the global semiconductor industry will recover further in 2000, growing 23% after growth of 17 % in In the first half of 2000, pricing recovery already began to make a bigger contribution to revenue growth than it did for most of 1999, as capacity remains tight and semiconductor vendors regain their long-lost negotiating power, particularly for mass-market products. World Semiconductor Sales
19 After two years of modest capital expenditure in the semiconductor industry, analyst expect a 40% rise in spending in Although tight utilisation rates at the moment would justify this expenditure, increasingly aggressive spending targets and accelerated building suggests that the current industry upcycle will end in just the same way as previous ones with a crash. If capex does rise by 40% in 2000 and the semiconductor industry grows by 23%, this would be the first time that capex has risen faster than semiconductor revenues in an 'unexceptional' year. With the transition from 200mm wafers to 300 mm wafers scheduled to occur during 2002, the industry will see a significant jump in capacity by then, much as happened in 1994 with the transition to 200 mm wafers. This could be the precursor to the next downturn. 1 9 Against this background however increasing demands for flexibility and reductions in time to market have encouraged the development of the market for semiconductor circuit designs ("Silicon Intellectual Property") which are marketed by "fabless" companies. Such companies are likely to be better protected from cyclical downside risk with longer term licensing models, lower fixed overhead costs and little capital expenditure. Key Semiconductor Applications PC Other Computer Other Wireless Analog Consumer Industrial Automotive Datanetworking Digital Consumer 1999-e2002 CAGR Bubble size corresponds to relative market size Source: Deutsche Bank Feb 2000
20 Compound semiconductor components represent exciting new markets Although the market for compound semiconductor components is much smaller than the silicon semiconductor market, their unique capabilities suit them to a wide range of the most dynamic market segments in the electronics industry- fiber optic communications, mobile telephony, satellite communications, computing and consumer electronics. Numerous other niche and emerging applications underpin the market. The voice, data and video communications industries have a seemingly unlimited appetite for communications bandwidth. The growing need to deliver internet services alone is severely stretching the capabilities of telephone companies to expand their infrastructure. Additional bandwidth can only be delivered through further use of optical fiber and through higher frequency radio frequency (r.f.) communications. Compound semiconductors provide critical components for both markets. As such, the compound semiconductor industry holds a determining key to the future development of the global communications industry. The market for compound semiconductors is highly specialised, smaller and currently less competitive than the market for components based on silicon. Importantly, the market has not exhibited the cyclic behaviour of the market for silicon components or the associated price instability. Although compound semiconductors represent only 0.7% of the total semiconductor market by wafer usage today, they represent 10% by value. Optical Storage is becoming the dominant storage medium for data, audio, and video due to its technological superiority. The DVD (digital versatile disc) market is growing very rapidly, driven by the integration of DVD-ROM drives into PCs, and the increasing popularity of DVD movies. DVD unit sales are expected to grow from 80 million in 1998 to 2.6 billion in 2003, a CAGR of 100%. DVD Titles (Films) Source: Forrestor Research DVD-ROM is still in its infancy, with little more than 100 programs waiting for the important application that will convince everyone that they need a DVD drive, just as previous applications convinced consumers that they needed a PC, a VCR and an electronic game console. Games will be released on DVD in 2000 with the introduction of new players from Sony and Nintendo. Hybrid DVDs with embedded internet connections will provide new ways to market and provide information. The Internet can serve as a way to deliver digital content that can be consumed online and stored locally for offline replay.
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