Leithner & Co Pty Ltd - The INTERNET AND VALUE INVESTING: Part IV: Investors Meet the Internet

In the absence of clear and agreed criteria to guide their valuations, four optimistic (and perhaps heroic) sets of assumptions seem to underlie the assessment of many e-business and e-commerce stocks:

As noted by the U.S. Federal Reserve Chairman, Dr Alan Greenspan, the extraordinary hype about the Internet has been generated by the conviction that the Net will shortly become as ubiquitous as the telephone, and that a substantial proportion of the transactions, goods and services now conducted or distributed via conventional means will eventually be conducted via e-business and e-commerce.It seems reasonable to assume that the percentage of homes and businesses which have Net access, together with the amount and relative proportion of business conducted on-line, will continue to increase. As shown in Part III, however, it is by no means certain that the extent of Internet access in Australian households (currently 25-30%) will soon – or ever – approach that of the telephone (94%) and radio and television (96%). (Perhaps for that reason, strenuous efforts are currently underway to combine mobile phones and TVs with access to the Internet). The market valuation of e-commerce stocks far exceeds anything that could be justified even if e-commerce took over the entire mail-order sector. Indeed, to justify their current valuations, Internet sales would have to displace shopping malls; thus far, however, there is no sign that this is happening.

ISPs’ prosperity is conditional upon reaching a “critical mass” of subscribers. It also depends upon the extent to which technological developments render existing networks (in which billions have been invested) obsolete. Yet many investors – including professional and large institutional investors – are acting as if ISPs have already achieved critical mass and (curiously, given the breathtaking rate of technological change) today’s networks will not be superseded by new and better networks.

As shown in Part I, these expectations are questionable. Because one sees Internet addresses displayed almost everywhere, one might think that most people surf the Net daily. Surprisingly few people, however, do so. It requires time, money, technical skill and interests which the average consumer lacks. Users of the Internet, especially for services beyond e-mail, constitute a minority segment of the population; and although this segment is growing steadily, for the foreseeable future it may remain unrepresentative of the whole.

Given problematic economic fundamentals, the dynamics of stiff competition etc., it is likely that many – and perhaps most – of today’s Internet ventures will either earn meagre returns or fail outright. Investors readily acknowledge this likelihood but are not deterred by it. Quite the contrary, it encourages them: they believe that it will ensure that a select few of today’s minnows will become the giants of tomorrow which earn enormous and sustainable profits. Hence investors’ desire to “get in on the ground floor.” This motivation is hardly new: as stated in a 1905 ad for the De Forest Wireless Telegraph Company, “all great discoveries which have brought civilised communities into close touch have made millions for those who attained an interest in them in the early stages of their development.”

Investors in Radio Corp. of America, the biggest and best-established company in its field during the radio boom of the 1920s, would disagree. RCA, unlike most of its competitors, made profits during its formative years. It also launched America’s first nation-wide broadcasting network and diversified into a range of cognate technologies. Indeed, it would be difficult to name a company which was better managed and did a better job of planning and executing a long-term business strategy.

Nevertheless, investors who bought RCA shares in the summer of 1928, when the company, analysts and investors alike agreed that its prospects were virtually limitless, soon lost nearly everything. From almost $500 in 1929, between 1930 and 1950 RCA stock hovered around $US10. Its technology was indeed revolutionary, its business plan was executed successfully and its operations were therefore profitable. But its early investors lost heavily just the same. (Three decades passed before RCA’s stock, adjusted for splits, returned to its pre-crash high – in 1960, this time at the crest of a boom in consumer electronics companies created by the development of television).

This point applies not just to leading firms within a “New Era” industry, but to the industry itself. The aviation, air transport and airline industry also owes its existence to scientific breakthroughs and the development of particular technologies. Like computers in the last quarter of the 20th century, aviation revolutionised business and everyday life during its second and third quarters.

Warren Buffett has illuminated this point in a witty but nonetheless sobering way. Imagine if you were present with the Wright Brothers in Kitty Hawk, North Carolina, at the birth of aviation in 1903. Assume that you could foresee both the explosive growth of the industry and its enormous impact upon the country, and that you had the opportunity to “get in on the ground floor” with as much money as you wanted. What would have been the result? In Buffett’s words:

“Despite putting in billions and billions and billions of dollars, the net return to owners for the entire airline industry... [has been] less than zero. If there had been a capitalist at Kitty Hawk, the guy should have shot down Wilbur [Wright]. One small step for mankind and one huge step back for capitalism.”

To maximise their chances of survival, today’s minnows are plowing enormous resources into technology, marketing and people. Mike Vallender (CEO of the Internet stock forum HotCopper, which listed in November) has stated that “the Internet is unexplored territory when it comes to generating revenue. What we do know, however, is that getting your slice of the market is the number one priority in the short term. In two years, if we have 250,000 members of our forum, the value of our company will be so much more than what it cost to get the members and we’ll look like geniuses.” Growth for tomorrow, in other words, is infinitely preferable to profits today.

Some disturbing developments are appearing as a direct consequence of this optimistic assumption and the inability to evaluate Internet companies. Most notably, revenues are not always revenues. Some companies are using barter arrangements rather than cash transactions in order to increase their revenues and growth rates. At iVillage, an on-line media site for women, the barter of banner ads with other sites accounted for 21% of the company’s 1998 revenue. Quokka.com, a sports media site, received Internet services, computer hardware digital cameras and software to the value of $4.4 million in 1998 – and recorded it as part of its $8.6 million in annual revenue. And customers are not always customers. Although ExciteAtHome claims 38 million “registered users it has only 620,000 customers paying regular fees for the company’s high-speed Internet service.

Seemingly as a result of these optimistic assumptions and inability to assess their intrinsic values, the Australian share market (like its American and British counterparts) is currently besotted with the shares of Internet, telecoms and technology companies.

Just three years ago, just one e-business company (Sausage Software) and no ISPs or e-commerce outfits were listed on the ASX. By my reckoning, on 1 January no fewer than 127 companies (most newly-listed, others rebadged mining exploration companies) derived significant revenues from Internet service provision, e-business or e-commerce activities. Ten Net-related IPOs occurred in November and December, and at least as many have been scheduled to follow during January and February. Most of these IPOs have fully-subscribed within days of their announcement, and over-subscriptions have been the norm.

Lacking standards of evaluation and given very optimistic assumptions, no price seems to be too high to pay for these stocks. Take Microsoft’s newest listed competitor, VA Linux Systems. Floated at $30, its shares rose by the end of their first day of trade to $239. Yet its prospectus states: “we do not expect to generate sufficient revenues to achieve profitability and therefore we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.” Linux is capitalised at $10 billion – exactly the same as defence contractor General Dynamics, a company founded in 1952 and having 44,000 staff, revenue of $3 billion and a track record of profit increases throughout the 1990s.

At least ten other American IPOs floated in the second half of 1999 obtained first-day “stag” profits of at least 350%. This is not a purely American phenomenon. The prospectus of Melbourne IT, a company which registers Internet domain names in Australia, advised that it may not be able in future to charge fees for domain registration. No matter: floated at $2.20, on its first day it traded as high as $9.00. Other Australian companies floated in the past four months, including Open Telecommunications (350%), Technology One (305%), Lake Technologies (58%) and IT&e (56%), have also experienced huge first-day profits.

The total market capitalisation of the approximately 100 small computing, IT, Internet, telecom and biotechnology companies which comprise the Deutsche Bank Technology Index has increased from $9 billion in mid-1999 to almost $25 billion today. In mid-December, the total market cap in the Australian Technology Index established by Warburg Dillon Read was $23.6 billion. And according to a report released by stockbroking firm Hartley Poynton in November, Australia’s 41 listed telecoms and Internet stocks have a total market capitalisation of $A136.4 billion. (If Telstra is removed from this list, the remaining 40 have a market cap of $34.4 billion).

In the U.S., technology stocks comprise an unprecedented 25-30% of the capitalisation of the Standard & Poor’s 500 Index, and the average price-to-earnings multiple of stocks listed on the technology-heavy NASDAQ Index is no less than 170 times (up from 21 times in 1990, 39 times in 1996, 62 times in 1997 and 78 times in 1998). The NASDAQ itself has risen from 5% of U.S. GDP at the start of the ’Nineties to more than half – 55% – of GDP today.

Amazon.com, the e-commerce retailer which has yet to earn a penny of profit from the billions which has been poured into it, has a market capitalisation approximately equal to that of General Motors, the world’s largest vehicle manufacturer; and the market cap of Yahoo!, the Internet portal which trades at more than 100 times its annual revenue (that’s right, revenue, not earnings), is twice as great as GM’s.In Australia, One.Tel, the fourth-ranked ISP and telco, and Computershare, the share market registry firm, were capitalised in January at $4.1 and $4.0 billion respectively. That is equivalent ($4.2 billion) to Cola-Cola Amatil and greater than industrial giants such as CSR, Fairfax, Lion Nathan, Boral and Pioneer International. Yet in the past year One.Tel’s profit was less than $1m, and Computershare sells for no less than 240 times earnings. Australia’s largest “Internet” stock (it derives surprisingly little of its revenue from the Internet), Ecorp, has no earnings but a capitalisation of $800 million; and Sausage Software, whose shares have risen in the past year from $0.25 to $5.40 (a modest 260 times earnings), is capitalised at $690 million.

In ancient Rome, the seven-day festival honouring Saturn, the deity dethroned as ruler of the world by his son Jupiter, took place at the end of each year. Its ostensible purpose was to pause long enough to resynchronise the lunar and solar calendars. As the years passed, however, it degenerated into a lengthy debauch during which Romans of many walks of life engaged enthusiastically in all manner of licentious, self-indulgent and excessive behaviour.

Strong parallels exist between the Saturnalia and segments of today’s Internet IPO industry. The original purpose of merchant banking and venture capital industries was cautiously to couple particular investors (i.e., those possessing considerable knowledge, capital, appreciation of and appetite for risk) with particular technology firms (i.e., those possessing a record of short but nonetheless profitable operations, sound business plans and promising proprietary technologies). Today one might be forgiven for thinking that their purpose appears to be frenetically to marry inexperienced people possessing untested ideas to those possessing much money and even less common sense.

Today’s Internet sector concentrates upon the selling of business plans for their own sake, and the lust for money derived thereby, rather than upon the creation and nurturing of viable businesses. “MBAs aren’t going to class anymore; they’re taking sabbaticals to write Internet business plans” says Ann Winblad of Hummer Winblad Venture Partners of San Francisco. Unfortunately, however, this “overwhelming flood of plans are products for Wall Street, not real businesses, says Yogen Dalal, a general partner with the Mayfield Fund venture firm in Menlo Park, California.

The Internet boom, like a typical central bank, is thus creating vast amounts of “near-money” (i.e., pieces of paper which can be converted readily into cash). Shares of Internet and technology companies constitute one type of “near-money.” Until recently it was rather expensive to buy and sell the securities of small companies, particularly technology companies, and these transactions might take several days to consummate and process, thus attenuating the demand for these companies’ securities. Today, however, on-line transactions can be conducted cheaply and quickly. The Internet itself, then, is helping to create “Internet stocks” whose supply is constantly increasing and which can be liquidated readily and quickly. People want the dot com stocks to trade, not to hold as long-term investment.

Options over shares in these companies constitute a second type of “near-money.” Options are perfectly suited to cash-strapped, start-up companies: like banknotes printed by a reckless central bank, options can be created at any time and in virtually any quantity by their parent company. An option offers its owner the right (but not the obligation) to buy an underlying share at a fixed price. The greater the share’s market price exceeds the option’s exercise price, the greater the gain to the option’s owner. The owner thereby participates fully in the “upside” but bears no penalty if the share’s market price remains below the option’s exercise price. Options have become the inducement of choice for Internet and technology companies, and their use (allegedly to “motivate” senior executives) is spreading well beyond these sectors.

Internet and technology companies have voracious cash requirements, their business models presuppose its availability and near-money provides it. Both types of near-money derive ultimately from an expanding base of shareholders. In this respect the Internet and technology sectors of American, Australian, British and other equity markets resembles a giant Ponzi scheme. (Named after the infamous swindler, Charles Ponzi, who operated in Boston in the 1910s and 1920s, a Ponzi scheme is essentially a scheme in which returns are paid to earlier participants entirely out of money paid into the scheme by newer participants.) It is noteworthy that all Ponzi schemes have met ignoble ends because a point is eventually reached at which there are too few new participants to reward existing ones.

An accurate description of 2000? In fact, Shapiro and Varian are describing the year 1900. The Internet would not unduly impress Victorians travelling in a time machine to 2000. This is because they had their own “Internet.” Tom Standage, author The Victorian Internet, shows that the development of the telegraph 150 years ago has many parallels with the advent of the Internet in the 1990s: “the hype, scepticism and bewilderment associated with the Internet... mirror precisely the hopes, fears and misunderstandings inspired by the telegraph.”

These authors conclude that the proponents of the Internet and today’s “New Economy” overlook two crucial points. First, the changes which the Internet has prompted, whilst undeniably important, are hardly unprecedented. Second, the laws of economics have not been repealed. Despite strident claims to the contrary, they are as applicable today as they have ever been. In Shapiro and Varian’s words: “technology changes. Economic laws do not.”

It is with this second point in mind that the insights of Bob Hoye (the editor of Institutional Advisors, a newsletter published at Vancouver, British Columbia) are particularly relevant. Hoye shows that over the past 150 years every major breakthrough in technology has produced both demonstrable benefits for consumers and a speculative frenzy on the stock market. Each breakthrough (i.e., turnpikes, canals, steam engines, railways, telephones, the motor car, aeroplanes, etc.) improved the productivity of production, transport and communications, and thereby raised living standards. Without exception, however, the promoters of each advance made vastly exaggerated claims about its benefits. By so doing they were able to attract large numbers of “investors” and large amounts of investment capital.

By 1893, for example, during the early days of telephony, it was widely predicted that the telephone would obviate the need for office workers to travel to work, eliminate regional accents, help eradicate military conflict and generally revolutionise society. Railways provide another example in which wild speculation preceded profits – and, in many instances, the laying of track. “The human mind,” according to John Steel Gordon, author of The Scarlet Woman of Wall Street, “is most creative about the fortunes to be made when you don’t have to look at hard economic statistics.”

But by creating unrealisable expectations, the promoters of each new technology also facilitated unsustainable expectations about the technology, excessive expansion of infrastructure and unsupportable debt. Serious financial reverses have thus followed and been attributable to major technological innovations. As Hoye emphasises, these reverses have had more to do with the nature of speculation on financial markets than with the ultimate significance of the technology in question.

Years may pass before the Internet fervour of past several years can be judged dispassionately. In the meantime, and as shown by James Lardner in U.S. News and World Report, history provides some warnings and sharp lessons for investors and speculators convinced that the Internet defies comparison with anything which has preceded it. Lardner cautions that true believers in the ’Net should ignore the early development of the radio industry.Like the Internet, which owes its success to quantum leaps in computing technology, the discovery of radio was the consequence of another breakthrough in communications: the telephone. Also like the Internet, radio passed through a long incubation period during which funds for its development were provided outside the private sector. In North America and Australia, many of the first wireless stations were run by educational institutions, local councils, municipalities, trade unions and churches. And as has been the case with the Internet, the amateur ethos was at the outset so pervasive that many businesses, once they began broadcasting, had little idea how it might be made commercially viable. Radio’s development thus closely parallels that of the Internet.

The exponential growth of the sale of wireless receivers and components, and the even more exponential predictions of their continued growth, soon attracted the attention of Wall Street. In the U.S., the industry’s revenues increased from $60 million in 1922 to nearly $850 million in 1929. By the end of the decade, one-third of American homes possessed radios and investors dreamt about the capture of the remaining two-thirds (just as Internet investors today dream about the 60% of homes without Net access). Car radios created another avenue for growth.

Like the dot coms of today, in the 1920s the market capitalisation of companies which made wireless receivers or components skyrocketed. Investors bought shares in anything even remotely to do with radio; and like today, a few speculative mining companies quickly rebadged themselves as radio companies. The stock of the industry’s flagship, Radio Corp. of America (which marketed the first radios in a patent-trust arrangement with General Electric, Westinghouse and American Telephone and Telegraph), increased from $5 in 1922 to more than $500 in 1929. The radio boom was fed by an unprecedented increase in the number of Americans with the means and the confidence to speculate in the stock market. As the pool of investors grew, newcomers naturally followed the example set by more experienced players. Under such conditions, even a real industry with a real future takes on some of the attributes of a pyramid scheme.