bubble. com. or valuing an internet company - In the looking-glass world of e-businesses, tiny companies that will be losing money for years to come are given bigger market valuations by Wall Street than major blue-chips. Where's the connection to fundamentals? How can you spot a winner when the payoff comes so far into the future? Are these, as Warren Buffet believes, unanswerable questions? Jo Johnson peers through the spin, hype and hysteria.
The last bubble like this contained iron horses. Back in the 1840s the speculative mania that gripped the imagination of investors was caused by railways. Here was a new technology that would change the speed of human existence. Inside Britain alone more than 200 companies were incorporated to run trains inside 10 years and they all needed money. There were predictable tears before bedtime.
The tracks may have been replaced by wide-band fibre optics, but the fervour to take a punt is no less dizzying when it comes to the internet. But what are people buying when there is physically nothing there? At least with railways there was track and engines; with internet companies there is nothing tangible at all. What internet companies do is pure mind. All a big noise like Yahoo! comprises is a couple of flat boxes in a Palo Alto basement. Welcome to the looking-glass world where companies like Amazon are capitalised at $32 billion ( £20 million) but have yet to earn a single penny.
Who can still complain about the short-termism of financial markets? In the democratic world of the internet day trader, the most highly prized companies are years away from profits and dividends. But how much of the internet stock market phenomenon is long-termism and how much is lottery?
A worrying indicator is that the word 'valuation' draws digerati sneers, looks of 'You just don't get it, do you?' Indeed, most old-market hands don't get it. This is not because they doubt that the internet is a global mega-trend that is already transforming the way people communicate, trade and relax, much as the printing press and computer did before it.
Nor is it that they are denying that the internet will continue to lead to vast wealth creation and redistribution via the stock market. But sceptics are telling us that the broad-based internet phenomenon is a bubble and that, for most of its beneficiaries, current market values will prove unsustainable. Precipitate falls in some of the leading net stocks this summer reflect a growing awareness of the flimsy foundations of most valuation analysis.
'On the final exam (for a business valuation course), I'd probably take an internet company and ask 'How much is it worth?' And anybody that gave me an answer, I'd flunk,' said investment guru Warren Buffett recently. One leading Wall Street analyst has described internet valuation methodologies as the modern equivalent of intricate theological tracts about the number of angels that can dance on the head of a pin. And there is truth in it. Determining whether yetanother.com is worth $10 billion rather than $10 million is more an act of faith than one of reason.
'The methodologies contrived to justify internet valuations are ridiculous,' argues James Marks, e-commerce analyst and managing director at Deutsche Bank Securities in New York. 'Sure, in 10 years' time we're going to look back and kick ourselves for not buying, say, four or five internet stocks, even at these prices. But of the other hundred out there, half or more will not be around at all and the rest will have suffered massive falls from current valuations.' Internet stocks are the paradox of Wall Street.
Even if some of the froth has come off the market, valuations remain stratospheric, with no seeming connection to fundamentals. Everything is back-to-front. The faster many internet companies grow sales, the greater their reported losses. And the more money they lose, the greater appetite investors show for them.
Take priceline.com, an innovative 'name-your-price' marketplace mainly for airline tickets and hotel rooms. Like most internet start-ups, its financial performance shows it is playing the long game. And how! Floated in late March after just 18 months' trading - it accumulated losses of $117 million on revenues of $35 million - its initial market value of $2.3 billion was astonishing. Since it had no profits, traditional investment ratios were useless. Furthermore, it admitted it would be loss-making 'for the foreseeable future'. So even discounted cash-flow analyses - which try to express in today's money the value of all future cash-flows - could be little more than crude guesswork.
No matter. In the next six weeks, priceline.com's stock rose nearly nine-fold to value the company at $23 billion, not far off the combined value of the world's three largest airlines. Yet what has the wealth generation really been based on? Since financial analysis was all but impossible, all that investors were buying was the story, marketing spin, hype and hysteria.
Priceline.com is, of course, far from unique. Most stocks with the merest whiff of the web get chased skywards, with exiguous free floats exaggerating a supply/demand imbalance. The problem is that most valuations are relative, often no more rigorous than a cursory calculation of a stock's discount to Yahoo!/AOL/Amazon's price/sales multiple. This is something US Federal Reserve chairman Alan Greenspan calls 'a lottery mentality'. People pay far more for a ticket than justified by the chance of winning: similarly, most net stocks will fail, yet nearly all are being valued as winners.
But investors need to be able to separate the wheat from the chaff among the myriad start-ups now coming to market. European investors, in particular, will have to adjust to this new phenomenon of companies, driven by the need for a non-cash acquisition currency to pay for acquisitions and entice staff, floating so early in their existences. According to Morgan Stanley estimates, the US share of e-commerce revenue is set to fall from 78% in 1998 to 54% in 2003 as Western Europe's share rises from 11% last year to 33%. Germany's Neuer Markt, which is geared towards growth stocks, has so far proved the most receptive European market for the flotations that are following this trend. But the demerger from electrical retailer Dixons of its Freeserve subsidiary, the market-leading internet access provider, will soon take internet investment to the wider UK public too.
'One way not to pick winners is to use price-to-revenues multiples,' believes Deutsche's Marks. 'The trick is to identify the few stocks that have some sustainable advantage in the form of brand strength, operational gearing and efficiency.'
By far the most important attribute is brand strength. Take Amazon, which along with AOL, eBay, Yahoo! and Schwab, represents today's internet aristocracy.
Its triumph over barnesandnoble.com has shown that first-mover advantage can be more important than brand strength in the offline world. The ending of the landgrab phase of the internet's growth means that although the game may just be starting, it's already game over for many. However, first-mover advantage must be ruthlessly exploited if it is to be sustained.
According to Nick Gibson, an internet analyst at London-based Durlacher Securities, internet start-ups are enjoying their golden age now, but need to move fast to head off the threat existing retailers will pose when they realise how seriously they have to take the internet. 'Existing retailers are not going to lose significant market share in the next few years, but that must not allow them to get complacent.'
One recent example of complacence, he says, was the finance director of Next, the UK clothes retailer, saying that anyone using the internet to buy clothes was 'sad'. 'The whole internet community figuratively slapped their foreheads at his massive ignorance.' Warren Edwards, chief executive of consultancy Delphi Communications, maintains that in a few years we will no more discuss e-commerce than we now describe using the telephone in business as t-commerce or the fax as f-commerce.
The need to sear their name into the online public's consciousness, grabbing and retaining consumer attention in the chaos of the net, is the overwhelming priority for companies. Hence the importance of marketing, the efficacy of which can be measured by rates of growth in unique users and site 'hits'. Amazon, for example, has invested heavily in building its dominance in the book retailing market. Its latest estimate is that it will lose about $300 million this year (up from about $130 million) and about $280 million next year. Shareholders are being asked to hurl a lot of money at the company on the hunch that its managers can extend the business model to other products, even without the first-mover advantage it had in books. The year-on-year trebling in its revenue proves that something dramatic is happening. But founder Jeff Bezos' infallibility is now in question and Amazon's shares are already down more than 40% from their high.
After brand strength, operational gearing, known in the jargon as 'scaleability', is the next most important sign of an internet winner. In essence, it means the ability to make incremental sales without a proportionate increase in costs; it means the ability to widen a product range and add virtual shelf space without increasing inventory costs and real-world retail square footage; and most of all, it means eliminating commissions and intermediation costs. Any internet business that lacks the ability to generate operating leverage on a scale inconceivable in the physical world is probably a loser. However, given the internet's lower entry barriers, running a leaner cost base than other online competitors is the best way for companies to price keenly and win sustainable market share.
Take confetti.co.uk, an online provider of wedding services. Like its US counterparts TheKnot.com and WeddingChannel.com, confetti.co.uk has the potential to widen its product range at minimal incremental cost. At the moment, it primarily offers budget planning, outfit ideas, wedding list services and honeymoon bookings. But its co-founder Andy Doe, formerly commercial director at UK internet service provider LineOne, sees enormous scaleability in the potential to exploit the relationship built up with the wedding couple as their lives develop.
'At the moment, we're focusing just on weddings; and the millennium is going to be a huge year for weddings. But after that, we aim to develop our life-cycle range to include setting-up-home services, early parenting services, and perhaps early educational services too.'
Doe and his co-founder David Lethbridge, also from LineOne, have just completed a $3-million fund-raising round, led by the US firm Atlas Venture.
With nearly 2,000 registered couples on their database, they stand a strong chance, should they wish, of being bought out by one of the larger US players. If they gain more than 100,000 registered users, confetti's founders could start to think about a stock market flotation.
When companies are structurally loss-making, measuring efficiency may be hard. But if investors assume that ramped marketing expenditure is an investment, not an operating cost, then it makes sense to examine margins at the pre-marketing operating line. This gives a better feel for the likely steady-state economics of the company once the landgrab phase is over. Some companies actually lose money even then. This may just be because a very young company is not yet generating sufficient volumes to cover fixed costs. Or it could indicate more fundamental problems with the business model.
Management credibility counts almost as much as the business model. Take lastminute.com, a rapidly expanding UK retailer of distressed inventory, founded by Martha Lane Fox and Brent Hoberman, former media consultants.
It operates in an increasingly competitive sub-sector but its latest round of venture capital funding valued it at $35 million. Fox says the calibre of the board, which includes Peter Bouw, a former chairman of Dutch airline KLM, boosted investor confidence. Fox is demanding of investors: 'We don't just want money. We have hundreds of people offering cash. What we need is our investors' experience and contacts.'
'It's great to have a visionary chief executive, but a first-class finance director will transform the rating investors give a start-up,' believes Nicholas Lovell, an investment banker at Deutsche Bank's Media Group, which recently floated fortunecity.com, an aggregator of home pages, on the Neuer Markt. 'I believe many start-ups lack the basic financial discipline to manage the growth on which their valuations are predicated.' Like many other experienced market watchers, Lovell recommends caution to investors who cannot afford to lose their shirts. 'Europe remains a huge opportunity. But today's money machine for all businesses with an internet tag is simply not going to last.'
Jo Johnson writes for the Financial Times Lex column
THE 'SENSIBLE' WAY TO CHOOSE A NET STOCK
LOOK FOR SUCCESS FACTORS:
Sub-sector market leadership
Sustainable competitive advantage
First to market
Strength of business plan
Credibility of management
THEN ANALYSE CRITICAL BENCHMARKS:
Quarter-on-quarter actual sales growth
Forward sales growth
Quarter-on-quarter visitors growth
Improvement of pre-marketing cost operating margin Premium to peer group's sales multiple Value per unique user.