Return on Internet Assets in the US and Asia
5 December 2000
In this installment, we ask what these Internet companies are doing with your money. Are they really frittering it away on boomerang ventures, or is that too cynical? In our quest for well-managed companies, we have boiled the accounting broth down to a couple of key ratios, and have identified the companies that create or destroy value.
We recently started digging into the balance sheet in search of new Internet valuation techniques. This was out of sheer frustration with the metrics upon which Internet companies are being valued: revenue growth, gross margin expansion, price to sales multiples.
You simply cannot judge a business by its revenues or gross profit. The biggest problem is that one cannot distinguish between the quality of revenues and gross profits at different companies. Companies inflate revenues and gross profits through their investment activities and accounting policies. Many companies have generated short-term growth in revenue and gross profit at the expense of long term value creation, the best measure of which is the trend in book value.
Moreover, revenue and gross profit give us no insight at all into what is coming around the P&L bend. Companies that otherwise seem comparable diverge rapidly when you look at earnings overhangs residing on the balance sheet.
Our solution to this valuation quandary was to compare operating returns to asset growth. This offsets the effect of acquisitions and lets us determine which companies are actually creating value as they expand. We hoped to measure the synergies, if any, between companies’ core businesses and their acquisitions.
Oyga, Jefe! We Lack Scale!
As a starting point, we looked at trends in the Operating Yield on Gross Assets (OYGA). This ratio gives us the return on total assets generated by a company’s operating activities.
Numerator: Earnings before interest & investment income, depreciation, and amortization (EBIDA, not EBITDA) shows us how much a company earns from its operations, stripping out the effects of its investing strategy and removing the earnings impact of depreciation policy.
Denominator: Average Gross (undepreciated) Assets are used to avoid distortions caused by measuring non-depreciated income against a depreciated (smaller) asset base.
Let’s see how our favorites fare on the OYGA measure. The term is fanciful, we know. By the way, "Oiga!" means "look, over here!" in Spanish.
What strikes one immediately is that all of the Asian companies have negative OYGA. One then notices that even the US companies have a miniscule return on assets. However wide their margins are, these guys would still make more money by putting their money in CD’s. Then again, all businesses have small returns in the beginning: the key is the momentum of the returns.
Momentum in the OYGA trend should show us how quickly a company is growing its operating profit. It should also reveal the company’s ability to absorb and scale up its acquisitions.
By this measure, it looks like Sina, Sohu, and Asiacontent are the winners. Internet.com, also, because it has passed the breakeven point even while pursuing an aggressive acquisition campaign. Sina and company because they have pared down their negative returns substantially and seem to be on their way to breakeven.
Alas, it’s not so simple
Closer examination reveals that the rapid reduction in negative OYGA is in most cases due to addition of assets rather than rapid acceleration in operating profit. For Sohu and Asiacontent the convergence toward zero is mostly due to their dramatically increased asset base. Sohu’s asset base has increased 15 times over the last 4 quarters, while its operating loss is about three times what it was at the end of last year.
Sina was slightly better than Sohu and Asiacontent, but it still gets no brownie points for earnings performance. EBITDA has been more or less rock-steady at losses of $11mn per quarter for the last four quarters. We’re not too excited about that kind of momentum. Although Sina has been dubbed the Chinese Yahoo! by some, we would bring that into perspective by pointing out a little known fact: Yahoo! never reported operating losses of more than $7mn. And it certainly never had stagnant operating profit for four quarters in a row. Where’s the momentum, Sina?
The real leader of the OYGA pack, however, was Alan Meckler’s internet.com. IPO-ing in the spring of 1999, Internet.com has since shifted its 4Q 1999 operating loss of $500,000 to a profit of $1mn in 3Q 2000. Assets have meanwhile doubled. Internet.com has acquired about 24 companies in the last year and all indications are that the acquisitions have created synergies with the core business.
Transcending Assets: Return on Intangibles
The Internet is supposed to lift us above the mundane world of fixed assets and allow us to make money from intellectual capital. The idea is simple and noble: eschew the production line, paper publications, and three hour commutes in favor of a high-tech, ultra-productive, idea-driven money-making machine.
But, as an encyclopedia salesman plying a rural route might tell you, selling ideas is a tough living. Selling other people’s mind space (banner ads) is even tougher, given the apparent fickleness of the Internet audience.
Tougher yet is making money by investing in other companies that have Big Ideas, yet no experience monetizing those ideas. In order to succeed at this game, there would seem to be a couple of prerequisites. Firstly, you need to have a core business around which all acquisitions are structured. Secondly, you need experience in bringing your own business to profitability. In other words, two wrongs don’t make a right and two Sohu’s don’t make a Yahoo!
With that pontification out of the way, let’s turn to the measurable achievements of the Asian Internet. How is their performance in the arena of non-financial (i.e., contributing directly to operations) investing activities?
Oiga, It’s OYGI!
To some extent we can measure the success of a company’s acquisition strategy using another measure, the Operating Yield on Goodwill and Intangibles (OYGI).
OYGI, or EBIDA/Gross Goodwill & Intangibles measures the return on a company’s cash acquisitions. This makes sense for Internet companies where goodwill comprises a hefty proportion of operating assets.
Goodwill is the amount paid for an acquired company (or invested into a company that is already owned) over and above the appraisable asset value of the company.
Intangibles: usually refers to brands or copyrights
Gross Goodwill & Intangibles is again used in favor of goodwill & intangibles net of depreciation so as to remove differences in depreciation policies between companies.
The four companies that should really care about OYGI are internet.com, Yahoo!, Chinadotcom, and Asiacontent. For these companies, Goodwill & Intangibles comprise between 43% and 11% of Total Assets, making up the bulk of operating assets. These companies have to make a return on their goodwill, which in turn represents audiences, ideas, and technologies.
As far as we can tell, internet.com is again the clear winner. Not only does it have the largest stockpile of goodwill (43% of assets) but it has also managed to turn this goodwill into a money spinner.
Yahoo! has a small stock of goodwill relative to total assets. This is probably due to its ability to make pooling-basis acquisitions, which do not generate goodwill. Yet, there is goodwill resulting from its key non-US Yahoo! subsidiaries and its recent acquisitions within the US and we expect Yahoo!’s goodwill to trend upward in the future. Interestingly, Yahoo!’s rather high initial yield on Goodwill and Intangibles appears to be falling. Is the master of scale now failing to scale up its acquisitions? Unthinkable but apparently true.
Asiacontent is not making out very well from its investments in intangibles. The content provider cum Internet consultant cum ad-server just cannot seem to squeeze any returns out of its acquisitions. Goodwill & Intangibles stand at $23mn, or 20% of assets, and operating income is going nowhere fast. This is a case of dead assets. The legacies of the past still haunt Asiacontent’s financial statements, and the company seems to be unable to realize any value from them. There’s nothing worse than an intangible gone bad: you cannot sell bad ideas after you’re done with them.
Finally, we have Chinadotcom, where Goodwill & Intangibles have grown by about $69mn in the past three quarters, reaching 12% of total assets. That translates into a heavy investment campaign, but what are the tangible results? Operating profitability (EBIDA), now at - $16.5 mn continues to fall and it is not clear whether there are, in fact synergies between Chinadotcom’s investees. What is clear is that Chinadotcom’s investee’s and subsidiaries have $18mn in receivables outstanding, not a trivial figure.
It's Not the Size, It's How You Use It
The moral of today’s story is that there are two types of acquirers in the Internet world: companies that make smart, focused, synergistic acquisitions and companies that invest in anything that is fashionable and promises some future upside. Once again, we find out that the battle for survival will be fought with management rather than cash.
How does management come into it? Management shapes the business plan and the acquisition strategy. Management determines whether or not the company buys that $20mn Malaysian golf web site and ends up with quarterly operating losses of $15mn. Asia doesn’t appear to have management skill on par with that of Alan Meckler or Jerry Yang, but perhaps a bit of starvation will teach us humility.
The problem with the Asian companies surveyed here is that they were born with a silver spoon in their mouths and have been subjected to heavy competitive pressures. Competition for funding, mostly. Many of them, such as Chinadotcom, succumbed to market pressure, squandering their hard-won cash in efforts to be BIG, ignoring the distinctions between size and scale. Mere size gives you more of everything: revenues, headcount, operating costs, etc. Scale, measured by OYGA and OYGI, gives you an increasing return on assets over time.
The most successful company in our survey was internet.com, followed by Yahoo! and Sina. The secrets of their success? Internet.com has a focused business and the ability to create synergies between its subsidiaries. Yahoo! again has a focused business and a targeted acquisition effort intended to increase the reach of that business.
Are we including Sina as the token Asian Internet company? Is it simply the best of a bad bunch? In response, while Sina has not impressed us with its earnings momentum, it has shown discipline with its acquisition dollar, solving at least one side of the yield on assets equation. Sina has the highest quality revenues and profits of the Asian companies we have discussed and that’s a good start. Now all we need is a bit more scale. We’ll be keeping a close eye on those asset yields, Sina.
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