Jubak's Journal
Git Out the Branding Iron
Brand power will help cull the winners among hot Internet companies.
Can E*Trade, Yahoo! and Amazon.com corral enough customer
loyalty?
By Jim Jubak
When it came time to justify a price-to-earnings ratio of 200, or a
market cap of $6 billion on almost invisible earnings, "We're building a
brand" was the mantra of choice at last week's Hambrecht & Quist
technology conference.
Amazon.com's (AMZN) mission, for example, is to create an enduring
brand franchise, chief financial officer Joy Covey told the assembled
money managers and analysts.
"People love brands," said E*Trade Group (EGRP) CEO Christos
Cotsakos.
And Len Leader, America Online's (AOL) CFO, summed it up most
bluntly: "Brands win."
But this emphasis on the value of a brand isn't merely an attempt to
drape a lofty stock price in the cloak of fabled brand-investor Warren
Buffett. Branding actually is the key to the entire Internet investment
story of the moment. AOL, Yahoo! (YHOO), Amazon.com, E*Trade,
Excite (XCIT), Lycos (LCOS), Intuit (INTU) and dozens of other
Internet stocks will turn out to be good investments or busts
depending on the value of a brand.
Let me use the financial model that I outlined in my last column
"Putting a Price on the Future" to show you why I think that -- and to
give you a sense of what numbers are most important when you
analyze any Internet stock as a possible investment.
Take E*Trade. I've written about the stock before ("Know Thy
Business"), so this electronic stock-brokerage firm should be familiar
to at least some of you. (Thanks to a report called Creating Lifelong
Customer Relationships by analysts Genni Combes and Jeetil Patel
at Hambrecht & Quist, I've got some solid numbers to plug into my
example. They're not to blame for any conclusions that I draw from
their data, however.)
Here are the key numbers for E*Trade, according to the report.
Currently the company reaps an average of $500 in revenue from each
customer every year. Figuring a 50% gross profit margin, that's about
$250 a year. (That's a little lower than E*Trade's current 64% margin,
but I agree with the report in thinking it's closer to the company's
sustainable gross margin over time.) It currently costs E*Trade about
$75 to acquire a customer.
Remember that in my last column I laid out a way to value an Internet
company by thinking of its customers as a stream of revenue. We can
now do the same thing with E*Trade. And then, if we know how many
customers E*Trade will have in a particular year, we can figure out
what the company should be worth then.
So let's do the calculation for E*Trade. Hambrecht & Quist estimates
that the company will have 1 million customers in 2000. Seems a
reasonable number since E*Trade now has 400,000. Let's say that
each customer results in $500 of annual revenue and the average
customer stays with E*Trade for 10 years. Now that revenue stream
isn't actually worth 10 times $500 (or $5,000) since some of it won't
materialize for ten years. Instead, using a calculation called present
value that discounts for future cash flow, I figure ten years of $500 in
revenue a year is worth $3,900. So in the year 2000 when E*Trade
has 1 million members, the present value of the company's revenue
stream would be $3.9 billion.
Details
Quote Detail
1-yr Chart
SEC Filings
* Earnings Estimates
* Growth Rates
*Highlights
If I value E*Trade
based on the
present value of its
revenue stream, the
stock in 2000 is
worth either $178 a
share or $54,
depending on the
power of its brand.
Let's not worry about turning that into a precise share price, but
instead look at how branding can affect that figure.
First, branding has the power to change how many dollars each
customer spends per year. Consumer-goods companies such as
PepsiCo (PEP) are masters at what is known as line extension. If
customers know the Frito-Lay name in potato chips, why not get a
few more dollars by adding a deli chip to the existing line of snack
products? E*Trade is following the same route when it talks about
selling loans and options to its customers. Amazon.com is doing the
same thing when it adds CDs to its inventory of books.
How much can that add to the gross profit stream? Well, if E*Trade
can get each customer to generate an extra $100 of revenue -- so that
he or she spends $600 a year with the company -- then the present
value of each customer's ten years with E*Trade comes to $4,700.
That's a 21% increase in revenue from branding.
Second, branding has the power to change how long a customer
stays with the company. Powerful brand names tend to reduce
consumer sampling of competing products. They tend to produce
long-lasting loyalty that can extend over generations. I grew up eating
Skippy peanut butter, for example. I've tried relatively few competing
brands over the last 30 years -- a jar of Jiff, another of Smuckers. I still
buy Skippy. (Think of it as a very sticky brand.)
Look what happens if E*Trade can build a brand powerful enough to
extend the tenure of a customer with the company from 10 years to
20. The present value of $500 in annual revenue rises to $6,100 over
20 years from $3,900 for a 10-year period. That's an increase of 61% if
E*Trade can build a brand that's strong enough to generate extreme
customer loyalty.
Combine the two scenarios -- line extensions and brand loyalties --
and the future looks really sweet. A customer who generates $600 in
revenue at E*Trade and that stays with the firm for 20 years produces
a revenue stream worth $7,300. That's quite a change from the $3,900
in revenue per customer that I started with before factoring in branding
power.
Problem is, no investor can know if E*Trade or any other Internet
company will be able to build a brand this strong. Will an E*Trade or a
Yahoo! or an Amazon.com turn out to be Frito-Lay -- or will it be the
equivalent of Utz? (Hey, the company makes a great chip, but do you
miss the brand if it's not in stock?) E*Trade was incorporated in its
current form in July 1996. Yahoo! dates all the way back to March
1995. We won't have the data for a while yet to know if these
companies have created such profit-extending brands.
Just look at the difference between a great and a not-so-great
scenario for E*Trade's brand-building effort.
Scenario 1: The company builds the brand of its dreams. The
average customer sticks like glue for 20 years and buys an extra $100
a year in services and products: present value of that revenue stream
$7,300.
Scenario 2: The company never becomes a Coca-Cola or a
Gillette. The average customer stays on board for just five years and
generates average annual revenue of just the current $500: present
value of that revenue stream: $2,200.
Financial
Statements
* E*Trade
* America Online
* Amazon.com
* Yahoo!
In the year 2000 when E*Trade has its 1 million accounts, the
difference between Scenario 1 and Scenario 2 is a rather extreme one
-- a revenue stream worth $7.3 billion vs. one of $2.2 billion. If I value
the company based on the present value of its revenue stream
(assuming that the company doesn't add to the 41 million shares
outstanding), the stock in 2000 is worth either $178 a share or $54.
And please note that this lower value still assumes reasonable
success on E*Trade's part -- 1 million customers who like the
company's product enough to stick around for an average of five
years. Even $54 is by no means guaranteed.
I've gone through this analysis not to knock E*Trade, but because I
think it shows an investor precisely what numbers are important in
analyzing any Internet stock.
First, look at the trend in revenue generated per customer from one
quarter to the next. (Fortunately, inflation is so low that you don't need
to do the math to compensate for any decline in the value of a dollar.)
Companies that are growing revenue but not getting more revenue out
of each customer probably aren't building a strong-enough brand to
earn your investment dollars. They indeed might simply be buying
customers by spending more and more on advertising and marketing.
So check to see whether the amount spent on marketing per
customer is rising or falling. Companies that have built strong brands
will often show rising dollar amounts spent on marketing and
advertising, but the amount spent per customer and as a percentage
of revenue is likely to be falling. One of the best measures of AOL's
success as a brand is the decline in dollars spent per customer on
marketing from $6.77 a month in the second quarter of 1997 to $3.31
in the second quarter of 1998.
A powerful brand,
which took lots of
marketing dollars to
build, should
produce a gradual
decline in
marketing dollars
spent per customer
-- and that drops
straight to the
bottom line.
(Successful branding thus has extra value for an investor. A powerful
brand, which took lots of marketing dollars to build, should produce a
gradual decline in marketing dollars spent per customer -- and that
drops straight to the bottom line. In the fiscal year ended in
September, E*Trade, for example, reported sales of $143 million and a
gross profit of $75 million. Selling, general and administrative
expenses ate $49 million of that, so after incidentals such as interest
payments, only $23 million dropped to pre-tax profit. A strong E*Trade
brand would help the company bring in more accounts for less money
per account -- word of mouth, for example, would bring more
customers to E*Trade's home page. That would reduce selling,
general and administrative costs as a percentage of gross profit and
pump up earnings.)
Second, look for any indication that customers are staying longer.
Sometimes the company will actually publish the numbers --
especially if they're good. But you may have to infer the trend from
changes in marketing costs and from the company's initiative in
adding features to its products that create incentives for customer
loyalty. Frequent buyer programs, personalized e-mail or newsletters,
and brand-linked credit cards are some of the current hooks.
Third, look for fast revenue growth out of the gate. There's no
guarantee that a front-runner in any category has staying power, but
the powerful upside from branding rewards an all-out assault of the
market. I think the consumer Internet marketplace will be ruled by a
very few brand leaders -- one or two or at most, three in a category.
Expect market share to follow consumer product tradition too -- 50%
of revenue will go to the top brand. There really isn't a good case to be
made for buying second-tier and third-tier Internet companies -- except
as short-term speculations by investors who feel they can surf the
waves of emotion.
There really isn't a
good case to be
made for buying
second-tier and
third-tier Internet
companies -- except
as short-term
speculations by
investors who feel
they can surf the
waves of emotion.
And fourth, go for companies with big dreams and targeting big
markets. I hope I've demonstrated the inherent risk of Internet stocks
-- we just don't know who will succeed and who will fail because we
don't have the data we need and won't for years. I think I've also
demonstrated the potential upside from backing a winner.
In some industries -- such as biotechnology -- an investor can address
this problem of big reward and high uncertainty by buying a portfolio of
stocks because companies in the industry are selling at cheap prices.
That's not possible with Internet stocks -- they're simply too
expensive. In a situation like this, if you want to play at all, you have
to invest in companies that, if they win, will pay handsomely enough
to compensate you for the risk that you've taken. There is no point
taking the very real risk of losing all the money you put into an Internet
stock for a potential 20% gain. Look for stocks that have the real
potential -- according to your honest, best-case analysis using some
of the tools that I've used in this column and the previous one -- to
multiply your money by 10 times in three years. Everything probably
won't go right and you won't see this return even if the stock is a
winner. But this is the kind of potential upside you need to make the
risk worthwhile.
If you can't find any stocks that meet that test, just stay out of the
game. And don't play with money that you can't afford to lose. |
