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Tim Albright (talbright@dlj.com) 212.892.6801
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The Internet Observer, 05.18.98
DLJ Internet Research
Deferred Gratification
The deliberate postponement of happiness is a trait of social existence,
in constant opposition to the general appetite for unearned exultation.
The whole idea of earning or deserving one's joy is as old as Calvin,
and most modern economies are at least partially built on a measure of
self-denial among the citizenry. The act of investing, the purest form
of capitalism, is a straightforward demonstration of this notion of
present sacrifice for future gain. So why is everybody so tense about
Internet companies that don't have current earnings? Mostly because it
can be tough for any good Calvinist to get around the paradox of losing
money now to make a ton of it later. But we propose that the new
Internet economy demands a new definition of thrift, which is embodied
in a number of companies that are trying to spend their way to extremely
valuable franchises.
Not to say that the new thrift is easy to believe in. The lure of the
Internet is a combination of hyper-growth on the top line combined with
unparalleled operating leverage, yet the reality for many of our
favorite companies is an unbroken string of quarterly losses at least
until the millennium (yes, we do mean the impending millennium, but
that's still far off with the smell of burning cash in the air). On top
of this general earnings remoteness, we are increasingly hit with the
broken promise of profitability from those managements that dared to
claim a specific predictability for their models. So why are we so
bullish on companies like Amazon.com and DoubleClick, which may not earn
a penny until at least one of us has children? The answer, as so many
answers are, is found in three simple letters: AOL.
Clearly, AOL provides investors with a map, however untopographic, to
category dominance, and those who've held on have more than just white
knuckles to show for their patience (look at that wallet those knuckles
are grasping). Having spent $1 billion over ten years to build its
brand, AOL (and its now-formidable income statement) has become a beacon
to those management teams and investors trying to withstand the
withering pressure of large and consistent losses. As importantly, AOL
continues to write the manual on Internet company maturity, its own
business model having reached the next inflection point in operating
philosophy: now that AOL has actual (and accelerating) profits, how much
should management re-invest? We're heartened that they appear to have
chosen the disciplined path (and dicipline is the operative word here)
of balance between the Street's profit expectations and the investments
necessary to maintain the brand and further develop the service. Over
time, we expect the most successful of today's leading early-stage
Internet companies to reach a similar juncture in their development.
Reflecting AOL's successful execution of a youthful
spend-til-you-almost-drop strategy, a number of Internet content and
commerce companies are emulating the master. After all, Internet market
share will never be cheaper, right? Clearly there are some vertical
categories for which this logic holds true, but the question remains for
investors: what are the vertical categories and management teams you
want to believe in? For it's the category types and the underlying skill
sets required to compete in these categories that are the
differentiating investment variables.
As a counter-example, take free e-mail, a large category, aggregating a
huge amount of traffic and individual users. But for all that investment
and effort, once Yahoo! and Microsoft entered the category, much of the
value was sucked out. Yahoo! did exactly the same thing with classified
advertising, mapping, and Yellow-Page listings, where the only value
that accrued to category leaders accrued to those that got acquired. The
point of this observation is not to suggest that there is no advantage
to grabbing market share in a vertical category. But investors to think
hard about the underlying economics of the category, the degree to which
unique management skills create a competitive barrier, and the degree to
which these skills are extensible into additional categories.
No company holds up better under this kind of scrutiny than Amazon.com,
and no company has better trained investors to survive on a thin gruel
of distant earnings. Every quarter, Amazon torches analysts' revenue
estimates (that's good), and, every quarter, Amazon forcefully declares
that it's pursuing a strategy to actually accelerate near-term losses,
without even a nod to when profitability will occur (that's the new
thrift). And, also every quarter, we voice our wholehearted approval of
Amazon's strategy, as we should, for several reasons. The book market is
an $80+ billion market that is well-suited for online retailing, but it
requires a consumer value proposition that can't be easily replicated.
Amazon has achieved a first mover advantage by being aggressive in the
face of formidable land-based competition and is committed to locking in
its customer base and strenuously supporting its native Internet brand.
To that end, it has raised a war-chest of over $300 million dedicated to
out-marketing any and every competitor or possible competitor in its
core market. Under the burden of interest reserves, our projected losses
extend into the year 2000.
So why do we get downright giddy about Amazon's prospects? Because we
believe that Amazon has the capability to win more than just the book
category, that it can become the de facto Internet retailer in any
vertical space to which it applies its formidable template. This makes
us nervous, for instance, about the CD Nows and N2Ks of the world.
Vertical market share leadership in music is not that impressive when
confronted with a giant brand that has a tremendously transactive
customer base 10 to 20 times the size of the music market leaders.
Amazon's incremental losses over the next eight quarters, to be
partially incurred while pursuing the music category, are a small price
to pay when compared with the incremental 10%-15% sequential growth that
music dominance can provide. In other words, in the long run, Amazon is
not incurring incremental losses merely to be the book retailing leader;
in fact, these losses are incurred to lock in dominance over a much
larger category, online retailing. Ultimately, online retailing
leadership is a defensible skill in a way that leadership in a single
retailing category is not. A final point on this company: Amazon is up
front about its earnings intentions and is clean in its presentation of
ongoing losses. Investors are not asked to acquire the messy habit of
dealing with unforeseen, unusual or non-recurring items. And the stock
is near its high, which suggests that the market may pay a premium for
predictability in losses as well as in earnings.
The second company we'd like to focus on is DoubleClick. DoubleClick
operates the leading ad sales network, with its sales force representing
a variety of sites. In essence, DoubleClick is an aggregator of both
impressions and advertisers, and given the very nature of this
operation, category leadership easily transitions into category
dominance. Advertisers have limited bandwidth, they only have time for a
few sales people, and they want to be sold only the highest quality
inventory, while sites only want to be represented by a sales force that
can deliver the goods. DoubleClick's early leadership ensured that it
represented the most and the best impressions, which in turn enabled it
to operate one of the few truly productive sales forces. In the process,
DoubleClick developed an exceptional underlying ad-serving system that
enables advertisers to dynamically target individual users with specific
advertisements. DoubleClick has turned this technology into a service
revenue stream by enabling large clients with an internal ad sales force
to serve ads via the DoubleClick DART system, charging a nominal fee
(roughly $1.00 per 1000 impressions served) for the use of said system.
DoubleClick's solution taps into the $375 billion in advertising,
promotion and direct marketing dollars that are migrating to the
Internet, and the company is comprised of a combination of people assets
and technology assets that are hard to mirror. Consequently, DoubleClick
is spending to bulk up its impressive sales force and to further extend
its targeting, ad serving and tracking leadership. Over the next several
years, we believe this should result in the substantial elimination of
direct competition, as most competing ad sales networks become
marginalized and as ad serving software developers remain or become
vendors of shrink-wrapped software (which, of course, is a lower value
model). DoubleClick's first quarter revenues were three quarters ahead
of expectations, which inspired the company to accelerate its investment
in both its sales force and technology platform development. We would
love to see DoubleClick double its sales force head count over the next
three quarters (if they can find the bodies), and we would encourage
them to further increase their technology spending. In the long run,
this category will be defined by its skills, which are primarily sales
execution and technology development. DoubleClick is the only franchise
that matters here, and if the company extends its dominance over the
next few years, it could be a very big company. And big companies are
usually big stocks.
Despite today's lecture on the benefits of deferring gratification,
certain things just shouldn't be postponed, among them forgiveness,
dentistry, and thanks. As this issue marks the first anniversary of the
Observer, we want to say how grateful we are to all of you who read,
provoke, and inspire us. We hope your enjoyment and learning have been
even a fraction of ours.
===================================================
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