GREAT OVERVIEW OF E-COMMERCE
Charging ahead with electronic commerce
Bill Burnham foresees a revenue rise in Internet-based business from $3.8 billion to $228 billion by 2001. And he's already discerning who'll have the biggest pieces of that pie.
By Eneida Guzman
When an analyst tells you that his sector's revenues are going to increase from $3.8 billion last year to an eye-popping $228 billion by 2001, it's time to either bet the farm or offer him the name of a good therapist.
Investor decided to hear more of what Bill Burnham, Deutsche Bank Securities' new electronic commerce analyst, had to say. While only four weeks at his new post, the 27-year-old Burnham had already built a reputation at the Minneapolis-based investment banking firm, Piper Jaffray, and he is one of the sector's most widely quoted experts. He's also the author of several electronic commerce industry studies.
Burnham has yet to release any buy recommendations or price targets in his new job. But he gave us a preview of his long-term outlook for the group and a few names that he believes are radically oversold.
You've established a way of measuring your sector's stocks called the EC Index. How did it come about?
The EC Index is just a component index of a number of the companies focused on electronic commerce. So it's a way of measuring the stock health of the electronic commerce industry.
Where does the EC Index stand now?
This month the index has been swooning. After racing ahead of itself in early 1996, electronic commerce stocks had a period of consolidation where expectations were adjusted downwards. And as a result, the index went down. But ever since late spring of 1997, the industry's been fairly healthy.
The Internet has spawned a variety of businesses. Give us a little background on the e-commerce category.
The e-commerce space is comprised of 100 private firms and about 50 public ones. Almost 60% of the publicly traded companies in the group have gone public since the beginning of 1996. Right now, the business-software sector and the commerce-content sector are the fastest-growing segments in the group. The Internet-payment segment is the smallest one, with only two publicly traded companies in the group.
Framework for a sector
So new, and already spinning off segments! Tell us more about how you categorize the sector.
We actually break the industry down into five different buckets. Four of the buckets are infrastructure pieces that provide the technology that enables businesses to do business on the Internet. These companies are all focused on providing new technology that secures networks and their business transmissions over the Internet.
Security is really the first priority for many businesses on the Internet. It's like the vegetable aisle in the grocery store -- it's the first place everybody stops when shopping for electronic commerce technology. Names in this category include Network Associates (NETA), Check Point Software (CHKPF), VeriSign (VRSN), Cylink (CYLK) and Internet Security Systems (ISSX). The second category involves companies that are creating services and technology that allow businesses and consumers to pay for things on the Internet and to move money around on the Internet. If you can't actually buy something, having all these stores and other things really doesn't do you a lot of good. Companies like CheckFree (CKFR) and CyberCash (CYCH) have been dominant in this space.
What's the third bucket of the sector?
The third category is the financial-software sector. These are companies that are focused on enabling both businesses and consumers to get access to their financial accounts via the Internet. Some people might want to get access to their accounts just so they can manage them and get updated on their status. Others might want to do it so that they can see whether or not they have the money available for an investment over the Internet. In this category, I pay attention to Security First Technologies (SFNB), Sanchez Computer Associates (SCAI), Edify (EDFY) and CFI ProServices (PROI).
The fourth category in the sector is what I call the business commerce software companies. Many of the companies in this space create catalogs or software that allow a business to display its goods on the Internet. BroadVision (BVSN) and Open Market (OMKT) are examples of companies in that category. There's also a group of companies in there that are focused on traditional electronic-data interchange technology, like Sterling Commerce (SE) and Harbinger (HRBC). It's simply a way of formatting information so that computers can understand it -- sort of e-mail for computers. Those four infrastructure segments essentially are the pillars upon which any business on the Internet rests.
And the fifth category would be . . . ?
The fifth category I cover with the help of our Internet analyst Lise Buyer. It involves companies that are focused on selling particular types of merchandise or services over the Internet. Companies like Amazon.com (AMZN), OnSale (ONSL) and E*Trade (EGRP) fall into this category. They've seen some of the most explosive growth recently. What's interesting is that I'm actually adding a sixth sector to the electronic commerce industry, which I call electronic commerce enablers.
What are those?
E-commerce enablers are sort of like hiring your own personal shopper. Today, companies have to do their own shopping for infrastructure goods and then, once they get them home, they've got to try and fit them all together like a couple of parents trying to piece together a complicated toy on Christmas morning. Wouldn't it be easier to have a service or a company that went out and bought all those different infrastructure pieces and stitched them together into a single solution so you simply bought the solution from them? I think there are going to be a number of companies that bridge the middle layer between the infrastructure and the users of the infrastructure. Essentially, these companies create packaged service offerings that allow businesses to very quickly get up and running on the Internet. Digital River, Cybersource, Intrek and Ordertrust are making great inroads here, but they are still privately held.
Best long-term potential
Of the six categories you've mentioned, which one do you feel offers investors the most potential rewards?
I think the e-commerce-enabling sector ultimately has some of the greatest long-term potential. Those firms are offering a service-based business, but they're not under the same kind of intense competitive pressures that I believe many of the retailers will be under. The trends in the economy seem to favor outsourcing and third-party service providers. I think we'll see those same trends play out in the e-commerce-enabling sector.
E-commerce is skyrocketing, but it's difficult to know how much business will be done online. What's your prediction?
We're been looking for about $228 billion in electronic commerce by the year 2001. What's important to point out about that number is that the vast majority of those transactions will actually be business-to-business purchases. The business-to-business economy is much larger than the retail economy. Always has been and always will be. There is great incentive for businesses to do business electronically because many of them have very familiar, stable relationships with their customers. Therefore, they're able to automate those relationships with greater ease than retail businesses.
I think the e-commerce-enabling sector ultimately has some of the greatest long-term potential.
Going from $3.8 billion to $228 billion, no matter how you slice it, is an extraordinarily bullish outlook. How are you coming up with that figure?
$228 billion sounds like a big number, but it will represent just about 2.4% of gross domestic product in the year 2001, and only about 1.2% of total projected business revenues. So if you think I'm crazy to say that revenues will jump from $3.8 billion to $228 billion in the next four years, you'd think I'd be even crazier to say that e-commerce revenues will represent only 1.2% of total business revenues. You'd probably say it was too low. In reality, the percentage of business revenues generated by the Internet could conceivably be well north of 1.2%. Every 1% increase means another $200 billion in purchases. And if I came out with estimates of X trillion dollars everyone would . . .
Look at you like you have three heads?
Yeah, they'd lock me up. I just arrived at Deutsche Bank Securities a few weeks ago and I like my job. But I'll tell you what -- it's not outside the realm of possibility.
Creating a buy list
The e-commerce sector is a two-year-old industry. Most of the companies have gone public way before establishing any measurable track record, successful or otherwise. How do you create a "buy" list from this?
As you can see, I try to cover a breadth of companies across the different categories within the sector. As an analyst, it's important for me to build an early-warning radar. The different categories within the sector are all fairly interrelated and dependent upon each other. Meaning that if there are tremors in one category -- positive or negative -- it will likely affect others. Let's say there's a security breach and one of the security companies has a problem with its software. It's likely to affect the companies in the other categories because it will slow down or prevent purchases while the problem is being fixed. Therefore, as an investment analyst, it's important to me to have a view as to what's going on, because events in that category could likely affect the stocks and the fortunes of companies in other categories within the group.
In your short time at Deutsche Bank Securities, have you initiated coverage on names with "buy" recommendations yet?
Not officially, but I'll share some names that I think look timely. I like both Security Dynamics (SDTI) and Check Point Software. I think they've been oversold in what essentially is an overreaction to well-known competitive threats from Microsoft (MSFT), Cisco (CSCO) and others. I think that they have not only been oversold but also there's a good chance that they will be taken over at some point. The trend in the security sector is for one-stop shops. Today there aren't any one-stop shops, so companies are attempting to create them by buying other companies and essentially pooling all their products together. The trend is driving consolidation in the industry.
What if that scenario doesn't take place?
Even if they aren't taken over, there's a good chance that one of their competitors in the sector will be taken over and that should increase their valuation.
Any other names in the security sector that we should be following?
I also like Cylink. That stock has been oversold a bit, but not as much as Security Dynamics and Check Point.
What about names in other categories of the sector?
Those are my top three picks at the moment. The other categories are currently dominated by pricing competition and technology changes. There's too much risk in them right now, so at the moment there's nothing else I'm enthusiastic about.
Several Internet companies have gotten away with having loosely defined business models. Recently we've seen some of the stocks back off and several market experts are questioning the sustainability of the sector's stock prices. When will these companies start reporting profits?
Let's face it -- if you think that the Internet's going to be a big deal and you think that electronic commerce is going to be a big deal, then a lot of these companies are going to be a big deal. Many of the companies are software companies. Software companies typically lose money in their first few years of operation as they develop products and build their sales channels. But once they complete development and organizational structure, they rapidly start to improve their profitability. The key thing for investors to focus on when they think about long-term profitability is to look at the gross margins of the business that the company's involved in . . . and to look at the potential for that business to reach scale and then measure its level of profitability when it reaches scale.
When I see stocks blindly trading at high prices and earnings multiples regardless of their underlying gross margins, that's a red flag that people are getting over-excited about a particular stock.
The valuation quandary
What should those margins look like to give investors an initial indication of future success?
I compare the e-commerce sector to the software industry because many of the companies are software firms. A software firm should have gross margins in the 70% to 80% range. And in the e-commerce realm, a lot of the firms have gross margins in the 15% to 20% range . . . which means that those firms have to get much bigger, much faster in order to become profitable.
Do the meteoric levels of Internet stocks concern you?
Absolutely. When I compare stock valuations within the sector, I often see stocks trading at similar valuation ranges but the stocks have radically different fundamental business characteristics. So when I see stocks blindly trading at high prices and earnings multiples regardless of their underlying gross margins, that's a red flag that people are getting over-excited about a particular stock.
Prior to the last few days, the tech sector had been cooling off a bit, and we're moving into summer, which can be a seasonably slower period for the group. What's your short-term outlook?
I think we're going to continue to see tremendous growth across the board, and I don't think we're going to see a major readjustment in expectations until third-quarter earnings are announced. The moment of truth for the sector will come when earnings are announced after the slow summer period and investors get a chance to digest the real and potential growth rates of these companies.
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There are not a lot of catalysts that can negatively impact this sector over the next few months other than falling short of earnings expectations, which makes these stocks particularly risky around earnings season. But long-term, the prospects for this industry are very bright. If you believe even half of what people are projecting in terms of increases in the number of Internet users and the increase in the amount of electronic commerce, that translates directly into a tremendous amount of business for all of these companies. |
