On the e-commerce front, Excite unveiled Express Order, which will
allow users to buy merchandise
on Excite with just a few clicks of a mouse; Excite will store credit
card, billing, and shipping
information online in much the same way that Amazon does, removing the
hassle of entering this
data multiple times.
Netscape (NSCP)
Much of the furor in Netscape's stock (it is up 58% since the last
Capitalist edition), has been the
result of rumored talks with America Online, concerning some form of
browser deal. We profess to
know nothing about any such talks (other than that Netscape is almost
always talking with AOL,
especially on the AOL Enterprise side), but would hasten to add that
investors remember that much
of Netscape's revenue is derived from enterprise software.
Though you'll find us to be bullish on Netscape's Netcenter efforts, we
are keeping our powder dry
(and thus our neutral rating) until we hear from the company (this
coming Monday evening they
report their Q4 results) that the software side of their business has
turned around. Any AOL deal
regarding browser integration could certainly help Netscape's portal
efforts, but we're waiting for
both of Netscape's engines to be firing before we become more positive
on the company.
Netscape announced a few acquisitions over the last few ways, aimed
mostly at building out the
portal side of their shop from a small business perspective. Netscape
acquired the NewHoo!
Community Directory Project, 4,500 Internet 'volunteer editors' who
help consumers to find the
information they want; the entity, many of the employees of which were
already working for
Netscape, will integrate it into Netscape Open Directory.
Netscape also announced the acquisition of AtWeb Inc., a provider of
web site services like
automated web site promotion, maintenance and communication. No
financial terms were disclosed
(we expect management to give details on next Monday's call).
Reports that Netscape was in "re-negotiation" with Infoseek (SEEK-not
rated) over the terms of their
traffic deal caused some additional activity in these stocks. The
important take-away from an investor
stand point is that each of the portals companies that Netscape has a
traffic sharing arrangement with
go back to Netscape almost every month to re-evaluate and discuss
terms. Our view; no big deal.
Sterling Commerce (SE)
Sterling Reports In-Line September Quarter
Sterling Commerce, the EDI/EC software and service provider, announced
a solid Q4 (FY end
September) after the close on 11/19. Some highlights from the quarter:
EPS: Results in-line with consensus estimates, posting EPS of $0.38 (up
25% y/y and 15% q/q) Revs:
Total revenue of $151 million (up 39% y/y and 24% q/q). Revenue beat
our estimate by about $7
million (a big out-performance for such a stable company), thanks to
especially strong software sales
(recall that this was the first full quarter that XcelleNet results
impact the P&L) as well as nice
growth in both software support and VAN services. Higher-than-expected
SG&A kept a lid on the
EPS number, with Sterling spending aggressively on International.
Top-Line. Software license growth nicely outperformed our expectations,
besting our estimate by
more than $3 million thanks to strong software license sales overall
(especially internationally).
Product (software) revenue was $64 million (45% of total, up 39% y/y
and 42% q/q); product support
came in at $30 million (20% of revenue, up 41% y/y); services (network)
revenue came in at $53
million (35% of revenue, up 38% y/y). International revenue grew a
strong 30% sequentially to 21%
of total revenue ($32 million) versus roughly 20% of revenue ($24
million) last quarter.
Margins. Operating margin of 34% was 200 basis points below our
aggressive 36% estimate, and
should maintain itself at these levels for 1999 (though moving toward
the high end of the 33-34%
range. Gross margin trended up 140 basis points sequentially,
reflecting the strong showing in their
software business which offset gross margin contraction in their
services business (recall that the
services business is neutral to operating margins). Management
suggested a 28% earnings growth rate
for fiscal 1999 (down from previous guidance of 29% y/y EPS growth)
thanks to the reallocation of
$25 million in expenses Sterling thought they would be able to write
off.
Re-Allocation Of M&A Costs. Sterling, at the behest of the SEC, had to
re-allocate about $25 million
in costs associated with the XcelleNet acquisition to COGS
(specifically, product COGS). Because the
amortization period is over 10 years, the "hit" to COGS is about $600K
per quarter. We've lowered
our gross margin assumption going forward to reflect this new data and,
though we remain confident
that the rest of the model, particularly the top line, remains strong,
the net effect is to bring down
EPS in 1999 by two pennies. We are now at $1.60 for FY:99.
Not The Cleanest Quarter. Sterling reported an effective tax rate in
the quarter of 35.8%, below our
37% estimate (and below the 36.6% rate for Q3), thanks to
end-of-the-year adjustments and the
higher international component to revenue. As well, the software
capitalization rate (at 38% in the
quarter) was higher than either management of the Street had been
anticipating (R&D costs were
$1mm and 1%, as % of rev, lower than our model), thanks to the
development work Sterling has been
undertaking in the Web arena. When combined, these two factors prevent
the quarter from being as
robust as it necessarily could have been, since both of these elements
act to increase EPS somewhat
artificially. Though the rest of the business was quite strong, the
quarter may be marred (however
undeservedly) by the implication that the EPS could have been a shade
lower.
We've seen this before: Q2:98 was, despite having strong fundamentals,
tarred by the same brush.
This perception, then, may keep a lid on the stock in the near term, as
the Street awaits evidence that
Sterling's many bets (international, Internet, acquisitions) are
beginning to pay off in spades. We
should get better visibility on these factors as we approach 2H:99.
Meanwhile, now that Sterling is
pool-able, we'd expect the next major catalyst to be an acquisition,
which management reiterated
could be sooner rather than later.
Observations
Making Markets More Efficient
There are a whole host of things that we look to in evaluating how
attractive an Internet business is
from a shareholder stand-point. One of those that we come back to with
some frequency is how well
an Internet company exploits the primary drivers of the Internet as a
consumer and commerce
medium. Of course, one truism that has long since been digested by
Internet investors is that the
Web makes commerce more efficient; it removes artificial barriers to
the completion of transactions
(time, space, form) and helps to make the market for that particular
good or service more efficient
(perfect efficiency, where the process of price discovery is unimpeded,
being, like serendipity, hard to
pin down).
One of the key reasons why we're such fans of EBAY as a business, is
that they are making one of the
most inefficient markets out there, consumer-to-consumer transactions
for collectibles and other
unique, hard-to-find goods, now one of the most efficient. They are
providing the opportunity for
price discovery to work its magic between supply and demand for these
hard-to-price goods. Though
their success to date is a function of many factors (timing, execution,
capital, etc.), in our view the
simple idea that they are creating efficient markets where they did not
exist (or existed in limited
form - see Sotheby's). This is at the heart of EBAY's astounding growth
in customers, auctions, and
transactions since its introduction.
In this light EBAY finds itself with a kindred spirit in the form of
Amazon.com. Jeff Bezos could have
chosen any one of the 20 categories he thought would be viable on-line
retailing businesses. The
smartest move he ever made was choosing the most inefficient industry
on that list, books, since the
opportunity to add value up and down that industry value chain was
manifest (which incents each
participant, customers, distributors, and publishers in this case, to
do more and more business with
Amazon.com).
And so it goes with EBAY, since they exploit the same gross
inefficiencies in their market and incent
each participant (in this case consumers selling and consumers buying)
to transact with greater
frequency and in greater size; a positive feedback loop that benefits
the company tremendously. Just
like Amazon's introduction to the book industry changed the dynamics of
that business (see Trend
Watch above), so too has EBAY's introduction changed the entire
antiques, collectibles, and auction
market. For some real-life examples of this, we encourage readers to
see an excellent story in New
York Times dated 11/12 on EBAY. It can be found at:
www.nytimes.com/library/tech/yr/mo/biztech/articles/12internet-antiques.
html.
Barnes & Noble Reports Online Sales
Barnesandnoble.com, for its quarter ending October 31st, reported sales
of $17.2 million (versus
$5mm last year and $13mm in the July quarter), representing a 330% y/y
and 38% sequential
increase. Customer count grew to 930,000 (29% sequential increase),
while sales from repeat
customers were 51% of total.
Admittedly, these are some impressive numbers - on a stand-alone basis.
When compared with the
figures Amazon released for their Q3 (4.5mm customers, $154mm in revs),
they clearly are less
impressive. That said, Barnesandnoble.com's results continue to point
to a few key elements that we
like to point to repeatedly as the basis for our bullish view on
Amazon: the benefits of increasing
returns, the power of first mover advantage, and an understanding of
and execution against a unique
on-line retailing skill set. We have no doubt that Barnesandnoble.com
will continue to post strong
results on a sequential and y/y basis. After all, a rising tide
certainly lifts many boats - yachts and
skiffs alike.
The Web As Consumer Medium, Revisited
As we've talked about in past editions of The Internet Capitalist, we
like to keep one eye on
anecdotal evidence that the Internet is emerging as a viable, strong
consumer medium. Another data
point to this end was released last week; a new survey from Jupiter
Communications shows that more
than 80% of US online consumers trust online news as much as they trust
newspapers, broadcast
television, and cable news outlets, with another 7% viewing online news
as more reliable than other
mediums. At a time when traditional media sources are coming under
increasing scrutiny (for bias,
conflicts of interest, and self-importance), we are heartened to see
the Internet provide a viable
alternative to TV, radio, and print outlets.
MSN.com
Note: In our last issue of The Capitalist, we spoke at some length
about the new developments at
MSN.com and how Microsoft, in this their third "try" at the Internet,
may be "getting it" in a real
way. For an excellent article on that very topic, please see the New
York Times business section, page
one, dated 11/16.
Valuation Watch
Balance
We're often asked (told?) how great it must be to be a sell-side
Internet analyst in these times; what
with all manner of stocks and companies being valued like the next
Microsoft. But in truth, our
answer is almost always the same; it's a lot less fun than you'd think.
Though this may seem un-
intuitive, the most recent, indiscriminate run-ups in the stock prices
of the K-Tels, EarthWebs, and
theglobe.coms of this sector make this sell-side analyst cringe. It
makes the whole sector look
sophomoric, clownish, and carnival-like, and causes all manner of
popular ridicule and historical
waxing about bubbles, manias, and the madness of crowds. No disrespect
to these companies
specifically; we're sure they're finely run and deserving of lots of
accolades, but no one can defend the
notion that the market is acting rationally in allocating shareholder
value to these companies.
Perhaps the real reason we're frustrated is that we believe that some
Internet valuations are justified,
and we've tried to lay the case for certain of these Internet companies
(AOL, Yahoo!, and Amazon)
that they most certainly could be much larger some day. Clearly, the
investment horizons have
extended and the valuation levels for all of these companies leaves
very little room for errors of
execution or strategy. But the profligate buying of late clouds any
differences between the wheat and
chaff, a difference that we believe is worth discerning over time. As
well, such pocketbook generosity
also undermines the very real changes that are afoot thanks to the
Internet. As we try to illustrate
with each edition of The Internet Capitalist, there is something very
real going on here that is
changing the shape of entire parts of the U.S. economy. Lamentably,
this too, is lost in markets like
these.
Something will probably end this cycle of blind buying, though the
universal human susceptibility to
pattern recognition suggests that it may still be some time before that
happens. That said, we hope we
haven't stepped on the point of this essay, that the Internet is real,
despite the very unreal trading in
some of the stocks that lay claim to the name.
Which brings us to the title of this piece: balance. Trying to achieve
it in portfolios, as in life, is a
constant challenge. We encourage Internet investors to remain committed
to this sector, understand
the forces at work, and focus on risk as much as return, since return
has turned into a given and risk
is the only metric we can measure. We have no doubt that we'll be
cutting and pasting this piece into
another Capitalist edition sometime in the future, when the only
reflection from this space will be
pessimism. Then, too, we'll be talking about balance; about
understanding the fundamental business
changes afoot and about determining the best companies to buy to profit
from those changes. So for
now, enjoy the ride, but don't lose sight of the tracks.
The Calendar: Week of 11/23 & 11/30
Netscape Q4 earnings: 11/23: 800.374.2424
Books
Fool's Names, Fool's Faces, by Andrew Ferguson. A caustic look at
celebrity, widely defined, as a
quintessentially American construct. Our favorite essay: A People
Person.
Have A Great Thanksgiving Holiday (and remember.buy something on-line
this year, just so you
can tell your grandchildren how avante guard you were in the late
90's).
Note: Databank has been updated with new statistics.
The Internet Capitalist Manifesto
Why "Capitalist"? The Internet is interesting and hip. It's also
popular and cool. Unfortunately,
recognition of these facts wouldn't have necessarily made you much
money over the last few years.
Indeed, an investment strategy based on these gleanings would have left
you with a portfolio of Java,
VRML, and "push" technology vendors. And though each of these might
have created shareholder
value on the margins, none would have compensated you for the risk
inherent in Internet investing
or for the opportunity cost of not being more fully invested in more
profitable Internet themes. Our
goal, then, with "The Internet Capitalist" is to identify and profit
from the dislocations that the
Internet has created for businesses and consumers alike. We start by
asking three basic questions:
Which companies have identified the revenue opportunities created by
the Internet's growth as a
consumer and business medium? Which have the skill sets and management
breadth to execute
against these opportunities? and Which have business models that will
create substantial shareholder
value over time? Our answers to these questions should help you capture
the arc of our thinking in
this industry as it evolves from a network for academics into a medium
for the masses.
Why "Companion"? We hope this piece asks as many questions as it
answers, and generates as much
debate as it satisfies (which we plan to include). Coupled with a user
friendly layout, we want "The
Internet Capitalist" to stimulate and ease the investment decision. The
mental framework with which
we parse Internet investments is defined broadly and driven by a few
relatively simple themes. Within
this framework, however, there are multiple paths to generating
superior, above-market returns. "The
Internet Capitalist" is our attempt to illustrate those paths on an
ongoing basis, determine the
commonality among them, and suggest how shareholder value will be
impacted and where it will
flow. And though you'll find us to be bullish on the Internet sector
generally, our expectations for
these stocks are tempered by three realities. First, that the market
remains relatively inefficient for
these securities, which makes taking a substantial ownership position
both difficult and costly.
Second, valuation levels leave little to no room for errors of
execution or strategy. Third, profits (or
cash flow) matter; progress toward meaningful profitability is a
necessary condition for an increase in
shareholder value. With those caveats, we still believe investors can
achieve superior returns based
on a patient, disciplined, long term strategy toward investing in this
sector. We hope "The Internet
Capitalist" becomes an indispensable tool toward that end.
DataBank
3
18
The Internet Capitalist
SG Cowen Internet Research
3 |
