Report on Business: Investing
Five rules for Net profits The Internet is a fast-moving market -
fraught with danger - where there is big money to be made for
nimble investors.
MARK EVANS
05/01/1999
The Globe and Mail
Metro
Page B6
All material copyright Thomson Canada Limited or its licensors. All rights
reserved.
Investing in Internet stocks is much like buying lottery tickets -- it involves a
lot of faith and the chances of hitting the jackpot can be slim.
The Internet is a fast-moving market where a company seemingly
well-positioned one minute can suddenly find itself out of the sweet spot the
next. Even highly-paid analysts can be left scratching their heads about
where stocks are headed.
This was perfectly illustrated in December when Henry Bloget, an analyst
with CIBC Oppenheimer & Co. in New York, predicted that Amazon .com
Inc. would reach $400 (U.S.) a share within 12 months -- when it was
trading at $288. Jonathan Cohen, his counterpart at Merrill Lynch & Co.,
took the opposite approach, suggesting that Amazon .com was only worth
$50.
Amazon .com, the leading on-line retailer of books, compact discs and
videos, jumped to more than $600 soon after Mr. Blodget's forecast, on a
split-adjusted basis. In a delicious twist of fate, Mr. Blodget replaced Mr.
Cohen as Merrill's Internet analyst in February.
"It's hard to really know in this new environment what are the right
models," said Ian Ainsworth, a portfolio manager with Altamira
Management Ltd.'s $150-million (Canadian) E-Business Fund. "You have to
do your homework because the Internet is so new and young that we're
going to see a lot of business models come quickly and leave."
Although analysts have difficulty assessing how much Internet stocks are
worth and most traditional investment valuation tools are no longer
applicable, there are opportunities to capitalize on the Internet's rapid
growth.
For long-term investors, the mantra should be to avoid the exuberance and
hype in the marketplace and, instead, focus on a few basic guidelines.
Given the sometimes baffling and unexplainable trading patterns of Internet
stocks, there is no guarantee these "rules" will produce huge returns but they
may help you sleep a little better at night.
1. Management.
The quality, experience and credibility of senior management is a crucial
consideration because many Internet companies have limited, if not
non-existent, track records.
Steve Harmon, a senior analyst with Internet.com LLC in New York, said
bench strength can not be underestimated, particularly the role of
high-profile executives who have worked in the high-tech industry with
well-known companies.
The obvious questions are "who is management, can they get the job done,
where do they come from, what have they done?" he said. "An easy to way
to measure results is looking at sales of places where they worked."
Vancouver-born Jeff Mallett gave Yahoo Inc. a large dose of credibility
when he joined the Santa Clara, Calif.-based company in 1995. Before
joining Yahoo, Mr. Mallett had spent 10 years in the high-tech industry and
had been vice-president and general manager of Novell Inc.'s worldwide
consumer unit.
Mr. Harmon said another key issue for investors is a company's management
mix between the visionaries who create strategy, pessimists who make sure
corporate enthusiasm doesn't get out of hand, "bean counters" who make
sure the company is spending its capital wisely and "bean makers" who sell
product. 2. Market opportunity.
Even with great technology and top-notch management, an Internet
company's prospects clearly depend on the potential size of their target
market. If the market is large enough, a company's strategy can be slightly
off the mark and it can still thrive.
The on-line auction market, for example, is attracting a lot of competition
and investor attention. Cambridge, Mass.-based Forrester Research Inc.
expects the business-to-consumer auction market to climb to $19-billion
(U.S.) in the United States by 2003 from $1.4-billion in 1998, while the
business-to-business market will jump to $52.6-billion by 2002 from
$7.7-billion last year.
While there's no doubt the market will be huge, the challenge is determining
which companies will emerge as the leaders.
Obviously, many investors think Mississauga-based Bid.Com International
Inc. has the potential to become a major player in the on-line auction
business. The company has a market capitalization of $1-billion (Canadian)
even though it had sales of just $20.1-million last year.
A secondary issue is whether there's room for more than one company in the
business and if there is an investor appetite to support multiple players. The
search engine business shows there are opportunities for a variety of players
such as Yahoo, Excite Inc. and Lycos Inc. to thrive.
3. Revenue.
In the Internet world, many fundamental financial methods can be
disregarded because many companies are spending heavily to establish
market footholds as they attempt to position themselves for long-term
growth.
As a result, revenue is a much more meaningful and relevant way to measure
a company's success than is its profit. A vibrant company such as Amazon
.com isn't expected to make money for several years as it invests in
marketing, sales and product development to cement its market dominance.
Analysts were far more interested that Amazon .com surpassed expectations
by reporting first-quarter revenue of $293.6-million (U.S.), compared with
$87.4-million a year earlier. The Seattle-based company's loss expanded to
$61.7-million, or 39 cents a share, from $10.4-million, or 7 cents a year
earlier, but that was deemed to be the cost of carving out a business on the
Internet.
"It may be the best thing that Amazon .com doesn't have earnings today
because in 36 to 48 months they could have the scale to have tremendous
earnings," Mr. Harmon said. " Amazon .com is an example of a company
posting huge losses but I can justify that."
As a rule of thumb, Mr. Harmon said he's encouraged if an Internet-based
company can post quarter-over-quarter revenue growth in the mid-to-high
teens or low 20-per-cent range, and year-over-year growth of at least 75 per
cent. 4. Go with best of breed.
One way to avoid some of the Internet's volatility is selecting the market
leaders in a specific category -- much the way investors may go with
Microsoft Corp. in the software business or Coca-Cola Co. in the soft drink
industry.
"Given the incredible craziness going on, since I don't know which company
will be the dominant leader, I would buy best-of-breed," said Duncan
Stewart, manager of the Navigator Canadian Technology Fund.
In the Internet space, that would currently mean America Online Inc. in the
access business, Yahoo in the search engine/portal market and Amazon .com
in the on-line retailing business. 5. Buy the ammunition makers, not the
soldiers.
The words "conservative" and "Internet" are probably oxymorons but there
are ways to make less risky investments in the Internet. The most
straightforward are companies such as San Jose, Calif.-based Cisco Systems
Inc., Nepean, Ont.-based JDS Fitel Inc. and Brampton, Ont.-based Nortel
Networks Corp. that make equipment used to build the Internet's backbone.
"When there are people shooting at each other with live ammunition, whom
do you buy? You buy the people making the bullets," Mr. Stewart said.
He suggests investors stay away from the foot soldiers such as CyberPlex Inc.
and Microforum Inc. of Toronto that help build and integrate Internet-based
systems for corporate clients. "Six months from now everybody will know
how to do it," he said.
An army of financial advisers will probably say that one of the keys to smart
investing is doing your homework, and the Internet demands this discipline
more than any other sector right now -- that is, unless your strategy involves
a lot of speculation, risk and momentum-playing.
"The pace is extremely fast," Mr. Harmon said. "If you don't have the
information or basic understanding of this industry, do not invest."
TAKING A LOOK AT TWO CASE STUDIES
Case Study 1: According to key criteria used by analysts to evaluate Internet
stocks, Infoseek Corp. is falling short on two fronts: Revenue growth and
management.
The Sunnyvale, Calif.-based search engine company disappointed investors
last month when it posted second-quarter revenue of $29.6-million (U.S.).
That compared with the $34.6-million forecast by PaineWebber Inc. analyst
Jim Preissler.
Another concern has been a rash of senior executive departures from
Infoseek in recent months, including the resignation of Barak Berkowitz, a
senior vice-president who oversaw the launch of the Go Network, a joint
venture with Walt Disney Corp.
While Infoseek is the fourth most popular search engine, Steve Harmon, a
senior analyst with Internet.com LLC in New York, said Infoseek's focus has
been unclear since Disney paid $473-million to take a 43-per-cent stake last
June.
"There's conflicting cultures," he said. "Infoseek is a technology company --
they are not media people."
Infoseek shares have dropped 48 per cent since hitting a 52-week high of
$100 in mid-January. Case Study 2. In baseball, a five-tool player is someone
who can do it all: Hit for power and average, play strong defence, throw
well and run quickly. In the Internet area, Open Text Corp. enjoys the same
kind of stature.
The Waterloo, Ont.-based company, which makes software that allows a
company's employees to share information over corporate Intranets, meets
all the criteria that analysts seek in Internet investments.
Most impressive is the company's revenue growth, which doubled in the
fiscal third quarter to $25-million (U.S.) from $11.7-million a year earlier.
Profit jumped to $4.7-million or 20 cents a share, from $1-million or 5
cents.
Open Text beefed up its management team last October by appointing John
Shackleton as president.
Mr. Shackleton's resume includes executive positions at Platinum Technology
Inc., Oracle Corp. and Sybase Corp. With Open Text looking to grow
through acquisitions, the company liked Mr. Shackleton's deal-making
experience.
Open Text is the market leader in the document management market and has
jump-started sales by moving its products to the Internet market, giving
Open Text a headstart over rivals such as PC Doc Group International Inc.
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