Andy Grove weighs in: "Intel chairman indicts Internet money models
By David Simons
Red Herring Online
May 11, 1999
At the Economic Strategy Institute conference two weeks
ago, Intel (Nasdaq: INTC) chairman Andy Grove said, "It
remains to be seen whether the Internet companies that have
essentially infinite access to capital will be able to grow up to
be self-sufficient institutions and adjust to a future when
money won't be free."
Placing some numbers on Mr. Grove's
"essentially infinite" description of
today's Net-friendly capital markets
puts an exclamation point on just how
true this statement may prove to be --
particularly in light of the lucrative
market for secondary offerings.
SECOND TO NONE
Lost in the shadow of IPO fireworks, there's been
extraordinary action in follow-on offerings.
Although the 44 Internet IPOs so far
this year have collectively raised $3.3
billion, secondaries by just six
mainstream Internet companies have
raked in $1.8 billion over the same
period. That excludes an additional
$650 million by three ISPs and nearly
$1 billion of debt offerings.
Leaving out eBay's (Nasdaq: EBAY)
curve-breaking $950 million secondary
and those of ISPs, the per-company
average for 1999 follow-ons is still
$178 million -- more than double the average $77 million
raised by IPOs.
Just as startling is how quickly secondaries have come after
the initial public offerings. It used to be that companies had to
wait at least a year; Netscape took fifteen months from its
August 1995 debut to the time of its secondary offering. Last
year, as interest in Net stocks intensified, the
IPO-to-secondary time span shrank to six months. CDnow
(Nasdaq: CDNW) and N2K (which CDnow later acquired),
for example, each raised $140 million in secondaries within
six months of their IPOs.
Recently, the wait has decreased again. In April, InfoSpace
(Nasdaq: INSP) and Xoom.com (Nasdaq: XMCM)
garnered a combined $472 million of secondaries money,
after December IPOs totaling $131 million. On average, only
35 percent of the follow-on loot went to selling insiders; 65
percent was for company coffers.
Most astonishing is that the trading prices of the stocks
barely blinked at the 15 to 30 percent dilution caused by
such additional offerings. Indeed, most just kept on rising in
the blistering heat of the Internet spring.
TREASURIES VERSUS INVESTMENT
Putting the sharpest point on Mr. Grove's observation is the
business performance of the companies relative to the
amount of investment they have already obtained.
Directory services supplier InfoSpace is an example. After a
$75 million IPO last December, the company raised $286
million in an April 1999 secondary, of which $144 million
went to insider shareholders' selling. Yet from its 1996
inception through March 31, 1999, InfoSpace's revenue
totaled only $16 million.
In other words, the public has staked INSP with an amount
twenty-three times its total revenue since inception. This is
despite InfoSpace's accumulated deficit, now at $11 million.
For the moment, let's forget about the accumulated deficit
and the $7 million invested in INSP prior to the IPO. Let's
assume that INSP, which in the March quarter lost
$700,000 on $5 million revenue (and lost $1.7 million on
operating basis), instantly attains a Yahoo-size (Nasdaq:
YHOO) 30 percent pre-tax margin instead of the March
quarter's negative 14 percent.
Even with that impossibly optimistic margin, over the next
five years, INSP's first quarter revenue would have to grow
at an annualized rate of 130 percent in order for the $361
million of public money invested to return the current
Treasury note rate of 5 percent compounded over five years.
In other words, InfoSpace's ability to deliver return on equity
befitting a growth stock (such as Microsoft's [Nasdaq:
MSFT] 30 percent five-year after-tax average) appears now
to lie only in the most vivid imagination.
The picture is similar for Beyond.com (Nasdaq: BYND) and
EarthWeb (Nasdaq: EWBX), as the table "A sampler of
scary Internet financing" shows.
WHAT GOES AROUND COMES AROUND
If companies such as Beyond.com, EarthWeb, and
InfoSpace are so far from delivering return appropriate to
what has been invested in them, then why do people buy the
stocks?
Because stock market investors don't think about capital
invested in the business. They seek return through
appreciation of the stock based upon expectation and
imagination about future earnings (or acquisitions via inflated
equity of other Internet companies).
The extremes to which they've done so with Internet stocks
has allowed the venture capital firms that seed these
companies to seek return via IPO far sooner than the
traditional 5 to 7 years, when companies' earnings power is
much clearer.
However, the basic equation of return on invested capital
always reasserts itself eventually. Demand for IPOs slows,
the cycle of escalating investment reverses over time, and
business fundamentals become more important. Sometimes
the reversal becomes an implosion.
SELF-SUFFICIENT OR SELF-DESTRUCTIVE?
Which brings us to the second half of Mr. Grove's statement:
will Internet companies be "able to grow up to be
self-sufficient"? This table puts it in perspective.
MARKETING EXPENSE AS % OF GROSS
PROFIT
quarter ending March
1998
1999
Amazon.com
101%
94%
Beyond.com
210%
472%
CDnow
587%
267%
OnSale
128%
465%
No company can persistently spend even 75 percent of
revenue (in the case of retailers, gross profit) on marketing
and survive without massive continuing investment from the
public market.
Many point to the positive result of America Online's
(NYSE: AOL) extravagant marketing spending as a model.
But when AOL was blanketing the planet with discs between
1994 to 1997, its marketing outlay of $1.3 billion was only
30 percent of its $4.2 billion revenue.
It wouldn't even take a full-fledged bear market to turn
around investor interest in funding such spending sprees; a
simple loss of patience or interest would do it. A Dow drop
of just 5 to 10 percent for more than a month or two would
be nuclear winter for Internet financing. Consternation about
Amazon.com's (Nasdaq: AMZN) recent projection of
increasing losses due to expanded spending hints that
investor patience can wear thin regardless.
Perhaps Mr. Grove is onto something.
David Simons is managing director of institutional
research firm Digital Video Investments.
A SAMPLER OF SCARY INTERNET FINANCING
Beyond.com
BYND
EarthWeb
EWBX
InfoSpace
INSP
Total raised
from public
$185m
$77m
$361m
IPO
6/98
$45m
11/98
$29m
12/98
$75m
Secondary
4/99
$140m
5/99
$48m
4/99
$286m
% $ to
company
75%
57%
60%
Dilution
15%
16%
18%
REVENUE
Since
inception
1994
$11m
(gross
profit*)
1995
$9m
1996
$16m
Total
raised/revenue
since inception
17x
9x
23x
Annualized
growth
needed**
60%
(130% on
gross profit)
80%
130%
DEFICIT
Since
inception
$(61m)
$(24m)
$11m
3/99 quarter
$(19m)
$(7m)
$(.7m)
Market
capitalization
(5/7/99)
$740m
$335m
$1.3b
Back to story
* Gross profit = revenue from software resold less cost of
software plus shipping.
** Annualized growth of Q1 revenue with 30% pre-tax margin to
return 5% compounded over five years on public funds raised.
Source: company reports. Compiled by DVI."
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