Godfathers of the 'Net
Do stocks of Internet incubators look like the "offer you can't refuse"?
by Andrew Day, Ph.D.
June 15, 2000
With Internet incubator stocks now trading at fractions of their pre-spring crash levels, the "wiseguys"
? the analysts ? have taken a more tempered approach to last year's hot "godfathers of the 'Net"
sector.
No one benefited more from 1999's fourth-quarter market madness than incubators, companies such
as Internet Capital Group (ICGE) and CMGi Inc. (CMGI), which nurture Internet companies with
financing and management. Many analysts and investors came to see incubators as something like
no-fee, new-economy mutual funds due to the diversity of their Internet sector-specific investments.
As a result, incubator stocks soared. In fact, several posted three-figure percentage gains, and one
? ICGE ? shot up almost 3000 percent for the year.
But even on Wall Street, what goes up must sometimes come down, and beginning in March, it did.
As investors fled from tech, incubators took a particularly hard hit. Again, ICGE led the pack, losing
around 80 percent of its value in the first five months of this year.
The "Don" of the Internet: ICGE
Let's take a look at a classic case in point: ICGE, which
invests in business-to-business (B2B) Internet companies,
including both private startups and such relatively
established public entities as VerticalNet (VERT),
Universal Access (UAXS), and Breakaway Solutions
(BWAY). While ICGE's holdings are diverse, it specializes in
growing "vertical e-market" players: companies that set up
and run Internet-based B2B product, information, and service
exchanges.
On August 5, 1999, ICGE debuted on the Nasdaq at $7 a
share with its initial public offering (IPO). With investors at
the time going crazy for B2Bs, ICGE's now-storied rise continued until December 22, when it hit
$212. In March, it went into a drop almost as steep as last year's climb, falling into the low $20s by
late May.
Of late, with investors returning to tech, ICGE has followed suit with a recovery. Since bottoming out,
it has made its way up into the mid-$30s. Even at these levels, it is still trading well above its IPO
levels. But while it fell far faster than the Nasdaq as a whole, it has also been slower to recover,
which is a clear sign that investors are still wary about its prospects.
One important reason is the collapse of the IPO market. In recent months, investors have been
unwilling to do what they did so many times last year: pony up premium prices for initial-offering
shares in anything with a ".com" after its name.
This anti-dot.com shift has hit the incubators hard, because they depend on an IPO "food chain" to
feed capital back into incubators. IPOs of the companies in an incubator's portfolio provide an exit
strategy for an incubator's investment in a company in the portfolio.
IPOs not only provide capital to the companies incubators invest in, but also return needed cash to
incubators themselves. Incubators then use the proceeds of the IPOs to fund newer "offspring" in the
portfolio that are not quite ready to go public. This food chain, which essentially involves selling
companies to the public to raise capital that would fund more companies, is the incubator's main
business. The weak IPO market has made funding newer companies much more difficult.
The wiseguys' views
Some analysts share the market's nervousness. In
a report issued May 11, the day after ICGE
announced its first-quarter results, Robertson
Stephens cites the weak IPO market as a key
reason behind its decision to downgrade ICGE to
a "buy" from a "strong buy."
Robertson Stephens notes with alarm that even as
the market for new issues has essentially dried
up, ICGE's cash demands have grown. In the first
four months of the 2000, the company "burned
through" nearly $800 million in cash on a
combination of acquisitions, its own operations,
and spending to bolster the companies in its
portfolio. Moreover, the report points out, this cash
hunger has forced ICGE to take on a large debt
load, which further weighs down its balance sheet.
U.S. Bancorp Piper Jaffray lowered its rating on ICGE the same day, to "buy" from "strong buy."
While praising the long-term potential of ICGE's B2B investments, U.S. Bancorp Piper Jaffray's report
mimics Robertson Stephens in expressing concern about the impact on its prospects of the market's
diminished desire for IPOs.
For some analysts ICGE still looks just as good as before. In another May 12 report, J.P. Morgan
reiterates a "buy" rating on the company. Morgan essentially overlooks ICGE's cash and debt
problems, arguing that the real story is the continued dramatic increase in the revenues of the
companies in which it invests ? up 342% in the first quarter of 2000.
In a report published the same day, First Union Securities dramatically cuts its price target for ICGE
(to $80, from $180), but reiterates its own "strong buy" rating on the stock. First Union chooses to
take a positive view of the impact on ICGE and of the dramatic drop in new-economy valuations. With
tech companies now selling cheap, it says, ICGE should be able to get a lot more bang for its
investment buck, building its portfolio at much lower cost than before.
And in a May 19 report initiating coverage on ICGE, E*Offering expressed concerted optimism about
its long-term prospects, calling it "an excellent investment vehicle to capitalize on the mammoth B2B
[electronic]-commerce opportunity."
Where all agree to disagree with the incubators: new metrics
If all these analysts still agree that ICGE is a company with great prospects, and a stock worth
buying, what's the problem?
For investors, in a word: valuation. As the Motley Fool points out in a May 9 report, no one knows
what incubators are really worth, largely because so much of their holdings are in privately held
companies, which do not have to disclose their revenue or earnings figures.
The only thing about which everyone agrees is that incubators' income statements ? usually the
basis for a company's valuation ? are essentially useless in determining incubators' worth. The chief
reason is that they so often hold less than a 50 percent stake in their "partners," meaning these
firms' numbers are not included on their balance sheets.
This technicality may explain why some analysts downgraded ICGE in the wake of its announcement
of first-quarter earnings of $1.01 per share. On paper, this number makes ICGE that rare, desirable
beast: a new-economy player that actually makes money. But in reality, it reflects almost nothing
about the performance of ICGE's main asset: its stake in the companies it nurtures.
So even the so-called "new metrics" aren't much use in assessing an incubator's worth. In the
absence of a method for valuing these companies, and hard information to use in doing so, analysts'
bets on incubators are essentially just that. More specifically, they are wagers on the long-term
prospects of the B2B sector, and on the ability of companies like ICGE to take advantage of the
opportunities it presents.
Andrew Day, Ph.D., is a regular contributor to Multex.com. His "The Week That Was" column
appears every Saturday, and beginning this week, his "Track Records" column will appear every
Thursday. |
