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The Internet Observer, 06.15.98
DLJ Internet Research
Ruby In The Dust
The search for what's truly valuable in this expensive age sometimes
brings us to what's on the ground. After all, if something appears
anchored to the earth, it may have a permanence or at least a natural
worth that's been overlooked during the gymnastics of commerce. Plus,
craning one's neck skyward all the time (the standard posture of the
ambitious) can damage one's backbone. The impulse toward value investing
is related, however distantly, to the humble downward glance, but its
vocabulary is still that of the market, and, convinced of the market's
inefficiency, it often mistakes rooting around in the garbage for
stepping into a clean and undiscovered stream.
What many investors, value and otherwise, miss at this point in the
evolution of the subversive Internet sector is that the bargains are not
the low-priced goods. Those quality companies that have arrived first
are the heirs of fame and riches, while the rest get a pretty thin
gruel. Take from us these words to live by: the power of the incumbent
is most apparent in marriages and Internet companies. But since the root
of optimism is often sheer terror (which, in this realm, includes the
terror of overpaying), there is still money and hope flowing toward the
undoubtedly doomed.
How else to explain the approach that large media companies are taking
toward the Internet? Not to pick on NBC, but let's use last week's
absurdly ballyhooed investment of a few General Electric dollars into
CNET's Snap! business as an illustration of what media companies are
missing. Snap!, with its dancing exclamation point logo, is CNET's
much-maligned entry into the Internet portal competition, and the
service has been distributed primarily through Internet service
providers and hardware vendors. As a consumer gateway, Snap! mimics some
of the features pioneered by the leading gateways (AOL, Yahoo! and
Excite), such as e-mail, channels, and personalization. But Snap!'s
reach and usage metrics are a fraction of the leaders; for instance,
Snap! attracted approximately 1.7 million unique visitors in March,
compared to Yahoo!'s 33 million. That's a big gap.
But NBC thinks it can close that gap with its traditional media skill
set and promotional muscle. So for a mere $6 million, NBC acquired a 19%
stake in Snap! and locked in an option to acquire an additional 41% for
$32 million. In other words, for $38 million, NBC could wind up with a
majority ownership of an Internet portal, however narrow that portal may
be. To put this investment into perspective, AOL has spent around $1
billion to obtain its status as the leading consumer gateway to the
Internet. With a different model, Yahoo! burst out of the gate early,
executed beautifully, and spent well over $100 million to become the
leading "native Internet" portal. Late-movers like Excite have been
forced to outspend Yahoo!, while Lycos and Infoseek move like gerbils on
an exercise wheel, frantically trying to keep pace with the market
leaders. Now, for $38 million, NBC has a seat at the exact same table.
Sure beats paying $7 billion for Yahoo!, doesn't it? NBC clearly thinks
it knows something the rest of the world doesn't.
Let's first give a nod to what NBC brings to the table, since the
network's marketing muscle is, of course, considerable. During prime
time, NBC regularly garners ratings in the mid-teens (each rating point
is equivalent to 970,000 households), and if the Snap! brand is
plastered all over the tube, a measurably heightened awareness should be
created, since it's been demonstrated that a big part of the value in
owning any network is cross-promotion. NBC (or CBS, or ABC, or Fox)
justifies huge expenditures for the likes of the NFL, the NBA or ER not
simply because of the direct revenue the network gets from advertisers,
but also because of its ability to launch new broadcast properties from
existing wide-reach programming.
And it is from the perspective of the huge sums that NBC and its rivals
are spending on programming that we should consider the Snap! deal. As
we've described, NBC currently has $6 million, and potentially $38
million, at risk in Snap!. Even the bigger figure amounts to less than
the reported cost to produce just three episodes of ER. So as NBC
allocates its in-house promotion time and calculates the opportunity
cost of touting Snap!, we think the risk/reward ratio is going to start
looking pretty high pretty quickly, given the distant return on
investment of many Internet businesses (this one in particular) and the
much greater investment NBC has made (and needs to recoup) in its core
business. Perhaps this is why NBC, amid the hallucinatory euphoria of
the Snap! announcement, was reluctant to indicate even on the broadest
level the value of the marketing commitments it was willing to extend to
Snap!. At the end of the day, NBC executives harbor a fear that Jack
Welch is going to think Snap! is a big waste of money. And who are we to
disagree with Jack Welch (especially given his credo of only owning the
number one or two franchise in any given GE business)?
The NBC - Snap! deal partly mirrors but is ultimately very different
from the template established by the CBS-SportsLine deal. SportsLine
granted CBS an ownership stake that scales up to 33% in exchange for $57
million of television promotion time. At the time of the transaction,
each party had defined value that was lacking in the other party: CBS
Sports had powerful reach, and SportsLine had emerged as the pioneer in
the sports category. Thus, the terms and the respective roles were
clean. To date, CBS has over-delivered on the promotion, and SportsLine
has delivered the highest quality online sports content anywhere. The
financial results have been equally notable, as evidenced by
SportsLine's market cap, which, even in this troubled market, is up 200%
since the IPO. As always, it has come down to good execution, especially
on the part of SportsLine. CBS hitched its wagon to a native Internet
category leader and continues to share in its accelerating success.
NBC faces a much more complex task than did CBS, and it's starting with
inferior raw materials, since Snap! is still without the following: a
strong management team as a standalone company (we really like Halsey
Minor and can hear him laughing all the way to the bank on this NBC
deal, but he's not going to spend much more time running Snap!); a
marketing strategy that either builds upon or redefines Snap's
positioning as a portal; a service with best-of-breed features, such
that it delivers enhanced consumer value versus AOL, Yahoo! and Excite;
and a dedicated online advertising sales force. In addition to these
voids, we're skeptical that broadcast TV marketing will provide the
appropriate call to action that gets a consumer to sign up with a
specific ISP and/or make Snap! a preferred start page. This requires
lots of commercial airtime that occupies revenue generating time slots
(see Jack Welch reference above), and the newer the product the greater
the required promotion. Also, it's much harder to drive traffic to a
gateway than to a specific vertical category Web site, and NBC has had
mixed results even with the latter (MSNBC is approaching critical mass,
but we doubt the numbers on NBA.com will be that compelling). In short,
when NBC paid for an inferior Internet property, the efficiency of the
Internet economy assured that that's precisely what they got. They
didn't get a bargain, and they didn't get a blueprint as to how to turn
Snap! into a market leader.
We have an increasingly strong conviction that if NBC (or any mainstream
media company) was really serious about owning a strategic gateway asset
on the Internet, it should buy AOL or Yahoo! and thereby acquire all at
once everything necessary to generate increasing economic value. That's
unlikely to happen soon, for a host of reasons. The near-term ROI bias
of most large public companies is an impediment to spending $10 billion
or $20 billion or $30 billion for anything still viewed as an early
stage company. And while media companies devote a lot of verbal energy
to the Internet, no real economic pain has yet been caused by an erosion
of their core businesses. Of course, by the time this pain threshold has
been crossed (and it's going to happen), strategic Internet assets will
be even more expensive, and panic buying on the part of media companies
could signal a market top.
We would argue that AOL in particular is anything but an early stage
company. Its subscriber base is huge, its brand couldn't be more
visible, and its model is working beautifully, all despite the relative
newness of the opportunity it's pursuing. Whether the media world is
ready to admit it or not, AOL has emerged as a fifth broadcast network,
as AOL's prime time ratings are rapidly climbing toward those of TV. The
average household spends around three hours per day (a number that's
flattening) watching TV, and highly rated shows pass 12 to 20 million
households. The average AOL customer spends almost an hour on the
service (up from 15 minutes just 18 months ago), usually in prime time,
and an AOL channel or event has a potential audience of 12 million
subscribers. With a market cap of $21 billion, AOL is currently valued
above what Disney paid for ABC, which in our view is more than
justified, since we would argue that, over time, AOL will generate far
more shareholder value than ABC. Clearly the stock market is starting to
believe that statement, but we doubt any media company really feels it
in its soul. They're all still looking for rubies in the dust.
With this issue, the Internet Observer marks the arrival of summer by
moving to a monthly publication schedule until after Labor Day.
Tractors, ponds, and the lavender moon will occupy at least a small part
of our time as we look toward a full harvest of ideas in the fall.
===================================================
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