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Technology Stocks : Amazon.com, Inc. (AMZN) -- Ignore unavailable to you. Want to Upgrade?

To: H James Morris who wrote (10564)	7/16/1998 4:19:00 AM
From: zebraspot	Read Replies (1) \| Respond to of 164684

Baron's article on Net Stocks and their false premises: >> Barron's Online -- July 15, 1998 'Net Stocks Are Flying High on False Premises By JOHN C. DVORAK Recently Internet stocks such as Yahoo!, Amazon.com and Inktomi have skyrocketed to seemingly ludicrous levels. Excite, Lycos and Cnet also have reached prices that cannot be justified by any standard measurement of valuation, whether it be price to earnings, price to sales, price to book value -- whatever. How do you explain such an illogical phenomenon? I'd say much of this is due to what I'm calling the "Microsoft syndrome." Combine that with the notion of "scalability" and you end up with the kinds of astronomical expectations and extreme valuations we're seeing today. Let me explain. Microsoft's success symbolizes the new economic theory called "increasing returns." This is far different from the concept of diminishing returns many of us learned in Economics 101 back in college. Increasing returns means that once you establish a dominant position in a market and become a "standard," your returns naturally grow. This appears to be particularly true in high technology: The "standard" product is perceived by users as a "safe" bet, so it grows to eventually take over the whole market. This theory implies that monopolies occur naturally. (For a complete discussion of this mechanism, see the February 1990 issue of Scientific American. The article in there on increasing returns actually motivated Microsoft to hire economists to refute this theory.) That's why investors go nuts over companies that look as if they could set an important "standard." Yahoo!, for example, is perceived as a standard Web "portal." Portals right now are the hot ticket for Internet-related investments. Interest reached a new level when NBC invested in Snap! -- the portal service developed by Cnet -- and when Walt Disney Co. took a big stake in Infoseek. The reason portals are so popular is the widespread belief that people who use the Internet are not creative enough to beyond a single online source for all their needs. After all, much Internet use in the U.S. is siphoned through America Online, which looks and acts like a portal, although it's really a closed online service with Internet connectivity. America Online's success drew further attention to Yahoo!, which attracts by far the most traffic of any Web site, making it the top portal. By the economic concept of increasing returns, the thinking goes, it could well set the standard and become the Microsoft of portals. Almost everyone in the Valley is skeptical about this -- and the stock's sky-high valuation at over 300 times this year's expected earnings. Yahoo! has a long way to go before it can establish itself as the "standard" portal. It faces a lot of competition, and this is not like the hardware business where Cisco got a foothold because it had a unique and reliable router to sell just as networked computing was really taking off. And unlike Microsoft's dominant Windows operating system -- a standard if there ever was one -- Yahoo! can be cloned with little effort. (Other portal sites, for example, offer better search engines and more attractive interfaces.) But Yahoo!'s fans do have a point that its great brand name is what makes it such a valuable property. And it certainly was in the right place at the right time -- and milked it for all it was worth. That brings us to something called "scalability" -- a favorite buzz word in the investment banking community. Scalability says that business W can generate X revenue on the Internet with Y customers at Z cost -- and Z is relatively fixed, whether the business has two customers or 50 or 100, for that matter. The 'Net allows businesses to scale up with the same fixed costs. Normal businesses have to increase all sorts of costs when they add customers. Not so on the 'Net, the thinking goes: One Web site can service 100 or 100,000 with little change. The implication: On the Web, marginal costs are close to zero, so marginal profits approach 100%. Unfortunately, scalability applies only to a small percentage of the businesses on the Internet. While this model works fairly well with informational sites, it doesn't quite hold up for companies like Amazon.com, which does require more than a new Cisco router to take on more customers. Yahoo! is partly scaleable, though more salespeople have to be hired to sell more ad pages; producers and technical people are needed to run forums, and additional content providers have to produce more features to actually fill those pages. But in fact there are diminishing returns with these businesses. A million hotshot computer experts who use the services today are being replaced by ten million newcomers, AOL users and newbies. Advertisers do not pay as much to communicate with this mass audience. In fact, while the notion of scalability sounds good, it's actually specious. In fact, there are only so many "good" visitors, and they are bound to get lost in the shuffle as these organizations scale up (and newbies need lots of hand-holding from customer service people). In fact, I believe it will be the more controlled, often closed, sites with specialized content and an almost fixed number of highly targeted users that will be more successful in the long run. Right now, investors seem driven by the ideas of portals and standards and scalability . But there are a lot of flaws in today's thinking, and these stocks are bound to come back down to earth when common sense returns. What do you think? E-mail your thoughts on this column to hgold@online.barrons.com. John C. Dvorak is a contributing editor of PC Magazine and writes on technology for many publications. Copyright c 1998 Dow Jones & Company, Inc. All Rights Reserved.<<END