The Internet Capitalist
S.G. Cowen's Companion To Internet Investing
November 6, 1998
SG Cowen Internet Research
Scott Reamer: 212.495.7769 reamers@sgcowen.com
The Week
Q3 Internet Earnings, Part Deux
AOL's EPS: Simply A Linear Algebra Problem?
Trend Watch
Broadband: The Age Of Aquarius?
Company Watch
America Online (AOL)
Amazon.com (AMZN)
Yahoo! (YHOO)
DoubleClick (DCLK)
Observations
Internet Marketing Appetites Are Growing
Some Thoughts On MSN.com The Microsoft/LinkExchange Deal
More Evidence; The Web As Consumer Medium
Disintermediation 201
Valuation Watch
Two-Factor Valuation
The Calendar
Data Bank and the S.G. Cowen Internet Universe can only be viewed via the PDF file.
"The Internet Capitalist" is published every two weeks by the S.G.
Cowen Internet Research team and is distributed through email, First
Call and fax. This companion piece attempts to place both anecdotal
and concrete data within a thematic context that will help
institutional investors gauge where the greatest shareholder value
will be created over time in the Internet universe. And though we
certainly subscribe to the notion that "less is more", we have
included a broad array of issues within this piece, the underlying
logic being that successful Internet investing necessarily demands a
wider, not narrower, view of these stocks and the issues that drive
them. Additionally, since the Internet is also a democratic medium at
heart we encourage feedback. Suggestions, challenges, criticisms; all
are welcome. Our hope is that this piece will offer, on balance,
greater utility for the one commodity with any real value: time.
SG Cowen Securities Corporation makes a market in AMZN, DCLK, MSFT,
NSCP, YHOO and XCIT securities.
SG Cowen Securities Corporation co-managed an offering of AOL and DCLK
securities within the last three years.
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The Week
September Quarter Internet Earnings
Part Deux
Now that the September quarter's earnings for the lion's share of
Internet companies are safely in the rear-view mirror, much of the
Street has (rightly) turned back toward the windshield and the
upcoming December quarter. Before the Street dives headlong into our
December quarter predictions however, (which we're happy to provide to
do at the end of this article), it's helpful to look back at some of
the conclusions we culled from Q3 results, with an eye toward helping
us further refine our thinking about what, precisely, drives these
stocks and these companies.
At the top-most level, of the 37 Internet companies that have
announced their September quarter earnings, 27, or 73% beat estimates,
which provided much of the fuel necessary for the rise in these stocks
over the last several weeks. Of course, the most noticeable (and
obvious) of these was AOL's and Amazon's Q3 results, which confounded
as many observers as it did surprise. So clearly, then, the vast
majority of these Internet companies are executing against plan, which
suggests that business conditions remains fundamentally sound:
consumers are increasingly turning to the net for entertainment and
commerce and that businesses are increasingly relying on the
Internet's underlying technology to re-engineer their operations. But
beyond this simple overview, what has the September quarter really
told us?
We've developed a few rules for Internet investing over the last few
years, which we call our Internet First and Second Principles (the
difference manifesting itself in how widely understood they are by
investors). A few of the more important First Principles are that the
Internet is an entirely new mass medium, that increasing returns drive
these businesses, and that Internet companies' businesses scale
fantastically. Having digested the better part of the September
quarters for the Internet stocks in our universe, these foundational
rules, happily, continue to make lots of sense.
Consistency is not the hobgoblin some believe it to be; perhaps no
where is this more true than in the trends being reported at AOL,
where a remarkable consistency has snuck up from behind the model and
is currently holding it ransom for an unspecified demand (perhaps a
free overhead account?). Subscriber growth continues to be
exceptionally strong (strong brand), churn remains at all-time lows
(high satisfaction), and profitability and cash flow continue to
accelerate (shareholder-focused management). These conditions most
certainly should be welcomed, given AOL's profile just a few short
years ago. Most importantly for investors are the dynamics and
conditions that have lead to this present state: though AOL has had
lots to do with their success, they have had a nice wind at their back
in the form of increasing returns. No where is this more obvious than
in the September quarter results.
That AOL was able to generate 951,000 new subscribers in the quarter
and something like 500,000 in the month of September is testament to
the power of word-of-mouth, a positive feedback loop common to certain
Internet businesses that gets stronger with time. That this 951K
figure was without the benefit of AOL 4.0 or the AOL 4.0 ad campaign
speaks to the power of positive feedback loops even more. Couple this
with a sales and marketing figure that seems to be stuck on $100mm per
quarter (this is three quarters in a row now, which makes it a
veritable law on Wall Street), and you've got all the ingredients of
increasing returns, that process by which big companies get bigger and
competitors get, well, less important.
For it's part, Amazon also had a great September quarter and, as
importantly, provided lots of data points in defense of our Internet
First Principles. AMZN added more than 1.2 million new customers in
the quarter, bringing the total to 4.5 million customers. And some
perspective is in order here, given the enormity of this number: last
September Amazon had only 940k customers, having taken them 2 years to
get to that figure. This quarter they added more customers than they
were able to for 8 quarters running. This is increasing returns at its
finest: word of mouth buzz coupled with smart marketing programs
equals outsized customer additions.
With AOL usage continuing to increase (at 24 hours per month), with
Amazon's customer base growing like kudzu, and with profitability
increasing nicely (at AOL anyway; AMZN will get there.), we have a
whole handful of confirming data for our Internet First Principles.
But, what, if any comfort does this provide to investors with the
stocks up big since September 30th? Plenty, in our view, since these
factors will continue to drive the underlying operations of these
Internet leaders. And though, at times, it may feel like much of the
benefit of increasing returns is already reflected in the price of
these Internet stocks (AOL, YHOO, and AMZN), we continue to feel that
we are just starting to get a sense for the ultimate profitability and
scale these businesses can achieve.
Because of this, we continue to believe that these stocks will never
look cheap enough (just like Dell has never looked cheap enough),
which has provided ample amounts of frustration. But we can certainly
count on them to continue benefiting from our Internet First
Principles, which will power their operating results, which will power
their stocks. We continue to be bullish on the three Internet blue
chips; AOL, AMZN, and YHOO.
AOL's Earnings Are Simply A Linear Algebra Problem?
Flipping through an old operations research textbook from college
while watching the '98 election results pour in on MSNBC Tuesday
night, we were struck by the idea that determining AOL's future
earnings has simply become a linear algebra equation with four
variables and two determinants. Well, perhaps not quite, but close.
Let us explain.
As we like to state, AOL's model is characterized most appropriately
by the level of control management has over it's four important
drivers: sales and marketing expenses, advertising and commerce
revenue, gross margins, and subscription revenue. Each of these line
items have their own drivers, but in aggregate, allow management to
simultaneously meet the financial goals of shareholders (e.g.
consensus earnings estimates or above) and operational goals of the
service (e.g. additional modems or customer service personnel).
So far, the company has shown a good deal of aptitude in balancing
these factors; it's a process we call Harvest vs. Investment. Now
that the business model finds itself within the four walls of
subscriber growth, ad/commerce revenue, gross margins, and S&M
expenditures, it will be up to management to determine where within
this great hall they position the model to produce maximum earnings
and maximum investment. At its simplest, this is a linear algebra
problem with four know variables and the goal of maximizing for two
variables, EPS and infrastructure investment.
But of course, it's not quite this simple. The relative importance of
any of these four variables changes with time (S&M expenditures behave
differently in September than in March), and is compounded by a lag
effect (modem build outs need to take place anywhere from one to
several months in advance of any expected spike in usage), which makes
aiming for "great earnings, continued investment" an exercise in
moving marksmanship. Further, these four important variables (sub
growth, S&M, gross margin and Ad/commerce revenue) are in and of
themselves functions of other variables, so without making some
simplifying assumptions, the process could get bogged down in infinite
complexity.
However, investors can be consoled by the management team's well
earned scars on this front; the access problems of the past have left
an indelible imprint on many folks there. So while we try to build a
computer model that summarizes and simplifies the AOL Harvest vs.
Investment equation (our goal is to deliver it to them for Christmas),
you can rest soundly knowing that AOL's aim and balance has been close
to the center for plenty of quarters now.
Trend Watch
Age Of Aquarius?
We've spent a lot of time lately speaking to institutional investors
about the impact that broadband technologies could have on the
Internet space generally and on AOL in particular; with everything
else so positive with the company and the stock, the issue has taken
on a life of its own (after all, we've got to worry about something).
It's clearly become an issue that's got folks in a lather.
We are struck by the vehemence with which both sides of the debate
(the "broadband changes everything" or "Age of Aquarius" camp and the
"everything stays the same" camp) defend their positions, so we
thought, given this backdrop, some clear thinking was in order, since
we've taken a very centrist approach. And as we mentioned in our last
Internet Capitalist (dated 10/23), we promised we'd explore this very
complex topic in more detail in a future issue, so here goes.
Central to the ongoing debate is the idea that broadband technologies
will indeed happen and happen soon; this much we can agree upon, since
AT&T's pending acquisition of TCI was and is predicated on developing
broadband technologies via the cable box in each of the homes that TCI
passes. Michael Armstrong, AT&T's Chairman and CEO, stated as much in
a speech to the Economic Club of Detroit:
"TCI will give us a path into almost one-third of all American homes.
But more than that it will give us the ability to exploit the
convergence of TV, PC, and telephone to create a whole new generation
of communications, information and entertainment services."
That said, the end game is anything but certain for ISPs, telcos,
media companies, or cable MSOs; it is as much a function of regulatory
issues (on which we lay no claims of expertise) as technological and
business ones. That said, investors have felt that AOL is somehow in
a precarious position in this new broadband world, that their leverage
with content providers and consumers won't necessarily translate into
the broadband arena and that they need to strike a deal, and fast,
with a cable company in the hopes of being included in the revolution
that will come through the coax cable line into our homes. We believe
AOL is actually in the driver's seat on this one (the reasons for
which we lay out below), but let's take a step back and survey the
landscape a bit.
Even a casual observer of the cable and telecommunications space
should be aware that something big is afoot; Microsoft bet $1 billion
on Comcast, MediaOne joined with Time Warner on RoadRunner, Compaq and
Microsoft put about $400mm into Road Runner, and AT&T, of course, is
in the midst of purchasing TCI. Lots of very smart, aggressive
companies are placing big bets on the future of broadband.
To this we will most certainly agree; both consumers and content
providers will be significantly impacted when broadband become a
ubiquitous reality. Consumers will almost certainly flock to broadband
if they perceive the value proposition to be worthwhile (certainly not
a guarantee, since cable modems are still being installed by cable
repairmen and the content and community features remain relatively
immature). For their part, however, content providers are not incented
yet to build broadband-specific content; they rightly view broadband
as a faster and potentially easier way to access their current Web
sites. A recent poll conducted by Forrester suggests as much; only 26%
of respondents suggested broadband was very important to them.
That said, we are in interested in the investment implications of
broadband; how will the shareholder value of the company's we cover be
impacted. Though broadband certainly will change the game to some
degree for each of the Internet companies in our universe, perhaps in
no other stock has this worry manifested itself more than in AOL
(indeed, we wonder what levels the stock could reach if this overhang
was eliminated).
Now, we don't claim to have any inside baseball on who AOL is
negotiating with on the cable side (or, to be perfectly truthful even
if they are actively engaged in negotiations), but we have been
intrigued by the public comments made by both Michael Armstrong, as
well as Tom Jermoluk, the chairman and CEO of @Home, the broadband
Internet service provider. Both have definite opinions about the
matter, about what role they will collectively play and how various
Internet companies can participate. As well, since there seems to be
an information vacuum of sorts (or at least a mis-understanding of
some of the data currently known), we've found the most insight from
the public comments from the relevant players themselves.
For his part, Michael Armstrong has been quite open about his desire
to negotiate with online service providers like AOL as broadband
evolves. In a speech to the Washington Metropolitan Cable Club,
Armstrong stated:
"Some OSP's have been publicly worrying that the new broadband model
we're launching might freeze them out by denying our customers access
to their services. But there's no way that's going to happen. That
wouldn't be in our best interests, or the best interests of our
customers. Our message to the largest OSP and all the others couldn't
be more direct: If you've got a service our customers want, we want
you on our system."
"We look forward to a broadband version of the cooperative arrangement
in place right now in the narrowband market. Today AOL, for example,
allows customers the option to "Bring your Own Access,". It's a good
deal for all concerned especially AOL. They collect $9.95 a month from
each of these customers, without the bother and expense of actually
providing access."
"So AOL or any other (online service provider) can actually gain
revenue by our customers reaching their services via our broadband
network. That means enhanced advertising, e-commerce and other
advantages. It's a win-win situation."
However, @Home has been a bit more aggressive, with Tom Jermoluk
positioning the @Home service as a replacement for AOL and other
online service providers, and suggesting that the two services, aside
from the speed, are being viewed as comparable to consumers. At a
speech at the National Press Club in June, he stated:
"@Home serves not only as a high-speed pipe, but a value-added
Internet experience. It's an Internet Service provider, and a content-
rich online service. It's e-mail, multiplayer games, IP telephony,
enhanced TV and more and the technology behind all of it is
transparent to the user. It's just a high-performance, easy to use
information appliance in the home."
And more recently, he has been vociferous about @Home's impact on AOL
in the markets where @Home has an offering: |
