Pavan Report Part # 2:
MANAGEMENT
We believe ILI has the management in place to execute its business plan over
the next 12 months.
Key Management
Paul Godin, President and Chief Executive Officer, has an extensive
background in marketing and sales with a portfolio of experience including:
Director of Corporate and Client Services for Star Data Systems,
Vice-President and General Manager of Casio Canada Inc. and Vice-President,
Sales and Marketing of Alpine Electronics of Canada Inc.
Jeff Lymburner, Executive Vice-President, is responsible for product
management. Prior to joining ILI, Mr. Lymburner was President of Completely
Mobile Inc., National Manager Corporate Sales for Multitech Warehouse
Direct, and a Systems Engineer with IBM.
Chris Bulger, Chief Financial Officer, has reduced his partner role at HDL
Capital Corporation and now devotes all of his time to his CFO duties at
ILI. Mr. Bulger has financial and operations management experience as
Vice-President Finance of Erin Maxx Canada Corp. and in the merchant banking
group of Central Capital Corporation.
COMPETITION
There is strong and aggressive competition in the online auction market
since there are no significant barriers to entry and little regulatory
overhead. As a result, auctions on the Internet have become prolific, with
over 250 auction sites currently online. We believe that the industry will
undergo a process of consolidation and many of the smaller competitors will
exit the market. Competitive advantages must therefore be generated in one
of the following ways.
Customer service: Differentiation can be achieved through a strong product
warranty and refund policy, timely shipping, fast and efficient payment
processing, and a user-friendly Web interface.
Pricing: The ability of the customer to receive a deal is directly
dependent on the number of bidders and the company's ability to secure
products more cheaply than its competition.
Selection: A greater variety of products will attract more buyers,
providing that awareness can be created for the scope of products offered.
Technology: The technology and interface must be extremely easy to use and
reliable. It must also be highly scalable to accommodate the anticipated
growth in the industry.
Advertising: Awareness must be generated and consumers must be guided to
the Website. The ownership of key Internet real estate will assist in this
process and will also make it more difficult for new entrants to achieve the
same awareness and presence levels of early market entrants. The Site that
can lead and retain customers will survive in the long term.
ILI has a competitive advantage due to its ability to co-brand with its
strategic alliance partners, its focus on customer service and its wide
variety of product selection that appeals to a broad segment of Internet
users. ILI also has an advantage in that it has "ownership" of certain AOL
sites and competitors cannot advertise there. The company believes that its
easy-to-use user interface and the declining bid auction technology, which
will be rolled out in Q2/1998, provides a technological advantage over its
competitors.
Mind-Share Is A Key Indicator Of Internet Competitive Advantage
Normal measures of competitive advantage include market share and
mind-share. However, measuring the comparative benchmarks of each
competitor is very difficult at the present time because comprehensive Web
measurement methods are still evolving. However, one indicator that may
provide partial insights into industry ranking is "presence in ratings".
ILI received a relatively large amount of press in early 1997 when it was
named as one of the top 10 e-commerce sites by PC Week magazine. However,
in March 1998, PC Magazine failed to include ILI as one of the Top 100 Web
sites, of which 26 were e-commerce based and two were Internet auction sites
(Onsale and eBay). Although these two auction sites have slightly different
business strategies than ILI, a relative deterioration of ILI mind-share may
be indicated. However, an article in the New York Times on March 5, 1998
listed ILI as one of the more prominent online auction sites.
Whether or not mindshare is increasing or decreasing is difficult to
conclude given the lack of evidence. This problem is compounded by ILI's
recent change from the URL www.internetliquidators.com to www.bid.com. As
part of the change-over, ILI delayed and suspended advertising for several
months until the Bid.com transition was complete. It is uncertain what
effect this delay may have had on ILI's mindshare
Barriers To Entry Are Developing
There are currently very few barriers to entry, but new barriers will
develop as the industry evolves. Some barriers are already gaining presence
in the market including exclusive contracts, economies of scale and perhaps
most importantly, the transition from e-tailer to content provider. Early
market entrants will be setting the pace and taking advantage of their
competitive position.
Exclusive contracts can exist in several forms, as exclusive vendor
agreements or as exclusive advertising agreements. An example of the
exclusive advertising agreement is ILI's agreement with AOL that provides it
with exclusive auctioneer advertising rights to certain AOL pages such as
the AOL Business Services and AOL Computing Superstore. Other key
advertising sites have been locked up by other e-tailers, such as Onsale's
participation with Yahoo.
Economies of scale will also provide a barrier to entry as the industry
matures. Certains companies will gain critical mass and will have greater
ability to form exlcusive agreements and to lock up key advertising
locations. As the industry matures, it will become increasingly expensive
and difficult for newcomers to gain critical mass.
The transition to content provision can be seen in the recent joint
marketing effort between Onsale and Yahoo in the creation of Yahoo
Computers. Onsale provides content for the site and, as a result, they
receive significant Web exposure and marketing at a greatly reduced price.
Onsale's payments to Yahoo are tied directly to the number of click-throughs
to the Onsale site. As the industry evolves, it will be significantly more
difficult and expensive for newer market entrants to achieve the same level
of distribution.
Aggressive Competition In The Future
Consumer-oriented marketing will only become more aggressive in the future
with continued strong pressure on margins. ILI's planned expansion into the
business-to-business niche will also be extremely competitive. The recent
announcement by Ingram Micro Inc., the world's largest distributor of
computer products, indicates that it is creating an auction site targeted at
the business-to-business group. We expect further movement into this space
by established distributors in the upcoming months.
Association With America Online (AOL)
ILI's association with AOL brought immediate attention and recognition to
ILI. The initial agreement with ILI saw AOL assume a minority equity
position in ILI with an option to increase their position to 51%. In
return, ILI enjoyed a competitive advantage through the branding of the ILI
product with the AOL name. ILI's auction product was to be known as the AOL
Online AuctionTM. A two-year marketing agreement was also concluded whereby
ILI would receive strategic advertising locations and anchor tenant
positioning on certain of AOL's e-commerce pages, and ILI agreed to purchase
US$1.25 million in advertising per quarter.
On February 15, 1998, AOL declined the option to increase its equity
interest in ILI. Shortly after, ILI announced that it would no longer be
known as the AOL Online AuctionTM and that it would use the name of
"Bid.com" in the future. AOL has retained its minority position in the
company and a seat on the Board of Directors. Both ILI and AOL have
stressed that a strong relationship still exists, and that both companies
benefit from the option expiry. AOL now has increased freedom to seek
increased advertising from ILI competitors, and ILI has the ability to seek
new forms of business combinations and financing without the overhang of a
potential AOL acquisition of control. Although benefit accrues to both
parties, business execution risk increases for ILI.
The association with AOL was one of ILI's initial competitive advantages.
As the AOL Online AuctionTM , significant customer recognition was created.
With the AOL brand leverage removed from the equation, ILI does not have any
identification advantage over its competition and it is now building its
Bid.com brand recognition from scratch. The AOL association did help to
generate momentum for the company and assist in building a track record with
consumers and suppliers, and this should make the brand building process
easier than a cold start.
FORECAST AND VALUATION
In determining the value of ILI, in addition to our comments above, we have
considered the following factors:
· The industry currently represents an almost perfect competitive
environment since location no longer matters, the cost for consumers to
switch e-tailers is zero, there are low barriers to entry and sheer price
competitiveness prevails. Pressure on margins will be intense for an
extended period of time due to the significant ongoing number of new market
entrants. We believe that the long-term winner in the segment will be the
one who has the economies of scale and critical mass to support high volume
purchasing.
· Reputation is a critical success factor. The buyer has no visual or
physical controls on the Web over product reliability, product
representations, returns or timely delivery. Therefore trust is a key
element of the transaction. Trust is predicated on reputation, which must
be earned by consistent performance over time.
· In changing its brand-name leveraging strategy, the company has foregone
much of the leverage of its biggest alliance - AOL. However, the Bid.com
name has the potential to be a long-term benefit to the company if
sufficient equity can built into this brand. ILI's entire marketing program
is now based on the Bid.com name.
· Management of margins is a key item. With extreme competition and
significant customer latitude in price setting, margins are under constant
pressure. A track record of positive margins must be established before the
company can be considered a serious competitor.
· The business strategy is based on high volume, as pressure on margins is
great. To build up volume, a strong marketing campaign is required to
improve brand awareness.
Assumptions
Due to the limited operating history of the company, the changing Internet
demographics and the novelty of the e-tail market, it is difficult to
project earnings. Our forecasts and price target are based on the following
assumptions:
· Gross margins will gradually increase to approximately 11% over the course
of F1998 and should remain at this level throughout F1999. ILI's "loss
leader" policy has a direct effect on gross margins. ILI has stated that
any losses or negative margins associated with its "loss leader" program are
recorded as advertising and promotion expenses. They are not presented as
part of gross margins. The policy has the effect of boosting reported
margins. Our model assumes that advertising and promotion will not exceed
35% of sales in F1998.
· The product management group will be able to source up to $10 million of
product per month at sustainable margins.
· ILI will able to maintain a competitively high customer retention rate.
Forecast
ILI has been using cash at a rate of C$2.0 million to C$2.5 million per
quarter in the three most recent quarters. With an estimated C$3.0 million
in cash at the end of March 1998, we anticipate that the company will
require new financing within the next three months. We have assumed that
the company will raise C$20 million in an equity financing before the end of
Q2/1998. We have also assumed that the company will raise an additional
US$25 million through a NASDAQ offering during the first quarter of F1999.
The proceeds from these offerings would fund the heavy capital requirements
needed to build the Bid.com brand name and the other associated platform
development and advertising costs. These expenditures will be incurred
throughout F1998 and F1999. In comparison, online bookstore Amazon.com has
spent approximately US$90 million to create its current niche and level of
awareness.
We are forecasting C$29.1 million in revenues for F1998 and a loss per share
of C$0.58. For illustrative purposes, we have estimated F1999 results based
on a quarterly revenue growth rate of 30%. Due to the high level of
uncertainty, we have not used the F1999 results in our valuation. In
forming our F1998 estimates we have based our expectation on a combination
of industry growth and ILI performance. Our expectations for F1998 are
approximately 25% lower than the expectations of management.
Although our forecasts for F1998 and F1999 indicate negative earnings and
significant cash outflow, we believe that attainment of these targets would
indicate success. In achieving the revenue projections, sufficient critical
mass will have been generated to solidify ILI's presence on the Web. We
believe that such mass will result in significant economies of scale on both
a purchasing and an advertising level. As well, ILI will then be in a
position to capitalize on the significant advertising revenues and other
benefits that accrue to companies with such critical mass. Our share price
target is not based on the F1999 forecasts due to the high associated risks.
Should the company achieve our F1999 projections, a substantial increase in
the price target would be warranted.
Recent Financial Results
On April 30, 1998, ILI released its results for F1997 and Q1/1998. ILI
reported F1997 revenues of C$2.6 million. Revenues for the quarter ending
March 31, 1998 (Q1/1998) were C$1.8 million vs. C$1.5 million in the
preceding quarter (Q4/1997). This represents revenue growth of 28% quarter
over quarter. We believe that the slower-than-anticipated growth in Q1 is
attributable to the transition to the Bid.com name.
ILI also reported revenue for April 1998 of C$1.4 million. This represents
a significant improvement over the first quarter and continued growth at
this pace would put ILI on track to reach our second quarter revenue
estimate of C$5.5 million.
The strong April results may also indicate success of the Bid.com name and
marketing efforts. Extrapolating the April revenues indicates
quarter-over-quarter growth of 300%. The transition from the AOL Online
AuctionTM to the new Bid.com brand in the first quarter of F1998 caused
advertising and promotion expense to increase to C$2.1 million (117% of
Q1/1998 revenues) from C$1.3 million in Q4/1997 (86% of revenues for the
quarter). This increase in advertising and promotion is due to the
marketing slowdown leading up to the Bid.com transition and the subsequent
heavy marketing roll-out following the announcement. We anticipate
continued large advertising expenditures in the future as ILI builds the
Bid.com brand name.
Comparable Companies
We have selected key competitors to ILI as comparable companies. These
companies do not trade on the basis of traditional valuation parameters.
Few of the competitors are generating positive cash flow and all are
jockeying for position in the long-term stake for Internet mind-share, which
is expected to lead to future profitability. As discussed previously,
mind-share is difficult to quantify, and since positive cash flow and
earnings for most of the industry companies are not expected to materialize
within the next 12 months, we believe that revenues are the most appropriate
basis of valuation. Inherent in this basis of valuation is the assumption
that revenues are an appropriate indicator of commercialization, i.e., the
ability to generate positive returns on investment.
Considering that most of the Internet commerce stocks are essentially
start-up phase and operating on a pre-commercial basis, we believe that
current valuations in the sector are extremely optimistic. Parallels
between the hype surrounding these e-commerce stocks and the 1995-1996 hype
surrounding Internet service providers (ISPs) are particularly strong, and
like ISPs, we expect that the e-tailer stock hype will deteriorate over
time.
Despite the comparative advantage in reduced overhead compared with
traditional retailers, e-tailers still have a high break-even level. We
estimate ILI's revenue breakeven, including advertising and promotion, to be
approximately C$200 million. Based on industry estimates, revenue
breakevens for industry comparables are: Onsale - US$300 million; N2K -
US$275 million; and Amazon.com - US$500 million. With the significant risks
associated with these companies and the recent run-up in market valuations,
we believe that a price correction is inevitable as the industry matures.
ILI is currently trading at 2.7 times our F1998 revenue estimate compared to
the industry sector average of 7.5 times. In comparison, Onsale, ILI's most
recognizable competitor, is trading at 2.2 times projected F1998 revenues.
We have applied a 40% discount to the industry average revenue multiple to
arrive at an appropriate multiple for ILI of 4.5x. This discount is based
on our view that the Internet commerce market segment is generally
overvalued at the current time, we expect ILI to grow faster than the
industry average, and on the risk factors identified in the section below.
Risks
We emphasize that this investment should only be undertaken by those
investors with a high tolerance of risk. Major risk factors associated with
this investment include:
· the limited operating history of the company;
· intense competition and the minimal barriers to entry into the industry;
· the ability of management to manage the anticipated rapid growth;
· the current dependency on a few key suppliers;
· ability to secure sufficient volumes of high quality products at
competitive prices; and
· the ability of the company to remain technologically innovative and
competitive.
We estimate that ILI's F1998 revenues will be C$29 million with a
corresponding net loss of ($0.60) per share. We have ascribed a revenue
multiple of 4.5x on F1998 estimated revenues, resulting in 6 to 12-month
target price of $5.00. We are initiating coverage with a Speculative Buy
recommendation.
Descriptions Of Comparable Companies
Amazon.com, Inc. is the leading online retailer of books and is one of the
most used and cited commerce sites on the Web. It offers over 2.5 million
titles and had annualized revenues of US$350 million in Q1/ 1998. The
company began operations in July 1995.
E*TRADE Group, Inc. is a provider of online investing services and is based
in Palo Alto, California. The company also offers automated order placement
and execution, portfolio tracking, charting, real-time market commentary and
analysis, news and other information services. The services are offered
seven days a week, 24-hours a day through the Internet, touch-tone
telephone, interactive television and direct modem access. Annualized
revenues based on the last reported quarter were US$213 million.
Onsale, Inc. is an e-tailer specializing in online auctions. The company
specializes in selling excess merchandise, such as refurbished and
discontinued products and offers a variety of merchandise including computer
hardware, consumer electronics, housewares, power tools, fitness equipment
and travel packages. Based on Q1/1998, the company has annualized revenues
of US$160 million.
N2K is an online provider of music and music-related products and also has
its own record label. N2K had its initial public offering in October 1997
and has annualized revenue of US$20 million based on Q1/1998 results.
Preview Travel provides travel services over the Internet, targeting
personal and small business travellers. The company went public on November
19, 1997 and has exclusive distribution agreements with AOL, AOL.com, and
Excite. The company derived 45% of its 1997 revenues from its online
initiatives and had annualized revenues of US$16 million based on the last
reported quarter.
Cendant Corporation is result of the merger between CUC International Inc.
and HFS Incorporated and operates in memberships, travel, and real estate
and has a major online presence with more than $1 billion in annual online
and interactive sales.
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