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Tim Albright (talbright@dlj.com) 212.892.6801
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The Internet Observer, 01.25.99
DLJ Internet Research
The Great Reveal
Surprise, even to the confident or jaded, is always unnerving. Expectations
are mocked, appearances belied, the calmness of habit is broken, and a
series of psychic adjustments takes place to internalize the new
information. This is true whether the face of the surprised reflects it or
not, and whether the news is good or bad. In the exotic realm of events
planning, there's a term for the happy discovery of a beautiful space within
the doors of a plain building. It's called a great reveal. You enter from
the street bowed with the weight of the everyday, and beyond the hall stands
a bright, high-ceilinged room that lifts the heart and eye with the promise
of a new experience, or at least a good party.
At the DLJ Internet Conference last week, the great reveal had more to do
with what was said than the rooms it was said in. Even Internet optimists
like ourselves had to come away from the event with a freshened sense of
enormous opportunity, and an even deeper respect for the people pursuing it.
Twelve hundred audience members listened to presenters and panelists from
nearly every major (or soon-to-be) Internet company talk about the business
of creating value in a new medium. And several key themes for the coming
year were sounded repeatedly: the opportunity is still young; transactions
rule; consolidation will accelerate; market share wins; standards are
forming; valuations are, for some, ultimately justifiable; and broadband
changes everything.
Although it's commonplace to say the Internet became mainstream in 1998,
AOL's founder Steve Case set the tone in the first keynote of an even
grander future by reminding us that only 25% of U.S. households are now
online, with much lower penetration overseas. The investor panel, comprised
mostly of venture capitalists (and one Smoking Man), described how many
vertical markets in the consumer and business-to-business segments have yet
to be conquered, and how many business models and management teams they're
seeing that have a real chance to become significant. And company after
company talked about how strong the tone of business is, how quickly
activity is ramping (even after Christmas), and how mindshare among
consumers, advertisers, and businesses of all stripes has reached critical
mass. As we've pointed out often before, when critical mass on any Internet
metric is achieved, the increasing returns nature of the medium starts to
show its power. In our experience, mindshare always turns into dollar share,
and 1999 is likely to be the year that dollar share turns up in a big way on
the operating income line of the category leaders.
To be simple about it, the primary force behind the Internet's growth has
been and will be transactions, benefiting all involved companies at least
indirectly. Again, it's not that the adoption of both consumer and
business-to-business electronic commerce is new news, it's the acceleration
and magnitude of the adoption that's revelatory. Amazon with $250 million in
revenue in the December quarter, AOL with $1.2 billion of gross online sales
over the holidays, and eBay with what's likely to be one of the biggest
upside topline surprises of the group are among the most visible of a
growing set of stirring data points on the consumer front. To amplify that
set in advance of the conference, we undertook an online survey with help
from our friends at Excite/MatchLogic, and the results were more than
corroborative of the anecdotal evidence.
Here are some highlights: 74% of respondents said they made an online
purchase in the last three months, and almost a third of those made total
purchases in excess of $250. 90% declared an intent to purchase online in
1999, with 65% planning spending levels north of $100. The top three
purchase categories were software, books, and music (in that order), and the
top three purchase sites were Amazon (#1 by a wide margin), AOL, and Yahoo!,
with eBay just a few Beanie Babies away. We'll publish the entire survey in
the near future, but you don't need to wait for a full report to hear the
sound of a stampede.
On the business-to-business side, the Observer format is too short to list
all the talented companies, many operating in huge vertical markets, that
will allow investors in 1999 to finally stop waiting for pure B2B plays.
Business models built around a pay-for-performance value proposition to
customers, or around trading exchanges of many and various kinds that
disintermediate sleepy distribution channels, or around streamlining the
workflow inherent in procurement processes, all will arrive for analysis
shortly. These sound a bit abstract today, but once real companies show how
they're leveraging the unparalleled efficiencies of the Internet as a
marketplace and as a platform for communication, these notions will be more
concrete (and they'll have real dollars attached to them). Stay tuned.
Another big topic, broadband, is also beyond the scope of a paragraph or
two, except to say that as the communications pipe gets wider, it's not an
incremental change, but one that alters the geography of the Internet
entirely. Tectonic plates are shifting already, as established companies and
new ones build and partner their way to advantaged positions. Broadband's
instant-on access, capacity for richer data types, and portability across
different access devices will all drive the creation of unforeseen content
and services that could knock the unprepared out of the game. And when
inflection points are discussed in the growth curves of things like
advertising spending and consumer commerce, the creativity and
virtualization enabled by broadband platforms is expected to be their
trigger.
Does it happen tomorrow? Obviously no. But getting back to our mindshare
versus dollar share point, if you're not acquiring the former today, the
latter is almost certainly going to be elusive. What this means for
investors in public companies is another rule-to-live-by: if a company can't
persuade you that they've got at least the draft of a broadband strategy
right now, shun the stock. Although that strategy is likely to do lots of
pirouettes as broadband lurches into the mass market over the next several
years, the dance cards of the big players are being filled quickly.
We haven't touched on other themes of the conference, like consolidation
(evidence of which is hitting us over the head on an almost daily basis), or
market share (we continue to believe that the return-on-invested-capital
dynamics of well-run Internet companies are the source of dramatic wealth
creation). But we did want to close with a nod to valuation.
Ironically, there was less anguish this year about Internet stock valuations
than at past conferences we've hosted. Sure, a week into the new year
everything was up way too much and it got there way too quickly, but Brazil
and day-trader exhaustion provided the excuses for a pullback, and our
belief is that many of the 1200 real investors we were with last week were
waiting and hoping for such a break. Only the press is still relentlessly
focused on silly comparisons of market value, like Yahoo! versus Kodak
(found in a brainless New York Times article this past Saturday). Yahoo! is
more valuable than Kodak? It better be. Having covered Kodak when we first
arrived on Wall Street, we can tell you that it's a terribly run company in
a negative growth market with fierce competition. Competition may be tough,
perhaps tougher, in Yahoo!'s business, but Yahoo! keeps widening the gap
regardless (just glance at Excite's quarter, with sequential revenue growth
of less than half of Yahoo!'s). Execution, competitive barriers, a
tremendous business model, and an almost undefinably big opportunity all
define Yahoo!. Sounds to us like the framework for a premium valuation,
against even more relevant comparables than Kodak. What we and many others
left the conference re-inspired to do is the homework necessary to figure
out how big a premium is warranted.
And that was the ultimate great reveal. The Internet sector is now the
object of great intellectual energy from smart investors, and there will
continue to be enormous demand for valuable Internet franchises, at prices
that may look inflated to the unanalytical. Be astonished, but not horribly
afraid. Stupefaction can turn into stupidity if it hangs around too long. We
hope our own efforts in the coming year to avoid being stupefied will help
you understand the sources of true value on the Internet.
=================================================
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