and the main article -- truly an ouch
economist.com
check out the article at the url -- some decent charts and a cute cartoon
INTERNET SHARES
When the bubble bursts
The Internet is a remarkable invention. Amazon and its peers are remarkable businesses. Even so,
net-obsessed investors have lost touch with reality
Valley of fear
The Internet
Search archive
A FEW weeks ago, Jeff Bezos, the founder of Amazon.com, the
Internet's leading book and music retailer, was asked what he thought
about his company's sky-high share price. He emitted an embarrassed
giggle. “Really,” he said, “we don't think about it that much. If we
concentrate on running the business, the stock price should kind of look
after itself.” And so it has.
But in the past couple of weeks something has happened. Although still up
on the year, Amazon's shares have started to slide. Despite a rally on the
back of lower-than-expected fourth-quarter losses this week, its price was
a third off its peak of January 8th. And where Amazon goes, other Internet
shares will surely follow. Is this just more frenzied trading of the sort that
gripped the market in December and early January? Or is it what many
experienced investors see as an Internet bubble about to burst very messily
indeed?
Amazon is one of a handful of elite Internet pioneers—notably America
Online (AOL) and Yahoo!—to have acquired blue-chip status with Internet
enthusiasts. These three have created pre-eminent Internet brands, defined
the markets they inhabit and proved themselves able to evolve at a
blistering pace. Although only a few years old (AOL has been around for
rather longer in different forms), they are powerful companies that seem
destined to keep step with the exponential growth of the Internet. In some
investors' minds they are the next Microsoft or Intel.
Which is why, in 1998, Amazon's shares grew 966% in value. Between
the beginning of December and early January 1999, its share price climbed
a further 150%, its market value for a time surging past $30 billion,
overtaking Texaco, an oil company. Even now, Amazon is worth more
than all America's bookstores, including Barnes & Noble and Borders,
put together.
Just before Christmas, Henry Blodget, an analyst at CIBC Oppenheimer not
noted for his irrational exuberance, declared a pre-split price target for
Amazon of $400 by the end of 1999. Although some doubters scoffed, within a mere 14 trading days, after the
Seattle-based firm announced fourth-quarter sales of $250m, more than three times the level of the same
period in 1997, Amazon's shares blasted through the Blodget target. “The market just isn't really prepared to
listen to naysayers,” concluded a commentator at TheStreet.com, a financial-news website. It will react to bad
news, but not to sour views.
And sourness about Amazon seems to most Internet investors just silly. The first virtual bookstore, it has
consistently set the standard for online retailing. Its 5m loyal customers find buying books from its website
simple, secure and satisfying. Despite competition from well-financed imitators, Amazon has about 90% of the
online book market and in just a few months has claimed the number one spot in music sales from CDnow. As
Amazon stretches its brand—videos and computer games are next—nobody is better placed to lead the
Internet-shopping revolution.
It is all so convincing and exciting. Forrester Research, a technology consultancy, estimates that online retail
sales last year to Americans were worth $7.8 billion, more than three times the $2.4 billion of 1997. It predicts
that by 2003, Internet retail sales will hit $108 billion as 40m American households make purchases online.
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At which point, perhaps, a little reality should be allowed to intrude. Wal-Mart alone is expected to have taken
more than $130 billion in sales last year. The total value of American retail sales in 1998 was around $1.7
trillion. Even if Forrester's forecasts prove correct, the Internet will five years from now account for no more
than 5% of total retail sales.
Even so, the Internet will threaten margins. It puts an unparalleled amount of information at the disposal of
consumers and thus tends to exert enormous price pressure on the greedy, the inefficient and intermediaries
everywhere.
That will make profits harder to come by for Amazon—let alone worse-placed Internet retailers. By its own
account, Amazon is still a few years away from turning any profit at all. Meanwhile, extending the Amazon
brand into new product areas is both risky and expensive, while giants like Wal-Mart are only now getting
serious about the web.
Customers may be ready to pay a small premium for Amazon's superior service. But eventually, when
consumers can use “bots”—search engines that scour the web for the cheapest prices and the latest
offers—and rivals are only a mouse-click away, even dominant firms will have to accept thin margins.
In a foretaste of the price wars of the future, two rival Internet retailers, Onsale and Buy.com, are promising to
sell goods at wholesale prices and below. Indeed, Onsale has just launched a service called “atCost” which will
offer a broad selection of computer products for the same price that manufacturers charge. Both firms expect
to make their profits from selling advertising aimed at customers who visit their websites (and their founders can
presumably cash in on investors' enthusiasm for Internet shares). Is it too implausible to imagine Dollar.com—a
company that sells dollar bills for 90 cents and makes money from advertising?
Amazon could yet become a $10 billion business with the profits of a corner shop. The very possibility makes
its current share price vulnerable not just to a further correction, but to something much nastier. And if this is
true of Amazon, what of Yahoo! and AOL? And what of the smaller fry—such new companies as
broadcast.com, which two weeks ago hit a value of nearly $5 billion on revenues of $16m last year, or
Marketwatch.com, a fledgling provider of financial data to Internet sites, that was worth nearly $950m a week
after its listing?
Portal problems
Retailing on the web is especially tough, but all these firms are rendered fragile by their relative immaturity and
the sheer pace of online change. That applies even to AOL, with a market value greater than General Motors.
The leading Internet-service provider (ISP) has more than 15m subscribers and expects to command millions
more eyeballs with its acquisition of Netscape's popular Netcenter “portal”. Advertising and “transactional
content” are rapidly-increasing sources of revenue, but the bulk of AOL's income comes from subscriptions,
giving it an appearance of solidity.
AOL's revenues are growing fast—its second-quarter revenues of $960m, were 62% higher than a year earlier.
However, it faces both technological and commercial threats. It may be denied equal access to broadband
cable systems, which are likely to be the most popular providers of high-speed Internet service in years to
come. Even more troubling is the move towards free Internet access. In a matter of months, Freeserve, an
Internet-access service provided by Dixons, a British electronics retailer, and Energis, a telecoms company,
has become the biggest ISP in Britain.
Like Yahoo! and Excite, which was recently sold to @Home for $6.7 billion, AOL is also a portal, and portal
mania has shown few signs of flagging—despite an 11% fall in Yahoo!'s share-price last week. These launch
pads to the Internet are the web's most visited sites and intend, increasingly, to become destinations themselves
as they add content and services. Yahoo! is the most visited site of all, with 167m page views a day. Yahoo!
has consistently beaten expectations in the three years since it went public and is currently worth more than
Boeing—after all, it actually makes a modest profit, earning $25m in the past quarter.
Yahoo!'s career from search engine to content aggregator has been phenomenal. It rapidly learnt that the key
to success was getting people to come back to Yahoo! each time they logged on and to spend increasing
amounts of time there. By letting users create their own news service, and offering free e-mail and popular
message boards, Yahoo! has gone some way to providing a one-stop shop for web users, as well as building a
sense of community.
However, everything that Yahoo! has done has been either copied or previously offered by rivals such as
Excite, Lycos, Netcenter and MSN. That it takes time to customise a portal to your own tastes makes switching
tiresome, but most web users are fickle and the inconvenience is unlikely to deter them for long. None of the
well-known portals have tried to make themselves distinctive by appealing to a particular group, in the way that
most other media do, preferring to be all things to all people. If they want to inspire real—profitable—loyalty
they will probably have to become less inclusive.
The consumer Internet is too young for anyone to be certain that portals may be any more than a passing
fashion. For the moment, all Yahoo! really has is a wonderful brand and several hundred bright, motivated
young people beavering away on the second floor of a slightly down-at-heel, low-rise office block in Silicon
Valley. And a market capitalisation of over $30 billion.
So much for the aristocrats of the Internet. Not surprisingly, behind them there is a queue of tiny, profitless
Internet companies jostling to go public. A few weeks ago, their timing would have looked perfect. Everything
that has been driving Internet shares onwards and upwards appeared still to hold. Business magazines were still
printing breathless profiles of net firms and their cool, rich young bosses. Analysts, typified by Morgan Stanley
Dean Witter's bullish Mary Meeker—who was recently crowned the “Net Queen” by Barron's, an investment
newspaper—couldn't see where a correction was going to come from. Most of all, online retail-investors, the
“day traders”, an army variously estimated at 5m-7m strong, were brimming with animal spirits after what had
seemed to many a lifetime of uninterrupted gains. Then came last week's sharp losses in net shares. Still,
enthusiasm is undimmed
It is impossible to disentangle the rise of the gun-slinging day trader—an amateur investor equipped with a PC
and a connection to the Internet—from the Internet-share phenomenon itself. Using accounts at online
brokerages such as E*Trade, Ameritrade and Charles Schwab, which have themselves spiralled in value, and
exchanging gossip on the message boards of Yahoo! and more specialist sites, such as the Silicon Investor and
TheStreet, the day traders deal feverishly in the Internet shares they know and love.
Many spend seven or eight hours a day online, and for them the Internet companies they invest in take on an
unreal stature. As the virtual world displaces the physical, the idea that Yahoo! could be bigger and more
important than Boeing or Eastman Kodak somehow becomes plausible. For most day traders, conventional
market valuations derived from future profits are for idiots who just don't get it.
Typically, Internet firms trade in lots of 200-300 shares, compared with an average of 5,000 shares for normal
companies. Relatively few firms are listed, and the market in each is narrow—both of which feed the appetite
for Internet shares. Most net companies go public with “thin floats” designed to leave the founders with a lot of
the outstanding equity. Yahoo! has 51% of its shares publicly traded, but more typically Amazon, @Home,
CNET and broadcast.com only have around 35% of their shares traded, while the online auction house eBay
has only 9%.
Alan Suslow, who runs a San Francisco-based online trading firm called “Mr. Stock”, says: “There is a
disconnect between the value of shares and the underlying businesses.” Companies are inherently difficult to
value, there is a limited supply of shares and huge speculation, Mr Suslow argues. The wrong-footing of hedge
funds has not helped. Having seen values reach what they considered unjustified levels, many sold shares they
did not own. Amazon, for example, has 20% of its shares shorted in this way, compared with 1% of IBM's.
When short sellers get hurt by rising share prices, they like to buy more shares to cover their positions. In a
narrow market, this pushes up prices still further.
Meeker and wilder
Even an enthusiast such as Mary Meeker thinks that Internet shares could fall a further 30%. But if that is
coming, why should it end there? Once normal valuations fly out of the window, there are no reference points.
Nor does anyone know how the day traders will cope with sustained downward pressure. Internet shares are
not liquid and online brokerages may not be able to handle large volumes. In any other market, it would be a
recipe for panic selling .
Many things could trigger such a collapse. Financial results could fall below expectations. Investors could also
realise that however exciting and life-transforming the Internet may be, retail and content companies will never
make enough money to justify today's share prices. According to Gill Cogan of Weiss, Peck & Greer, an
asset-management firm: “It is very hard to apply to the Internet the old venture-capital rules about the need for
strong management, a proprietary technology and a small market growing fast.”
At least the better companies have managers who understand how to do business on the Internet, and who
have been able to reinvent their businesses to keep abreast of the remorseless pace of Internet change.
Perhaps, too, rivals from the physical world will not easily push aside Internet brands. The best firms, such as
Amazon, stand a good chance of dominating their areas, because there are no obstacles of place or time to
anyone's using their service.
Yet the valuations put on Internet firms imply much more than this. To justify such share prices, many of them
must have not only Microsoft's market share, but also its 49% pre-tax margins. At present that is implausible.
A large market share will bring far fewer rewards on the Internet than it does in the physical world, because the
Internet hands power to customers.
Unlike the owners of a dominant proprietary technology, Internet firms may be able to create only a very weak
form of network, or “tipping”, effect. True, the best can turn customers into online communities that feel loyalty
and which others want to join. But the very success of the Internet is based on open standards, rather than
technologies controlled by any one company or organisation. It is hard for Internet companies to create the
technological lock-in that has made the Windows operating system so dominant. That is partly why Microsoft
feels vulnerable to the Internet.
For technology lock-in to occur, there must be high costs associated with switching to a competing product, as
there are, for example, for users of Microsoft Word. But the Internet thrives precisely because browsers and
websites all work the same way, with intuitive “point and click” interfaces. The whole point is to make it easy
to move from one website to another. The barriers faced by new competitors are also relatively low, despite
the undoubted advantages for firms first into a market. Even if the brands of big firms gain momentum, new
companies with bright ideas will get noticed (although their best innovations will be speedily copied).
Meanwhile, powerful firms from the physical world should be able to make up for lost time on the web.
This is all a way of saying that the real winners are the Internet itself and the people who use it. If any firms look
likely to come out of the Internet bubble smiling, it is those that have built the net and those whose customers
are other businesses. Cisco Systems scores heavily on both counts, which is why it is a favourite of institutional
fund managers. The same is true of Microsoft, Oracle, Sun Microsystems, IBM and Lucent. Even MCI
WorldCom and AT&T, when it completes its purchase of TCI, will be in some sense Internet shares. But
beware: when the Internet bubble bursts, as surely it must, the shockwave will rock even firms as solid as
these. |
