SteveG @ H&Q, but this from WSJ on Dow tape this AM:
By David D. Alger
(Editor's Note: This is an opinion piece from Monday's Wall Street
Journal. Mr. Alger is CEO of Fred Alger Management, a New York-based
investment firm).
NEW YORK (Dow Jones)--There is no question that valuations of Internet
stocks are absurdly high by conventional standards. But should conventional
standards apply? Many comparisons have been made between Internet stocks and
previous speculative fads, from the bowling stocks of the 1960s to the Dutch
tulip-bulb craze of the 16th century. Here's the difference: Neither bowling
nor tulips ever had the power to transform the world's economy.
The Internet is more than just an industry. It is a revolution in
communication and commerce. Because it is moving so rapidly, many investors
simply underestimate the transforming power of the Internet. My brother,
Fred Alger, offers a wonderful analogy from his experience as a securities
analyst in the early 1960s. When Haloid Xerox first developed photocopying,
analysts computed the size of the market by multiplying the number of
secretaries in the U.S. by the average number of letters they typed by the
average number of carbon copies they made. It didn't occur to them that
everybody would end up Xeroxing every document, leading to a market many
thousands of times bigger.
The Internet is misunderstood because it just arrived. The inception date
of the commercialized Internet is roughly 1995, when Netscape introduced its
first commercial Web browser. Michael Hallman a Redmond, Wash.-based
technology consultant, points out that the commercial sales of automobiles
began in 1895. It would be 21 years before windshield wipers were invented,
19 years before the traffic signal and 40 years before the parking meter.
The Internet has developed far more quickly. Today some 55% of all of
Schwab's transactions are conducted online. Amazon.com has become the
nation's third largest bookseller in only three years. Intuit's Quicken
Mortgage did $375 million in mortgage originations in six months. The Web is
an enormous resource for comparison shopping and a vehicle for the global
interchange of ideas on everything from sex to the stock market. E-mail has
become the preferred form of communication for businessmen and students
alike. No force has ever shrunk the globe like the Internet.
Today there are more than 100 million publicly addressable Web sites. One
consultant suggests that this year $43 billion worth of retail sales will be
made over the Internet. This is expected at least to double by 2003. Much
more dramatic will be the growth of electronic commerce between businesses,
expected to grow to $1.3 trillion by 2003 from $8 billion this year. These
numbers do not reflect the use of the Internet as a reference, both for
business and the consumer. While some products may still be purchased in the
conventional way, they will be viewed, analyzed and priced over the Internet
long before they are purchased in a store. Result: an escalation in price
competitiveness across the entire spectrum of American industry. Another
gigantic market will be Internet based advertising. And other markets are
developing but have not yet reached the consumer. Revenues from Internet
telephony are expected to reach $14.7 billion by 2003.
The stock market itself is fueling the Internet explosion. Precisely
because of their high valuations, Internet companies can raise gigantic sums
of money at extremely low costs of capital. Internet companies have the
potential to gobble up non-Internet companies: Witness recent rumors that
America Online would take over CBS, a possibility unimaginable five years
ago.
I am frequently asked: How many of these Internet companies will actually
survive? I believe many will not survive - not that they will fail, but
because they will be absorbed into larger Internet-based companies. The
question we should be asking is: How many of their non-Internet-based
competitors will survive? In California, they have a saying for what is
happening to Barnes & Noble: It is being 'Amazoned.' How many small
retailers, distributors, service providers, travel agents, insurance
companies and conventional brokerage firms are going to find themselves
Amazoned - replaced by Internet-based companies - over the next five years?
As Internet companies replace other goods and service providers, the result
will be tremendous savings to consumers.
This will not be a complete zero-sum game. There will doubtless still be
Wal-Marts and Home Depots in 2003. But as the Internet forces conventional
companies to reduce their prices, much of these savings will accrue to the
bottom line of the Internet companies, which don't have the capital
expenditure that conventional delivery forms do. There are no real-estate
costs, bricks and mortar or display rooms. At the same time, the tremendous
gross margins inherent in electronics distribution will allow the Internet
companies to advertise on a level way beyond the bricks-and-mortar
competition. This year, AOL will spend $600 million on marketing. Amazon is
unprofitable not because books have such low margins, but because the
company is spending every dollar of its quite hefty gross margins on
advertising. This marketing clout could hasten the demise of the
conventional competitor.
Stock valuations come down to a single formula: The future price is equal
to the future earnings times the future price-earnings ratio. For growth
stocks, three factors combine to determine the future P-E; the rate of
earnings growth, the perceived consistency of earnings growth and the
'excitement' factor. Coca-Cola has frequently had a high P-E because, though
its growth is modest and excitement low, its persistence factor is high. The
Internet stocks, conversely, have the highest excitement factor I have ever
seen.
A skeptic would say this is all well and good, but these stocks are
massively overvalued based on the numbers. So let's examine one case. AOL is
presently selling at many hundreds of times projected earnings. Is this
justifiable? Consider our analysis: We expect that AOL will have 18 million
subscribers when its fiscal year ends this June. By June 2004, it should
have 39 million. Assuming an increase in monthly service fees to $28,
revenues from service fees alone should be between $12 billion and $13
billion annually. We further assume that by 2004 ad revenues will be $3.5
billion and revenues from other sources will bring the total to $16 billion.
Unlike an industrial company, proceeds beyond a certain point flow directly
to the bottom line. There is little reason, for example, why AOL should
spend appreciably more on marketing in 2004 than it is spending now.
Consequently, we estimate pretax margins of 44% and after-tax margins of
26%. This would produce net income of about $4.2 billion or around $4.10 per
share. Assuming the company is still growing at a 30% rate at this point, a
P-E ratio of 50 would be warranted, giving a value of $205 per share. The
company will have a considerable number of subscribers in nonconsolidated
joint ventures, which we believe would be worth about $40 per share.
Discounting to present value, this brings us to about where the stock is
selling today.
One additional factor considerably increases AOL's value: This year,
depreciation and capital expenditure will be approximately in balance. Thus
the net income produced by AOL can be considered effectively free cash flow.
Combining this with AOL's lofty stock price creates a formidable vehicle for
acquisitions, which could enhance the value well beyond what we have
outlined. (Our estimates of value don't even take into account the Netscape
acquisition.)
To be sure, there will be some disappointments in some Internet stocks.
These are very fast ships with very thin hulls. But to apply conventional
metrics to these economy-altering stocks is to miss the point - and the
boat.
(END) DOW JONES NEWS 04-26-99 |
