Vendit: " WSJ editorial: Big Profits On-Line " by D Alger.
TA
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4-26-99
Big Profits Are in Store
From Online Revolution
By David D. Alger, CEO of Fred Alger Management, a New
York-based investment firm.
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. |
