What becomes of the dot.com revolution?

Friday 8th December 2000

Last year Internet companies, the so-called "dot.coms," were the hot stocks for investors throughout the world. But by May this year these former darlings of the market were falling like the "autumn leaves". In the wake of such a rapid reversal of fortune, investors have been seeking the answers to a series of unresolved questions: What happened to the value of these investments in the so called "tech wreck" and why? Further, what has become of the New World Order widely promised by the rapid adoption of Internet technology? Should investors give-up on the Internet?

Several of the NZSE dot.com companies were not eligible for inclusion in this year's Scorecard as they had not been listed for the mandatory 12 months before inclusion. For those making the cut, the Scorecard results unfortunately tell a sorry tale. Table 1 provides a summary of the Shareholder Rate of Return for some of Australia and New Zealand's "New Economy" stocks. Due to continued volatility in this sector, we have up-dated the return period a further three months beyond the official close for the Scorecard.

Two points are of immediate note. Firstly, despite all the attention they have received, the dot.coms represent a very small element of overall market by market capitalisation. Secondly, as illustrated in the spread of negative returns among these and similar stocks, the "tech wreck" damage was not confined to a particular Internet segment - those focused on Internet infrastructure have suffered along with the business to consumer (B2C) and business to business (B2B) companies. However, the returns only tell part of the story. To get a feel for the roller-coaster ride that investors in these companies have taken, it is necessary to examine the returns index trend over time (see Figure 1).

What happened to these companies in April? It seems likely that the "tech wreck", has been less about the prospects of individual businesses, and more about a re-calibration of expectations by investors. It now seems likely that investors' perceptions of Internet values were predicated on two valuation fundamentals. Firstly the long-term cash flows from the current business and secondly an option value for future opportunities that the system might offer. In other words taking a "bet" that the investment vehicle could achieve spectacular success and become the next Cisco Systems (SROR last 10 years of 93%).

It's now fair to say that the time when a good idea was enough for an Internet business to attract investment is likely to have passed. Interestingly, the new paradigm that governs investment in New Economy stocks has all the hallmarks of conventional wisdom returned. Investors now demand a convincing revenue model. They want to understand how technology will provide a sustainable advantage, and how that can be monetised. The most shrewd have adopted the jargon of venture capitalists and now probe potential investments for the Path to Profit ("P2P") or Path to Cash ("P2C"). While an impressive picture can be painted using operating metrics such as unique visitors or pageviews, many dot.com entrepreneurs have been reminded in recent months that no financial institution accepts pageviews as a basis for paying bills.

Importantly, this shift helps communication between leaders of ebusinesses and leaders of traditional businesses. Likewise, businesses and investors are increasingly speaking the same language: cash.

Secondly, rationality is returning to investment decision-making. This includes decisions by the many traditional businesses that, having tried and failed to make their web investments fit an acceptable Internal Rate of Return (IRR), went forward with limited degrees of comfort simply because they felt they had to demonstrate that they were part of the New Economy. This pressure is now somewhat reduced, and hopefully their future eCommerce investments will be evaluated on the same basis as any other capital investment.

The autumn correction has also blurred the line between the New and Old Economies. With a more realistic valuation now being applied to the formative new businesses, stronger companies, with more effective management teams have been able to make the acquisitions required to further build out their competencies. In many cases (such as the acquisition by Australian retailer David Jones of The Spot) this has included the mergers with Old Economy businesses, the so-called "Revenge of the Bricks."

So, with the line blurring between New and Old Economy companies, does this mark the end of the Internet phenomenon? Not at all. In tracking the waxing and waning fortunes of individual businesses it is easy to overlook an important fact: The impact of the Internet on business and investment has already been profound, and continues to be so. Internet technology has altered the commercial environment for almost every business in five important ways:

Empowering the consumer: more information is available to buyers, and the powerful technology in the hands of most people enables better processing of it
Breaking down of traditional industry barriers: Convergence across, and within, industries means more competitors in many industries - and with increased competition consumers benefit from reduced prices and/or superior service
Promoting a global marketplace: Despite the on-going challenge of order fulfilment, there's no question that access to markets is much less constrained by geographic limits
Raising the rate of sustainable growth: The Internet has also clearly provided cost reductions like reduced search costs and marketing cost reductions, as well as efficiency enhancements, and promises continuing returns to scale
Challenging regulatory models: Already we have seen tax regimes and market definitions called into question, and responses by governments (such as on the vexing questions of privacy and the availability of pornography, contraband and gambling) mean that businesses can expect on-going changes to their operating environment

These are trends that have implications across many sectors and for businesses beyond just those with a dot.com suffix. Clearly the next industrial revolution is among us all. However the wave theory of excitement of all things Internet has waned. Now sound investment strategies must be based on understanding the impacts of these trends and the continued emergence of technology that challenges conventional business models. So what are the developments to watch?

In terms of the B2C area, the death knell has been rung loudest on the much hyped "e-tailers" or virtual retailer business model. This was most graphically demonstrated in the 90% reduction in the market capitalisation of US company eToys. The idea that you could create a retail relationship without physical infrastructure - be that warehousing, logistics, or actual stores - has all but collapsed. The lesson learned? The Internet is a supplementary not replacement channel for most retail goods.

B2C has been spectacularly successful in identifying and enabling greater customer control over price. Dynamic pricing (such as via auctions or buyer aggregation) has created a new and lasting dimension to the shopping experience that consumers will want to retain. Lesson learned? Retailers need to capitalise on the observation that control over price can result in higher (not lower) price realisation.

Investors may still be able to find companies in this arena that can offer superior returns, but they will need to examine the fundamentals of the business to ensure that they are businesses that have taken these lessons on board.

In the B2B arena, the initial enthusiasm for vertical markets and electronic trading hubs ("eHubs") has been tempered by the practical difficulties these companies have encountered in building a truly liquid market.

Vertical market makers include companies such as Chemdex, Metalsite and Verticalnet in the USA, or Artesian (beverages), FarmNet (agriculture) or BayNet (metals and mining) in Australia. Similarly, eHubs such as MySAP or CWO Marketplace bring together buyers and sellers based on other communities of interest, such as SMEs or users of particular software platforms. They propose to create value by establishing themselves as independent intermediaries that bring together buyers and sellers with the benefit of better price discovery and the opportunity for new sales. Research by L.E.K. Consulting recently identified over 60 such exchanges in Australian market. The jury is still out regarding which models will succeed - if any at all. However, since success relies so heavily on achieving liquidity, vertical markets that are formed by companies that can drive a high volume of their existing transactions on-line (such as those combining in corProcure) currently seem likely to dominate at the expense of the independent model.

So, are these B2B market makers the next gold mine for investors? Perhaps, but it certainly won't be overnight. In the United States, over 600 vertical markets have been created since January 1999. Most are still to post any significant transaction volumes. Much hard work is still required on the ground. Additionally, investors need to assess which companies are likely to be the ultimate winners. This is a model where there must inevitably be a shake-out, since there is almost certainly insufficient liquidity for all players to ground profitable businesses. Further, the survivors will need to convince regulators that they are not extracting undue rents from their market power. In Australia the ACCC has already signalled that it will monitor businesses such as corProcure and other eHubs for potential abuses of market power.

If winners are difficult to pick among vertical market makers, then where else is the value likely to be captured in B2B eCommerce? Potential "big winners" appear to be companies that resolve supply chain problems. For example, this can be through extending ERP systems to cover an industry segment rather than a single participant, as Ariba and Commerce One are doing, or via extend price discovery, such as using new applications that facilitate RFP/RFQ, or by adopting collaboration tools to eliminate re-work.

ASPs (Application Service Providers) also appear to represent a breakthrough for a new generation of digital goods distributed on and through the Internet. Essentially, an ASP enables companies to rent simple or complex software programs and other services via high speed Internet connections. Companies benefit by enhancing cashflows, refocussing on core competencies and getting access to higher quality, constantly upgraded software packages housed in more secure facilities than most would develop for themselves. Protected by stringent service level agreements, the trend to ASPs such as us Internetworking or Corio in the US, or Aspective in Europe, will be a major feature of the B2B landscape in the next two years. The value creation here will be significant for providers and customers alike.

Finally, companies that provide Internet infrastructure confront their own challenges, particularly given the transition away from the traditional model of paid dial-up access. The end of 1999 saw a major expansion in free ISPs in the United States. Netzero, Firstup and Spinway racked up an impressive 3 million users combined over the last six months of 1999. In the USA, Netzero is now the second largest ISP, having gained rapidly on market leader AOL.

The success of free ISPs and the roll-out of broadband access options such as DSL and cable modems will put considerable pressure on the paid ISPs, and it is now reflected in the declining share prices of paid access providers. Accordingly, the future of independent paid access without an associated range of content services appears limited.

Free ISPs in developed markets like the USA appear very exciting, despite the challenging economics. Free ISP models vary - but in large part rely on superior targeting of advertising and eCommerce. It remains to be seen whether similar models can create shareholder value in New Zealand and Australia. In this light, the shaky performance of Australian free ISP GoConnect.com since its recent IPO serves not only as a cautionary tale for investors, but also as a barometer for how conservatism regarding new business models has taken over from the ebullient spirits of 12 months ago.

Coming soon is a further challenge for investors to sort wheat from chaff, with prospects of a range of new services that take advantage of the ubiquity of the Internet. As broadband wireless Internet connection becomes possible, the mindset and mode restrictions of PC based access will be relaxed. The Internet will become like electricity, empowering people to fulfil a more complete range of tasks in much less restricted environment. This will start a new wave of creative ideas such as location-based services and digital distribution.

Should investors give up on the Internet? It would appear not, since close analysis of the fundamentals of Internet companies should continue to identify value-creating businesses - the key, however is seeking stocks where there is a clear path to cash. In any case, even if not investing directly in companies seeking to exploit the Internet as their primary business, the impact of Internet technology will continue to have an important impact on many more traditional companies, and investors cannot afford to ignore these impacts. For example, a key message for investors is to monitor how their traditional investment may be affected by competitors that use Internet technology to achieve lower prices. Alternatively, investors need to also be aware of what opportunities there are for current investments to exploit opportunities through an Internet complemented strategy.

Finally, we have already observed in the US that the changes have created a new exciting Internet marketplace. We believe that this will flow into New Zealand and Australian stocks as well. These changes being:

significantly less cash available for Internet start-ups

investors will closely focus on their current Internet start-ups burn rate

the clear motivator for executives of Internet stock options will be far less attractive

back to traditional methods of assessment

focus will not be on ideas but ideas with value-creation

significant opportunities for Internet consolidation

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