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Godzilla Net Stocks and the Death of Traditional Value Metrics

By Curtis Lang on Jun 20, 2000

This article appeared originally in OnMoney.com, a division of Ameritrade.

Who's Counting?

Alan Greenspan and I are in complete agreement.

Greenspan told conferees at the Boston College Conference on the New Economy that  investors "are groping for the appropriate valuations" of Net stocks. The world's  most celebrated and powerful central banker went on to point out that "The exceptional stock price volatility of these newer firms, and in the view of some, their outsized valuations, indicate the difficulty of divining the particular technologies and business models that will prevail in the decades ahead."

Considering the performance of many Net stocks during the last year, it's clear that  investors are having trouble forecasting which business models will work next month,  much less next decade.

In 1998 and 1999, "pure Internet plays" were burning down the house. E-tailers and  portals ruled and momentum investors cashed in. But those who stayed too long at the party are now suffering a very severe hangover.

Check out what's happened to the pros. The Goldman Sachs Internet fund was up 8.7%  year-to-date as of the first week in March 2000, falling far short of the NASDAQ   composite's 15.7% rise during the same period. Internet Fund, Jacob Internet Fund,   Amerindo Technology D., Firsthand e-Commerce Fund, and WWW Internet Fund also trail    the average technology fund for the same period.

And what's happened to investors in the content and community or vertical consumer portal space is even grimmer to behold.

Take iVillage ( IVIL ), for example. Last April, shares in the celebrated Silicon Alley content and community Web site reached a high well north of   $100 per share. Today the stock languishes at 26   15/16 and its 52-week chart looks like a downhill slalom course:

Sure, you say, but iVillage represents an outmoded business model, the content and  community site focused on ad revenues, and the old-fashioned idea that folks want to use the Internet to read content specially tailored for their interests, and to talk to one another. No high-ticket item e-commerce drivers here.

So what about last year's venture capital darlings, the e-tailers? Pets.com went  public Feb. 11, 1999, and it's trading about 33% below the IPO price. Bessemer Venture Partners, who took key positions in Etoys, BabyCenter and Furniture.com recently, won't  even meet with consumer-oriented Web entrepreneurs this year.

Why? Because of the $4 billion in web retailing sales last year, 75% went to just five  websites. Shares of at least 24 e-tailers are down 50% or more below their 52 week highs. There is a glut of multi-million dollar ad campaign-backed e-tail start-ups, and now WalMart, the Gap and Office Depot are moving into cyberspace.

But that doesn't mean there aren't some budding cyber-giants in the group. What about  the websites that are raking in the most dollars among the e-tailing segment? If the stocks of 24 out of 29 e-tailing websites are in the tank, that doesn't mean you shouldn't invest in the sector per se. It just means that the momentum investing strategies of 1998 and 1999 will no longer work in these areas, and that investors must use some sort of rational system for stock-picking and evaluating the worth of these companies going forward. Only in that way can investors be sure they buy a piece of tomorrow's e-tail market leaders.

Okay, so let's take a rational look at Amazon.com, the 1,000 pound e-commerce gorilla.  In April 1999, AMZN shares sold for over $100, but today you can buy a share for 63 11/16, and the 52-week chart looks like a roller coaster in a not so amusing amusement park.

This stock no longer has the mighty Mo-mentum going for it. Why? Your guess is as good  as most Wall Street research analysts'. An analyst report, penned when the stock was at $130 a share, came with a buy recommendation, even though the analyst's official projections calculated a valuation of $30 per share. The analyst admitted he could justify any valuation between $1 and $200 by varying some simple assumptions, and justified his buy recommendation by citing the market opportunity, the company and its management -- all totally subjective metrics, difficult if not impossible to quantify when calculating valuation.

Godzilla Companies and Qualitative Valuation

If you must venture into the murky world of e-tailing, portals and other business-to-consumer Net plays, there is a new set of emerging fundamentals you can track and study before you place your chips down on the table.

Kenichi Ohmae, a Tokyo-based former director of McKinsey and Company, writing in a recent issue of  Strategy & Business, claims that the emerging new economy justifies   the valuations of "Godzilla" companies that are as voracious in their appetite for    market share and growth as the legendary Lizard King of Japanese horror flicks.

Ohmae says that Amazon.com has maintained a high stock price despite logging zero profits because investors know intuitively that Amazon has staked out a valuable piece of cyber-real estate. Similarly, eBay and Priceline.com are considered to be first movers in new markets, which, although starting out as niches, will leap into the mainstream, achieving mass acceptance, and that the first movers will  dominate these new mass-market categories far into the future.

If intuition alone is an insufficient guide for you as an investor, Greenwich Asset Management portfolio manager Iain Anderson has some valuation tips for you. Of course, before you apply Anderson's techniques, you must be willing to accept certain basic assumptions: that there will be hyper growth in their markets, and that their revenues will come from sources you cannot anticipate today.

Pick market leaders with strong management teams, Anderson advises. In addition, invest only in companies that have a sustainable, defensive business model. How to determine that? Well, some of the best metrics for valuing Net stocks include: market capitalization to sales ratio, revenue growth momentum, gross profit growth momentum   (before sales and marketing expenses), subscriber growth momentum, and acquisition cost per new subscriber.

Low acquisition costs are a key metric according to Anderson, because low acquisition costs translate almost directly into greater customer profitability.

Savvy investors will attempt a customer value analysis. Check out the average annual revenue per customer, the average cost of acquiring a customer, and the average churn rate per year. These numbers will enable you to get a basic handle on the company's   prospects.

And keep in mind that heavy losses by Net start-ups can reflect high marketing costs aimed at attracting customers. But is this good or bad? Will all that spending result   in creation of Godzilla brands in new markets that explode into triple-digit revenue growth or will all that money spent on TV advertising just fatten the pocketbooks of young hipsters at mega-advertising agencies pumping out me-too commercials heavy on post-modern irony and self-deprecating humor?

Netcentric Metrics vs. Traditional Measurements

Three professors at the Haas School of Business at the University of California of Berkeley have attempted to make sense of Net stocks' sky-high valuations, to determine the importance of heavy losses and to develop some guidelines for using new types of metrics indigenous to the Net to evaluate e-tailers, portals and the like.

Brett Trueman, Franco Wong and Xiao-Jun Zhang found that financial statement information is of very little use in the valuation of Net stocks.

"We are unable to detect a significant positive association between bottom-line net income and our sample firms' market prices," the triumvirate reports. "In fact, the association is usually negative."

The trio did find that gross profits are significantly correlated with prices. Many of the companies studied were Web retailers, portals and content/community providers, who have yet to turn a profit at all. The study indicated that the bottom line at these types of companies can be distorted by one-time costs, and other charges that most investors would consider investments rather than expenses. (Whether that includes brand-building blockbuster ad campaigns remains to be seen.)

So, by subtracting cost of revenues from gross profits, the Haas team calculated gross profits and found that high gross profits indicated high stock prices.

The Berkeley professors suggest that investors should scrutinize the same metrics that advertisers use to determine the power, reach and value of a given Web site -- page views and unique visitors. Both of these metrics, widely available for the top Web sites from press releases  issued monthly by Media Matrix , the leading tracker of Net traffic, were found to have a substantial  incremental power to forecast stock prices.

The Haas trio found that for e-tailers the page-view count has much greater incremental explanatory power than the number of unique visitors. That's because e-tailers are   selling products. The more pages customers click on, the more products they see and   are likely to buy. Obtaining repeat customers, and especially retaining customers   that buy many items during one visit are, of course, more important to e-tailers than simply bringing new customers in through the homepage.

Page views and unique visitors were found to be of equal importance in evaluating portals and community/content websites. In addition, the Haas study found that bottom-line net income of portals and community/content sites had a positive and significant association with stock prices, in sharp contrast to e-tailers. In this respect, portals and community/content sites, like iVillage, are coming to resemble non-Net stocks.

The explanation for this divergence could be that the portals and community/content sites are older, and market leaders have emerged. The brand-building days are about over. New entrants find they must offer $1 million a month in prizes, like iWon.com , to get traction in an over-heated market.

E-tailing is a slightly newer category, and expensive brand-building exercises are still underway. All this suggests that it will not be decades before investors begin to apply  traditional metrics to Net stocks, and when this happens, a merger and acquisition wave in cyberspace could provide the investment banks that promoted all these dot-com companies with their next big profit opportunity.

And, of course, momentum investors are already checking out the dot-coms to determine which ones are likely acquirers, and which ones are likely food for acquisition. The   market rewarded rumors of a potential merger between e-Bay and Yahoo! in mid March, then took the two stocks down when the rumor failed to materialize into market fact.    Momentum investors intend to bet on these new mega-Godzillas, of course, although the AOL-Time Warner deal shows us all that even the most glamorous merger may lead to lower stock prices for the acquirer, not at all to an investors' windfall.

Which just goes to show you that picking winners in the dot-com arena will continue to be a very subjective exercise for the foreseeable future. It's enough to make you want to invest in business-to-business Net stocks, or just stick to the Ciscos of the world. After all, Levi Strauss's success selling blue jeans to miners during the great gold rush of '49 demonstrated for all centuries that in a hyperactive market it's much more profitable to sell supplies to entrepreneurs than to be an entrepreneur oneself.