Dow Jones Interactive

Ditzy Dotcom: Are Internet Stocks The Dumb Blondes Of The Business World?
Fiona Rotherham

09/22/1999
Independent Business Weekly
18
Copyright Pauanui Publishing Limited. All rights reserved.

The odds are on New Zealand investors joining the Internet fervour sweeping world sharemarkets. Our top two Internet service providers, Telecom's Xtra and Ihug, are mulling over possible listings. If they take the plunge, they will be the first "pure" Internet stocks on the New Zealand Stock Exchange.

Why would they do it? Despite Internet stocks' recent rollercoaster ride in the US, adding "dotcom" to your name is still attractive. A survey by the Wall Street bible Barron's found 77 people had gained fortunes on the US sharemarket worth more than $US100 million in the year to June.

Two-thirds of the 36 initial public offerings creating the multi-millionaires were Internet-related stocks. Telecom expects to make a decision within months on whether to spin off Xtra. It has been talking to the market for some time about its options.

A Warburg Dillon Read report last month suggests "there is an increasing probability that management will take this path." The attraction for Telecom is the enthusiastic pricing of dotcom businesses in the Australasian market. Full-value recognition for Xtra is unlikely while wrapped within the integrated telco business.

New Zealand is already in an "electronic ferment" with high levels of Internet usage. Growth rates for consumer market Internet penetration are 70% per year. Meanwhile Australian telco giant Telstra has publicly stated it won't be floating its Internet business.

It reckons it is more valuable retained within its telecommunications infrastructure. One Australian analyst says most telcos have rejected the idea because the Internet is such a valuable and integral part of their business. "Most of what they do now will be offered over the Internet in the next five to 10 years.

Why would you want to sell off your key to growth?" Valuations of Xtra depend on the method used. Warburgs estimates a value between $1 billion and $2 billion, using similar multiples to those applied to US Internet stocks. Xtra is unique amongst New Zealand's Internet service providers in that it was profitable at EBIT level during March and April.

Telecom says it is currently in an overall break even position. The Warburgs report says Xtra has rapidly become the main player since its 1996 launch. Its market share has grown 10% in the past year to reach 47%.

Ihug is running second on 27%. Ihug founders Nick and Tim Wood began the company four years ago with "$8,000 cash and a pc." Tim Wood confirms the company may float after its pending 30% sale to Sky Television, but a decision is unlikely until early next year as there is no urgent demand to raise extra capital.

"You have to be fast and loose in this environment and becoming a public company requires a lot more stringent reporting," says Wood. "We are not ready for it. Our focus is gaining market share and increasing revenues."

Overseas, the extent of 'net mania is revealed in a paper A Rose.com by any other name by Michael Cooper, Orlin Dimitrov and P Raghavendra Rau of Indiana's Purdue University. After studying 63 US stocks between January 1998 and March this year, they found adding "dotcom" to a company's name immediately increased the company's share price by an average 125%, even if the business had nothing to do with the Internet. One month after the name change the average increase was 200%.

The academics say only time will tell if this phenomenon is investor mania or a rational pricing of future Internet earnings. So far, the investor mania hypothesis is winning. Funky names that stand out, but are easy to spell, are said to be optimal for Internet companies.

The Wall St Journal reported Computer Literacy Inc changed its name recently to fatbrain.com. The company's shares jumped by 33% to $US20.75 the day before the company sent out an advisory notice about the name change, when Web chat forums leaked the news. The explosion in US Internet stock prices began in earnest last October.

The Australian Financial Review estimated the run added more than $A5 billion to the value of Australian stocks like ecorp, LibertyOne and One.Tel, along with content providers like John Fairfax Holdings and Kerry Packer's PBL. This is small beer compared to the 17 largest US Internet stocks, many of which are less than three years old. In October 1998 their combined worth was $US47 billion.

By April, those same 17 stocks had leapt to an incredible $US495 billion. The most spectacular rise was the online auction house eBay, rising from $US8.42 to $US234 per share. Online US investment adviser Motley Fool played an April Fool's Day joke on investors.

It announced it was underwriting an initial public offer for eMeringue, a bogus Idaho-based car parts dealership transformed into a meringue delivery service. eMeringue guaranteed to deliver meringue toppings for pies to anywhere in the US within seven days. On the day it listed, it was hit with allegations of food poisoning and fraudulent accounting practices and its chief executive arrested for hijacking a cruise ship.

All part of Motley Fool's scam. The dotcom bubble peaked in April. Since then, Amazon.com's founder Jeff Bezos has seen his net worth fall $US8 billion to $US5 billion.

At a July media business conference, America's most famous investor Warren Buffet commented on the Internet boom: "Fellas, this is going to end, and end hard, and a lot of people are going to be left bankrupt." One week later, stock prices fell. In August, Internet stocks dropped around 40% to a record low for the year.

The losses drove thousands of American online day traders out of the market. Many initial public offerings were deferred, cut back or canned altogether. Of the 40 IPOs that made it to market in August, 16 lowered their price before the offer date.

Most traded at a huge discount to the opening price. Online insurance provider Quotesmith.com.Inc. debuted just as the market slid down.

Its price went from $US11 on opening to $US7.50 a share. Its directors say the small company simply couldn't afford to postpone the float. By the end of last month the share price had traded back above its initial price.

Two years ago, Internet-related stocks accounted for only around 8% of Nasdaq-listed companies. Limited supply created demand and extreme valuations. Ord Minnett researcher Andrew Swan says until six months ago IPOs had raised about $6 billion over a three year period.

In the past three months there was $A8 billion in the pipeline. This market saturation, coupled with rising global bond yields and fears of rising US interest rates, pricked the Internet stocks bubble. "With increasing supply and macro conditions being unfavourable the weakness started to come through," Swan says.

The loss-making Red Hat, the largest distributor of the computer operating system Linux, bucked the trend. Its shares quadrupled on their first day of trading. It now has a market capitalisation of $US5 billion, while other IPOs have wilted.

Another exception, the Palo Alto, California-based Bamboo.com, providing 360-degree virtual real estate tours on the Web, rose 10% on its market debut last month. It now has a market capitalisation of just under $0.5 billion. It generated less than $US1 million in sales last year.

The market fears seem to have lessened and stocks have bounced back after the US Federal Reserve raised the federal-funds target rate and discount rate by only a quarter percentage point. Just after the Federal Reserve's announcement 1-800-Flowers.com. Inc.

traded above its $US21 offering price for the first time since its Wall Street debut in early August. Internet shares are particularly vulnerable to higher interest rates since many of the leading companies lose money. Almost half the market losses have been regained in the past few weeks.

Some Australian Internet stocks, such as LibertyOne, have reached new highs. TheStreet.com index shows Internet stocks are still up around 25% for the year to August. Investors holding onto their shares for longer than six months stand to make large profits.

Market commentators say the prick in the dotcom bubble was a necessary correction. Hangover over, it is time to party again. Some investors view the fall as a buying opportunity to gain exposure to the market.

The US and Australian markets are braced for a new IPO frenzy and resuscitation of slumped offerings. Ord Minnett's Andrew Swan warns investors to avoid companies just playing on the hype. 'Everyone has just been buying the dotcom stock.

I think people are going to get more and more choosey on what they will purchase." What should investors look for? Ord Minnett has a five point checklist for picking Internet stocks: l what is the actual product on offer and how will the company make money from it?; l are you prepared to be a long-term investor as these stocks are priced on future earnings?; l does the stock have a comparative advantage or a global brand?; l assess the stock's valuation by looking at its potential earnings in the next ten years?; l does it have good management, or strategic alliances and joint ventures in the offing with those who do?.

Internet stocks are picked to rise for the rest of the year, given they are on average still some 25% to 30% short of historic highs. The proviso is the overall US sharemarket remaining robust and interest rates staying down. A new example of online bandwagon-jumping is so-called Internet-based companies offering investors free shares.

Web Equity Capital Co is one such company seeking US Securities and Exchange Commission approval to issue globally up to 10 billion shares for free. The start-up company wants to attract up to 20 million "investors." They won't be able to do anything with the shares until WeCap actually raises money one day via an initial public offering.

What does it do? It lists its activities as providing free stock in WeCap, referrals for free stock in affiliates, expert market timing advice, and low-cost credit card loans. A bumper season is expected in the US for e-commerce as Christmas approaches.

This will improve the sales and online advertising revenues of many listed Internet companies. While debate rages on investing in high risk Internet stocks, few dispute the huge long-term growth potential of the Internet itself. In the US, Internet traffic is reportedly doubling every 100 days.

Back home, the number of NZ Internet users is forecast to grow from 331,000 in 1997 to more than 700,000 by the end of 2002. IDC Research predicts worldwide Internet commerce will reach $US426 billion by 2002. For investors the trick is to back the right horse, but a marginally more conservative strategy is to buy a portfolio of Internet stocks to spread the risk.

A safer play can be investing in established companies which are well positioned for Internet growth, such as telcos. These businesses offer a diversity of revenue streams without the volatility of pure Internet stocks. Another option is to invest in more traditional companies, such as retailers and banks, as they start to do more business on the Internet.