Manager's Journal: Big Profits Are in Store From the Online Revolution

Author: By David D. Alger

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Abstract (Abstract): 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.
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.
Full text: 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.
---
Mr. Alger is CEO of Fred Alger Management, a New York-based investment firm.
(See related letters: "Letters to the Editor: Perfect Competition, Zero Profit" -- WSJ April 30, 1999)
Subject: Managers journal (wsj); Internet; Stock prices; Electronic commerce; Industrywide conditions; Business
forecasts;
Company: America Online Inc
Publication title: Wall Street Journal, Eastern edition
Pages: A18
Number of pages: 0
Publication year: 1999
Publication date: Apr 26, 1999
Year: 1999
Publisher: Dow Jones & Company Inc
Place of publication: New York, N.Y.
Country of publication: United States
Publication subject: Business And Economics--Banking And Finance
ISSN: 00999660
Source type: Newspapers
Language of publication: English
Document type: Commentary
Accession number: 05513250
ProQuest document ID: 398703865
Document URL: http://search.proquest.com/docview/398703865?accountid=143960
Copyright: Copyright Dow Jones & Company Inc Apr 26, 1999
Last updated: 2010-06-26
Database: ABI/INFORM Complete
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