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Fool On The Hill

Thursday, December 3, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

The Internet and Human Endeavor

You're probably going to see this on the television news tonight or hear about it on your favorite morning radio show on the commute to work tomorrow, because I'm lifting the idea from a press release I read today. An America Online/Roper Starch "cyberstudy" (I thought we stopped creating words using using the prefix "cyber" sometime in 1996) released today shows 44% (+/- 3%) of the 1001 adult respondents who subscribe to an online service believe their Internet connection is a necessity. The majority of the respondents replied affirmatively to "feeling good about being online" questions posed in the survey. Most people believe that the online medium has improved their lives.

That's pretty powerful stuff, considering that over one-quarter of those surveyed have been online for a year or less. Their enthusiasm isn't just the result of newbie excitement about getting "wired" on the "'net." The more time a person has spent online, the more they have integrated online access and content into their lives. However, I would bet people thought the same thing about television in the 1950s and radio in the 1920s. Just how different will the Internet be from TV's influence on American society and world culture? Sure, the Internet is supposed to improve democracy and unshackle information blah blah blah, making for more perfect political unions. But online political forums can be really tiring to read and dulling to the soul in the factiousness of the debate. Some people would contend that the world has become more fractious because of new media and that the general level of the cacophony created by mass media has risen with each new innovation.

Well, maybe this is blas�, but I've come to the point where I view the machine on my desk as pretty much an appliance. It's a stack of circuit boards and semiconductors, and it does allow me to do things I never did before. Such as make trips to the bookstore on a weekly basis, whereas before that wasn't a viable option because I loathe shopping malls. Such as buy a car online, which I did earlier this year. Such as look up SEC filings rather than rely on occasionally unresponsive investor relations departments to send me those filings. I definitely appreciate that. But no longer do I marvel at the medium. No longer is the subject of how the Internet is changing the world a subject I want to talk about at a party. It's actually a boring topic.

What does this mean for investors? Not to worry, it means a lot. It means that after almost five years of using this medium for communication, it's no longer a novelty. It's mainstream and it's the way it's going to go for the rest of our lives and beyond. It means that eventually PC companies will no longer be fast-growers with great economics if managed right. They'll basically be television manufacturers. America Online (NYSE: AOL) and Yahoo! (Nasdaq: YHOO) will be like ABC and CBS and not akin to ham radio as they were in the beginning. AOL started as a platform for the distribution and play of video games, and Yahoo! was someone's list of bookmarks or "favorite places," for crying out loud. Now their market caps are multiples of the equity market value of Capital Cities/ABC when that company was acquired by Walt Disney Co. (NYSE: DIS) three short years ago.

Some people will say this is the result of mass investor delusion, that this is a bubble. While I'm quite ready to say that valuations are inflated, I'm not so skeptical to pass off as wildly overvalued anything that trades at 50 times book value or 20 times revenues. A company's value is driven by the value of the free cash flows it can produce over its lifetime. It's not driven by how much equity is on the balance sheet today or how many dollars of revenues it's generating today. Those are heuristics that serve as data points in assessing the value of a company. They don't tell you on their own what a company is worth.

Yesterday, I was told that I had hyped Amazon.com (Nasdaq: AMZN) because I compared the company to GEICO Direct Auto Insurance, a unit of Berkshire Hathaway (NYSE: BRK.A). This person told me that GEICO's business model all but assures it of making a profit, while Amazon.com's model is much different. Let's leave aside the notion that "all the rules have changed because of the Internet." They haven't. Companies will still be poorly managed and a select few companies will be very well managed, no matter what the medium of commerce is. If established competitors could just come in and crush entrepreneurial ventures, you'd be going down to Montgomery Ward this weekend rather than Wal-Mart (NYSE: WMT). And you'd be shopping at Ace Hardware rather than at Home Depot (NYSE: HD). You'd also be reading this data delivered to you through a Bell Labs router on your Digital Equipment Corp. computer with IBM Windows 98 as your operating system.

You might have picked up your computer at your favorite warehouse club at a severe discount, but don't try to tell that to people who want to sell Amazon.com short based on its low gross margin and the impossibility of the company to avoid the inevitable pricing pressures that will ruin all Internet retailers. According to such people, you can't make money on gross margins of 22%, and forget about it if you try to make money on gross margins of 12%. All of this ignores the very real fact that there are companies that make tons of money on gross margins of 20%, 15%, and under 12%. And these companies are very much cash flow positive, too. If you're having a tough time with that one, check out Costco's (Nasdaq: COST) numbers and the way it moves its inventory. Look a its cash conversion cycle (days in inventory plus days in receivables minus days in payables) and then compare that with all sorts of other companies. While you're looking at companies with gross margins under 12%, take a look at B.J.'s Wholesale (NYSE: BJ).

The very best Internet retailers have a very good shot at staying around. I won't say they will stay, because I don't know what jackass might come along five years from now and wreck a good franchise. The Internet is a fact of life and it's going to stay. And look out when midband and broadband pipes start to become commonplace for consumers. The way we invest, the way we communicate, the way we gather information to understand what's going around us, and the way we do a lot of things has been irrevocably changed. But that doesn't change the fact that human capabilities and outcomes are spread across normal distributions. In other words, not every retailer that operates on the Internet is going to be an incredibly well-run company. Not every retailer that has to deal with the fact of 10% gross margins will be a success. Not every Internet portal will be a good information aggregator just because it's called a portal in the company's press release.

Investors should realize that there are companies that will strike it huge on the Internet because they have the human talent, financial capital, the right products or services that customers want, and a rapidly growing market penetration in American, and eventually worldwide, homes. Low margins are a red herring, and the fact that a company might not be making money today doesn't mean that it will never make money. Arguments predicated on the perfection of competition on the Internet and the total destruction of competitive advantages born of brand names or goodwill that a company can build with its customers are pretty much at odds with the history of commerce over the last two hundred years. New companies will take advantage of new technologies and learn how to become preeminent in whatever industry in which they operate.

So get used to the fact that the Internet is here to stay and that it doesn't break all the rules that apply to human endeavors and that it will fulfill the rules of perfect competition that we suffer through in Econ 101. (Barron's had a great piece on this recently). Maybe competition will approach this condition more closely, but it won't ever get there while there's a service element to be overlaid onto a commodity good that is being sold. Whatever its effects on society and all the endeavors of the members thereof, for ill or for worse, the Internet brings incremental changes to how we already live our lives. It doesn't change everything, and it doesn't revoke time-tested truisms of the way things go.


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