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Wednesday, January 13, 1999

An Investment Opinion
by Louis Corrigan

What to Make of Compaq's Deal For

The surprising market moves we've seen in Internet stocks over the first two weeks of 1999 can leave one speechless. Over three days, online broadcaster (Nasdaq: BCST) runs up from $85 to $285, largely on the expectation of a stock split. Meanwhile, leading online portal Yahoo! (Nasdaq: YHOO), valued at about $27 billion on December 31, finds itself worth $51 billion by yesterday afternoon only to end the day worth $46 billion. Today, after another rocking earnings report, it opens down $7.6 billion only to close the day worth $42 billion.

Yet, the most surprising event so far this year may be the Monday morning announcement from Compaq (NYSE: CPQ), the world's top consumer PC manufacturer, saying it plans to acquire troubled online retailer (OTC Bulletin Board: IBUY) for $19 per share, or a total of $220 million. In cash, no less. The deal raises questions not just about Compaq's plans to capitalize on the Internet but about the value of third-tier Internet companies in general. In short, if a blue chip technology company like Compaq is willing to shell out such big bucks for what many short-sellers consider a thoroughly suspect enterprise like, then we may have entered the realm of corporate speculation on the Internet. Or, the naysayers may have badly miscalculated what some of these companies are really worth. In either case, the deal has left some short-sellers who dabble in third-tier Internet names feeling a bit spooked.

Based in Corona Del Mar, California, is an online retailer of over two million brand-name products, such as computers, books, office supplies, and CDs. Its online store consists of 16 categories of merchandise and services available through 1,000 different merchants. acts basically as an online intermediary between consumers and these suppliers. Its e-commerce software allows suppliers to be contacted directly to ship customer orders as they're received by the firm's virtual storefront. This commission model is ultra-light, meaning doesn't have even the inventory or capital requirements of an (Nasdaq: AMZN).

Despite opening for business on July 11, 1997, and scoring an 18-month online real estate deal last January with leading broadband Internet service provider @Home (Nasdaq: ATHM), doesn't have much to show for its efforts. While Amazon added a million new customers during its six-week holiday season alone, claims only 100,000 customers total over the past 15 months. For the first nine months of FY98, lost $18.9 million on sales of just $4 million. Moreover, it ended the third quarter with negative working capital and a negative book value.

Even better from a short-seller's perspective was the company's rocky history, part of which I outlined last March around the time the SEC halted trading in the company's shares for 10 days while it investigated possible market manipulation. was taken public by Waldron & Co., a brokerage firm based in Irvine, California. In the middle of the IPO process, Waldron learned that Nasdaq refused to list the company even on its SmallCap market because CEO Robert J. McNulty had violated the securities laws in the past. (Though he neither admitted nor denied the charges, he signed a decree in U.S. District Court on October 10, 1995 that enjoined him from violating the securities laws in the future.) Waldron, then, had to sell the shares only to high-net-worth individuals. Faced with that dilemma, Waldron allegedly engaged in unethical practices that drove some of its own employees to call up the National Association of Securities Dealers to complain. (Nothing has yet come of those charges.)

In any case, McNulty, who owns a third of the stock according to the last proxy, was out as CEO by June. John Markely, a management consultant, was brought in as the new CEO at that time. Of course, Chair Frank Denny, former Chair/CEO of Builders Square, had only joined the board in April. Yet, these management changes weren't the last. Just last week, the company announced another shakeup. Randall Read, former CFO at Stone Container, would become the new chairman while Denny slid into the CEO's position and the company brought in a new CFO. Three CEOs in 8 months suggests is more like a circus act than a cutting-edge online retailer. Indeed, the company's entire history would suggest this is a business one should avoid at all cost. went public at just $9 a share in November 1997. Even after soaring to nearly $33 a share last spring amidst one wave of Internet fever, the company was only worth $132 million based on the 4 million shares outstanding noted in the company's 10-Q filing. Of course, that underestimated the dilution from the gobs of outstanding warrants, preferred stock, and options. The Compaq bid suggests there are now some 11.6 million fully diluted shares outstanding -- and there's been no stocks split in the interim.

More important, Compaq's bid looks eye-popping based on where has been and given its dire financial straits. In September, it fell as low as $1 a share. As recently as November, even after the broad indexes recovered, it traded for less than $2 a share. Compaq's offer, then, represents not just a premium of nearly $6 per share from the stock's close last Friday. It values at 900% more than investors were willing to pay for the company just two months ago!

Why did Compaq's management decide to move now rather than two months ago, when they surely could have saved shareowners at least $100 million on the purchase. Has Compaq's strategy or the competitive environment really changed so much in so short a time? Perhaps it has. America Online's (NYSE: AOL) deal for Netscape (Nasdaq: NSCP) and the huge valuations being afforded Yahoo! and Amazon suggest that investors are willing to pay quite a bit for viable Internet portals and e-commerce sites. Compaq management seems to think they can play this game, too.

When Compaq acquired Digital Equipment last year, it picked up the highly respected Alta Vista Internet search engine in the process. According to Media Metrix, Alta Vista ranks number 10, ahead of even, among the most highly visited websites, with some 11 million visitors per month. Yet, Compaq has appeared uncertain about how to capitalize on this asset. Rumors have repeatedly floated that Compaq might simply spin-out this search service. The deal appears to be a means for Compaq to sell this spin-out as a true e-commerce contender.

Rod Schrock, general manager of Compaq's consumer products unit, told Reuters that a link to Alta Vista could drive 10 to 25 times more traffic to by the end of this year than it receives today. "We definitely plan to turn into a premiere shopping site on the Internet," Schrock told Reuters. "In our estimation, has one of the most state-of-the-art shopping capabilities" of any site on the Web.

So Compaq appears to be saying, what's $220 million if we can use this company's technology to help create a viable e-commerce portal that we can take public amidst the current Internet frenzy. No doubt, it could prove a smart business deal even if it looks to some like a game of corporate speculation on the current Internet frenzy. Nonetheless, at least one short-seller who says he's never been short still thinks was merely a "stock promotion." He argues that Compaq "probably hasn't done much due diligence" on the company. That's something to keep in mind if Compaq does spin-out its Internet business. Given's history, it would simply be surprising if it's really worth what Compaq is paying for it.

Related article:
-- The Dangers of Bulletin Board Stocks (3/27/98)

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