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Wednesday, March 10, 1999

An Investment Opinion
by Louis Corrigan

Why New Economy Companies Are Different

Many have commented on the allegedly ridiculous valuations of the best-known Internet stocks. Yet, it's discouraging to see naysayers still using terms that betray an intellectual framework that's incapable of seriously addressing the matter. Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups. The bears just don't seem to understand the bull case well enough to make a real stab at refuting it. Of course, even the bulls have more trouble explaining their faith than maintaining it.

So the top Internet stocks keep going up, and the market screams that there's something hugely different about these businesses. Meanwhile, the critics insist in authoritative tones that bubbles get created by exactly such a gullible insistence that this time is different -- when it never really is. It's worth asking, then, what's different, and how do we know? Put another way, is there really such a thing as a New Economy company, and if so, does it require that we use new valuation metrics?

In short, yes and no. At least, that's the answer Michael Mauboussin, the well-regarded head of value-based research at C.S. First Boston, gives in a recent paper called "Cash Cash Economics in the New Economy," co-authored with his assistant Bob Hiler.

In Mauboussin's view, (Nasdaq: AMZN) and Yahoo! (Nasdaq: YHOO) are New Economy companies with dramatically more attractive business models than their Old Economy counterparts like Barnes & Noble (NYSE: BKS) and The New York Times (NYSE: NYT). He concludes this from applying the same valuation standard -- free cash flow -- to all of these stocks. "We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."

By free cash flow (FCF), Mauboussin means something quite specific: cash earnings plus or minus cash investments. Cash earnings differ from "accounting earnings" -- regular old net income or earnings per share -- in that you back out the distortions created by goodwill amortization and financing costs. To get cash earnings, you basically begin with earnings before interest and taxes and then subtract cash taxes (or what the company would pay in taxes if it wasn't getting a tax break from its debt financing). By cash investment, he means the outflow or inflow of cash as the result of changes in working capital and fixed assets. Most businesses require lots of cash to pay for new property, plant and equipment (PP&E) and to fund inventory and other working capital needs. Unless suppliers are offering very attractive payment terms while customers are paying immediately, such investments typically result in a significant cash outflow, which must be subtracted from the FCF.

The nitty gritty adjustments one can make to these figures can get complicated, but what's of crucial interest to us here is the rationale behind this approach. Reported earnings, per se, just don't tell you what you really want to know -- which is how much net cash a company can generate for its owners over the long haul after subtracting what it takes to run and grow the business. To answer that, investors must focus not just on the income statement but on the balance sheet. For example, managers can improve a business by producing the same cash earnings with fewer assets. Even though the income statement might look the same, the balance sheet will tell shareowners that they're actually getting more bang for their buck. Doing as well with less is the same as doing better. Doing more with less is even better. This is why P/E ratios and earnings growth rates are, at best, mere surrogates for measuring real value creation.

Mauboussin takes this insight a step further by showing why earnings are a woefully inadequate surrogate for evaluating New Economy companies. These firms are far more capital efficient than their Old Economy counterparts. Indeed, cash earnings alone typically overstate the real FCF of the latter while understating the FCF of an Amazon or a Yahoo!

According to Mauboussin, Barnes & Noble produced around $150 million in cash earnings for the twelve months ending October 31. Yet, this retailer invested about $245 million net in long-term assets (like new stores) and working capital (like books to stock the stores). The result was FCF of negative $95 million. Barnes & Noble has operated with negative FCF every quarter since it went public. By contrast, Amazon delivered negative cash earnings of $58 million in FY98, but negative FCF of just $4 million overall. That's because it costs a lot less to scale an online store once the major infrastructure is in place. You don't have to spend a lot on construction, leases, and inventory. Also, Amazon pays its suppliers long after it gets paid by its customers, meaning that customers and suppliers are funding Amazon's working capital, as fellow Fool Dale Wettlaufer has pointed out repeatedly. So Amazon generated a $54 million inflow of cash investments that nearly wiped out the negative $58 million in cash earnings last year.

FCF scoreboard
Amazon -$4 million
Barnes & Noble -$95 million

On the only performance metric that really counts to Mauboussin, Amazon is already kicking its competitor's butt. Yes, profitable old-line businesses like Barnes & Noble could curtail its growth, cutting its cash investment outflow and producing a positive FCF overnight. However, a New Economy firm's ability to leverage current assets means that rapid expansion should actually accelerate its generation of cash investment inflows and, ultimately, positive cash earnings. That's why New Economy companies really are different.

Mauboussin offers a useful grid to depict this difference and to highlight the distinct "cash economics lifecycles" at play.

          Investment Outflow         Investment Inflow

Earnings  Profitable Buildout        Super Cash Flow
Inflow    (Barnes & Noble)           (Yahoo! today; Amazon in future?)
Earnings  Value Destruction  or      Turnarounds or Emerging Capital
Outflow   Start-up (Amazon Q1 FY98)  Efficient Company (Amazon today)
The horizontal cross-sections focus on cash earnings (the income statement) where inflows are better than outflows. The vertical segments focus on cash investments (the balance sheet) where inflows are better than outflows. So the sweet spot is the upper right quadrant.

Both Old and New Economy companies typically start in the bottom left quadrant by spending a lot to build basic infrastructure and inventories while still reporting earnings losses. Successful Old Economy companies eventually jump to the top left box where they hopefully remain for years, investing lots in the business while delivering healthy cash earnings. At some point, marginal returns on new invested capital start looking less attractive. After all, there's probably no point building Barnes & Noble bookstores across the street from each other. That's when investment spending declines to the level required simply to maintain existing facilities, dropping investment outflows toward zero while boosting cash earnings and bumping overall FCF higher.

Successful New Economy businesses act quite differently. After the start-up phase, they first move toward the bottom right quadrant (investment inflow, earnings outflow) rather than up into positive cash earnings. The most dynamic businesses then move up into that prime real estate occupied by Super Cash Flow companies that generate both earnings and investment inflows. Mauboussin notes that Yahoo! and Dell (Nasdaq: DELL) have occupied this sacred space of late. (Dell has recently, and perhaps only temporarily, veered into the Profitable Buildout quadrant since it has willingly sacrificed investment inflows in order to win more business from large corporate customers demanding looser payment terms.) Yahoo!'s super high gross margins and readily scalable business allowed it to move with lightning speed from the bottom left quad to the top right. Amazon's business model provides less leverage, but the logic of this New Economy lifecycle suggests Amazon could end up in the Super Cash Flow camp as well. The market agrees.

Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture. It's a picture that simply looks different for New Economy companies than it does for traditional firms. Cash inflows from the balance sheet make an Amazon or Yahoo! more attractive than cash earnings alone would suggest. Meanwhile, outflows from cash investments make a Barnes & Noble, New York Times, or Wal-Mart less attractive than they seem from their cash earnings alone. This means that even if an Old Economy company sports the same earnings per share and same earnings growth rate as a New Economy firm, the latter likely deserves a higher P/E, perhaps a much higher P/E, because its overall cash economics are almost certainly superior. This is why Mauboussin concludes that "there are solid fundamental underpinnings behind the high valuations in the Internet sector."

Related articles:
-- Michael Mauboussin, Cash
-- Momentum vs. "Value" Options 1/29/99
-- Amazon Impresses Again, 10/30/98
-- Amazon On My Mind, 5/5/98
-- Valuing Hypergrowth, 5/1/98

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