Lustrous Cobalt Dazzles (News) November 8, 1999

Lustrous Cobalt Dazzles

By Richard McCaffery (TMF Gibson)
November 8, 1999

After a blistering initial public offering November 5, shares of red-hot Cobalt Networks (Nasdaq: COBT) briefly climbed past the $140 mark Monday morning as investors decided that no price was too high for the three-year-old server appliance company.

Cobalt sold 5 million shares at $22 apiece on Friday in an offering led by investment banking firm Goldman Sachs (NYSE: GS) and watched the share price soar nearly 500% in a few hours to close at $128 1/8.

It's the latest in a string of Internet-enabling companies to go public and hardly touch the ground as investors scramble to back firms that develop hardware, software, and services that speed up anything Internet.

Other Internet newcomers to Wall Street include fiber channel manufacturer JNI Corp. (Nasdaq: JNIC), content delivery service provider Akamai (Nasdaq: AKAM), and optical network management company Sycamore (Nasdaq: SCMR). JNI is up more than 300% since its debut, while Akamai and Sycamore are up more than 500%. (Click here for Foolish takes on Akamai and JNI.)

What's all the hubbub?

Founded in 1996, Cobalt makes server appliances -- basically small, inexpensive devices easily hooked up to an existing network -- that enable companies to quickly establish an online presence. It provides applications such as website hosting and e-mail at a much lower cost than general purpose servers.

In addition, the company says its Cobalt boxes can be hooked up in about 15 minutes: Presto, instant Internet presence. Two of its products, Cobalt Qube and Cobalt RaQ, account for about 84% of its $13.8 million in 1999 revenues.

Adding fuel to its IPO fire, Cobalt's hardware is based on the open source Linux operating system, which has attracted a good deal of attention as a potential competitor to Microsoft's (Nasdaq: MSFT) Windows. Red Hat (Nasdaq: RHAT), a developer and provider of open source software and services, sparkled in its IPO last summer. Red Hat now trades at about $100 -- down significantly from its high of $135 1/4 reached shortly after its August 10 IPO.

In its prospectus, Cobalt cites a study from market research firm Dataquest that predicts the server appliance market will grow from $2.2 billion in 1999 to approximately $15.8 billion in 2003 -- a 64% compound annual growth rate. Sounds like spectacular potential.

Keep in mind, however, that the server appliance market may reach these lofty heights without Cobalt. It's very hard to pick the winners in a new industry. Ask Warren Buffett, who addressed this topic in a recent Fortune article. (It's a must-read.)

Despite its early success -- and this is not to say it isn't a great company -- Cobalt is a virtual start-up, and it's trying to grow in a new industry. It will have to generate some serious future cash flows to justify trading at these levels. Among the risks Cobalt outlines in its recent filing:

-- It isn't profitable. It lost $10.5 million in 1998 and $13.7 million in the nine months ended October 1, 1999. This means that Cobalt investors have very little in the way of operating history to analyze.

-- Its average selling prices haven't slid, but the company expects that products in the appliance server market will become more commoditized and that its price points could decline. This raises the issue of sustainability. How will the company differentiate its products and protect its turf as competition rages?

In its defense, it looks like Cobalt has done a great job of building a broad customer base in a short time. It didn't even start selling products until March of last year, yet by October 1 it had sold more than 17,000 server appliances to more than 1,300 end-user customers in over 65 countries, according to the company. That says a lot about the market's appetite for Cobalt's Web-access devices.

Still, it might be a good idea to give its products and management a chance to perform before slapping down approximately $13,881 (not counting transaction fees) for 100 shares in a firm still melting hot from its IPO buzz. Those who take this approach may not get in on the ground floor, but they'll know more about the company's business, products, and ability to execute as a publicly traded company. No purchase, at any price, is justified without a good understanding of these elements, and time will help flesh them out.

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