Lycos and the Valuation Blues (Fool Plate Special) November 16, 1999

An Investment Opinion

Lycos and the Valuation Blues

By Brian Graney (TMF Panic)
November 16, 1999

Internet portal, online community, and e-commerce company Lycos (Nasdaq: LCOS) turned in its fiscal first quarter results last night, which were largely in line with analysts' expectations. Keeping with its amazing tendency to put out at least two or three press releases daily, the company also announced an agreement to carry nearly all of the content of Microsoft's (Nasdaq: MSFT) news, politics, and culture Web-zine In addition, Lycos launched a personalized online shopping cart called LYCOShop Recommends for its e-commerce efforts, which is powered by technology from Net Perceptions (Nasdaq: NETP).

Overall, the firm's quarterly results were solid and indicated a company going in the right direction. Revenues grew 126% year-over-year and 24% sequentially to reach $56 million. Earnings per share (excluding amortization of intangible assets) was $0.01, in line with the First Call mean estimate. Interest income bailed out the company during the quarter and masked an operating loss of $505,530, which wasn't all bad considering the $4.5 million operating loss posted during the same period last year.

The much smaller operating loss is impressive considering the amount of money the company is spending to grow its four-year-old operation. Among the major expense items, R&D spending rose 75% from a year ago, sales and marketing expenses (including Labrador Retriever mascot costs) jumped 86%, and general and administrative costs climbed 119%. For comparison's sake, portal leader Yahoo! (Nasdaq: YHOO) saw overall generally lower advances of 88%, 62%, and 30% in the same respective accounts during its September quarter.

Comparing Lycos' valuation to its higher-profile Internet brethren and crying "Injustice!" is one of the favorite pastimes of Lycos President and CEO Bob Davis, who touched on the issue again during last night's conference call. "There's still a substantive valuation gap between ourselves and many of our competitors," Davis reportedly commented. In all fairness, the gap is less glaring today compared to three months ago, when Lycos' shares were fetching 40% less.

Many sell-side analysts, ever seminal in their valuation work regarding Internet companies, have picked up on the discrepancy and have taken to regurgitating Davis' viewpoints in their research reports. Currently, 21 of the 24 analysts tracked by Bloomberg as covering the stock have "buy" or equivalent ratings on Lycos, with the valuation gulf the major intellectual basis for many of the bullish opinions.

On paper, Davis' gripes appear to have some merit. The firm's 70/30 split between advertising and e-commerce revenues makes Lycos a hybrid portal, but comparing the firm to both Yahoo! and e-commerce leader (Nasdaq: AMZN) does not seem inappropriate. (This is Internet valuation, remember.)

In terms of business momentum, the three horses are running a pretty tight race. Over the past six quarters, Lycos has posted 20% compounded top-line growth, comparable to Yahoo!'s 23% growth and Amazon's 20% growth. Also relatively comparable are Media Metrix's unique visitor counts for the three firms. Yahoo! properties sported 38.4 million uniques in September, a respectable but not crushing lead over number four online property Lycos and its 27.6 million uniques. For what it's worth, Lycos whomped the 12 million monthly uniques attributed to Amazon.

In terms of average daily page views, Lycos' figure of 82 million in the past quarter loses big to Yahoo!'s 385 million. But does that alone justify the $55 billion market cap gulf between Yahoo! and Lycos, or the $20 billion leap between Lycos and Amazon?

Throwing the numbers out there and drawing the conclusion that the market is wrong may seem like a logical solution, but that kind of connect-the-dots thinking amounts to half-baked analysis. The market may not be perfectly efficient in the short run, but it's not off by $50 billion very often either. Rather than chalking up the difference to valuation junk science standbys such as "branding" and "first mover status," the market may be discounting something else -- namely, the "real options" that are perceived to be available to the three companies.

In an article on the subject earlier this year, CS First Boston analyst Michael Mauboussin concluded the following: "Investors must be attuned to the fact that stock prices may incorporate real options value. This options value is often not obvious from just looking at current businesses. The goal is to identify those companies that have options and are most likely to exercise them prudently." Viewed through this lens, the market appears to be willing to value Amazon and Yahoo!'s ability to execute at a much greater level than Lycos. If this reasoning is indeed correct, then closing the valuation gulf is not a job to be handled by the market, but by Davis and the rest of Lycos' management team.

Related link:
Michael Mauboussin, "Get Real: Using Real Options in Security Analysis"