How to Invest in Emerging Industries[Fool on the Hill] June 19, 2000

An Investment Opinion

How to Invest in Emerging Industries

By Warren Gump (TMF Gump)
June 19, 2000

The past couple of years have offered companies many opportunities to make tremendous short-term profits by announcing participation in new markets. In the heyday of the mania (can we already start to fondly remember the "glory days"?), companies would need to do little more than say they were entering the online garbage business before their stock would soar into the stratosphere. An old line company could easily see its stock jump up by 50% or more by "investors" looking to participate in an emerging market segment.

This enthusiasm was supported with pretty reports from Gomez Advisors, Jupiter, or Forrester Research stating how huge the markets were going to be. By 2004, the online garbage business could hit $15 billion, a Jupiter analyst might proclaim. Gomez could make that estimate look paltry, proclaiming the market would actually approach $25 billion over the next five years. A mighty difference, but the point is made: this market's going to be BIG. (Perhaps Gomez' inclusion of advice from Wall Street analysts, CNBC talking heads, and myself account for the difference?)

Given the warm market reception for one company entering the market, many others would soon follow suit, proclaiming their plans to take advantage of this tremendous opportunity. Before long, a dozen firms would have announced intentions to become leaders in the market -- some upstarts funded with deep venture capital pockets, others established firms with valuable brand names and cash flow (supported by deep venture capital pockets). Everyone was at the party, spending hundreds of millions of dollars on marketing, technology, and people to build a premier online presence.

Then reality hits, and while the market was estimated at $15-$25 billion four or five years out, it was only a few million today. Making matters worse, the only way to get people to spend those few million dollars is by offering services with low (possibly even negative) gross margins. Losses accumulate, stock prices fall, cash runs low, and venture capitalists stop funding. Companies that six months earlier were ready to become the "AOL" of the online garbage business end up closing down, restructuring, or selling out at discount prices.

The above scenario is completely fictitious, but it does in some ways resemble what happened with the online toy business. Over the past couple of months, this one-time exciting business has been awash in canceled public offerings, closings, layoffs, and bargain-priced acquisitions. Consolidated Stores (NYSE: CNS) recently said that its unit would forego a public offering because of weak market conditions. This news follows last month's firing of 30% of the unit's workforce, including its CEO.

At least is still in operation. Many of the companies have been shut down or sold. Viacom (NYSE: VIA) closed down its Red Rocket educational site in early May. Also that month, Walt Disney (NYSE: DIS) terminated its business after negotiations to find additional financing failed. The line of dying toy e-tailers got a little larger in early June, when and closed down their sites.

Even the biggest players aren't experiencing the best of times. EToys (Nasdaq: ETYS) announced a $100 million financing on Wednesday. But getting this money, which combined with current cash balances should last through late 2001, carried a steep price. The company had to issue convertible preferred stock with a 7% dividend yield, plus give a "kicker" of 5 million warrants with a $7.17 exercise price. That price is a heck of a lot lower than the $20 paid for shares in the May 1999 initial public offering (not to mention the $86 people paid for shares at their October high).

One company that was written off last year now exhibits some signs of strength., funded by parent Toys 'R' Us (NYSE: TOY) and a venture capital group led by Softbank, announced that it's continuing to grow, preparing to open up dual headquarters and adding staff. In addition, it's taking advantage of competitor woes, picking up the inventory from Viacom's shuttered Red Rocket unit and signing an agreement to sell Nickelodeon merchandise. The company may have started a little later than competitors and made a slew of missteps, but it is now utilizing its brand and financial strength to its advantage.

It's way too early to determine who, if anyone, will be a winner in the online toy retailing business. Before claiming "success," these companies will need to figure out how to profitably provide their service. One thing that is clear is that some companies moved too quickly out of the gate and fell flat on their face. This should be a reminder that it's imperative to evaluate business models, competitive threats, management, and financial strength when investing in emerging businesses, regardless of how exciting the sector appears. Yes, even in "giants-to-be" like biotechnology, fuel cells, fiber optics, and wireless.