FOOL ON THE HILL: An Investment Opinion
Finding the Next Microsoft

While many of the competitive elements of the emerging Connectivity Age are brand new to investors, the converged network business models examined this week incorporate many features carried over from the past. Notably, the recent experience of the PC Era and its many instances of substantial value creation will have long-lasting ramifications on how businesses will be run in the months and years to come. However, a warning: Just as in previous areas, future individual business and investing success in the Connectivity Age is not a sure thing.

By Brian Graney (TMF Panic) and Bill Mann (TMF Otter)
August 11, 2000

[This is the final installment in a five-part series. Part 1, Ubiquity, Part 2: The Sunk Assets, and Part 3: Nokia and the Agnostics, and Part 4: Qualcomm, Siebel, and other Standard Bearers, ran earlier this week.]

Future Value Creators: Common Traits and Themes
Many investors have become enamored of the idea of finding the next Microsoft (Nasdaq: MSFT) or Intel (Nasdaq: INTC) or Dell Computer (Nasdaq: DELL), a never-ending hunt that the mainstream media and the explosion of Internet media (including this very website) has done a great deal to promote.

However, to mix a business book metaphor, the winners of The Gorilla Game of the future will not necessarily need to come up with The New New Thing. In the end, many of the big winners in the Connectivity Age will prove to be those firms that successfully recognize the lessons learned in the PC Age and adapt them for today's new environment.

When Sun Microsystem's (Nasdaq: SUNW) Scott McNealy long ago claimed "the network is the computer," he was both ahead of his time and wrong. In fact, the computer will ultimately be a bit player in the converged network, one of many interfaces between client and server, end user and service, and person to person. In the end, the network is not the computer. The network is the network, and computers, telephones, televisions, energy services, data assistants, and the Internet will become agents of delivery of data residing throughout the network.

These heretofore separate applications and industries will be bent to become components of a single unit. The companies that will ultimately succeed in this realm are the ones that not only apply the lessons from the PC Era, but also those that create the new business models specific to the converged network environment.

This move to a data-centric approach from a dispersed device framework is arguably the greatest unifying theme among the Ubiquity, Sunk Asset, Agnostic, and Standard Bearer business models examined this week. Data, not the PC, will be the kingmaker. The next generation of value creators will be those firms that can most profitably capitalize on the growing amount of data flowing through underground fiber optic cables, over the radio spectrum, or down from space via Ka-band satellites. But as in the PC Era before it, the profits to be made in the Connectivity Age will not be distributed equally among all of the competing players.

Summarizing the Business Model Approach
To separate tomorrow's eventual winners from the also-rans, we believe investors should become familiar with the major business models that have the potential to dominate the Connectivity Age. Some of these models, such as the Ubiquity and Agnostic models, share similarities with strategies successfully employed in the PC Era. Here, the major differentiating characteristics will be specialization, customer focus, time-to-market, asset efficiency, and branding, not to mention advantages from technologies that the companies themselves can develop.

Other models will draw less on what worked in the PC Era and are either completely new to investors or are still in the process of proving themselves as viable. Firms looking to be Standard Bearers by means of interoperable technologies or patent protection fall into the former category, while many adopters of the Distribution and Transmissionless versions of the Sunk Asset model fit into the latter. In both cases, however, barriers to entry and the potential for high switching costs will be heavily relied upon to provide sustainable competitive advantages. Meanwhile, capital needs and proprietary technological innovation will be the major differentiating factors.

As is always the case in emerging business environments, a few models will ultimately prove to be more successful and profitable over the long-term than others. Becoming familiar ahead of time with what these models are, how they have played out in the past, and how they are being implemented in the Connectivity Age is the important first step that every investor interested in tomorrow's converged network world needs to take.

Armed with a business model-oriented mindset, investors will find it easier to cull through the staggering amount of information readily available on the Web concerning the individual players themselves, making it easier to uncover useful clues as to who tomorrow's massive value creators will be. We are still in the early stages of this ultimate determination, and some of the most promising companies of today will be marginalized.

The Connectivity Age has already attracted its ration of hype. We have watched over the last 18 months as many Connectivity companies have garnered enormous stock market valuations based upon a great story, some potential, and a lot of hot air. Let there be no doubt, however, that a number of years hence, some of these companies will have been extremely cheap even at the gaudy multiples they enjoy today. For just as even Andy Grove of Intel pooh-poohed the concept of PCs being in the majority of homes, and just as Netscape missed the opportunity to be the Yahoo! (Nasdaq YHOO) portal on the Internet, it is unlikely that the ultimate value drivers for the converged network have even been imagined as of yet.

No one, not even Web forefather Tim Berners-Lee, foresaw the massive sociological change that the Internet would bring, to the point that less than a decade into its commercial acceptance, a major issue in the upcoming U.S. Presidential elections is the "digital divide." In the end, we must consider the versatility and adaptability of the technology and business being forwarded by an individual company, not just to judge its potential as it exists, but also to properly assess its ability to adapt to that which we do not yet see.

Other Considerations: People and Price
Adopting a business model approach and building up a familiarity with the Connectivity Age's early players is a very good start for anyone seeking supernormal investment returns in the future. However, such an exercise should be seen for what it truly is -- a starting point only.

As our article on Standard Bearers showed, Microsoft hit upon a great value creating business model for the PC Era that investors could have identified, and in fact many did. But even the greatest of business models needs to be implemented, and that takes capable people. Such a characteristic will not show up as a line item in a firm's 10-K financial report. Investors must find their own ways of evaluating a company's key personnel. This may entail looking at past capital allocation decisions, listening to conference call webcasts, attending trade shows, tracking management share purchases, retrieving scuttlebutt from Internet discussion boards, or a combination of all of these.

Also missing from our articles this week has been any discussion at all regarding the issue of valuation and how it should be applied to tomorrow's Connectivity Age companies. While this issue is probably deserving of a series all its own, it is important to sound at least a singular note of caution here.

There can be a psychological tendency by investors in fast-emerging business areas to overweight "the story" and underweight the price being paid, opening the door for a potential permanent loss of capital. After all, for every Microsoft or Dell, the PC Era has witnessed several Control Datas and Amdahls. Given that many of the Connectivity Age's early leaders are currently priced to perfection with market capitalizations in the billions supported by little or no cash flow to speak of, "understanding the story" should not be mistaken for "margin of safety." Although it may be cliched to believe that catching "the last 5000%" of a company's stock appreciation would be sufficient, there is a great deal of validity to this sentiment.

Concluding the Convergence Emergence
The vast majority of investors who are looking to find the next Microsoft from its nascent stages are going to be disappointed. They will instead be holding, if not the next Iridium or another spectacular flame out, companies that will stay in the race but due to their own missteps, or unforeseen changes in consumer demand, never come to dominate. Those who wish to bet on the story may do so, but they must be prepared for disappointment, because convergence is not a process that will raise all ships.

This said, there is a spectacular amount of economic gains to be derived from the buildout, application, and mass customization of this industry. This should come as no surprise to anyone who watched Qualcomm (Nasdaq: QCOM) explode for a 2600% gain in share price in 1999. But the valuation bubbles that do form should not be confused with verification of eventual victory; fortunes will be lost along the way for those who bet big and bet wrong.

The investor who is ultimately successful, just like the company that tastes eventual success, is the one who retains clarity about the fact that no one knows what the end product will look like. In the same vein, investors and companies alike who become wedded to an idea or concept to the point that it blinds them to displacing developments are apt to ride their dreams into obscurity instead of ultimate success.

Your Turn:
We are actively seeking feedback on the Convergence Emergence series. Please post your impressions on the Fool on the Hill Discussion Board, and let us know if you agree, disagree, or if there are other topics you believe deserve similar (or, ahem, better) treatment in a series.

Fool on! Brian Graney and Bill Mann
TMF's Panic and Otter on the Fool discussion boards