Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

Internet Lovers? Nope.
Plus, AOL in space and Excite makes noise

by Jeff Fischer (TMFJeff)

PARIS, FRANCE (June 21, 1999) -- The mood of the stock market remained fickle as the Nasdaq rose and the NYSE was bruised a bit. The Rule Breaker advanced on strength in its Internet-related companies.

Internet businesses continue to go public at a record pace, with over sixty initial public offerings (IPOs) behind us this year, and at least eighty more in the works. The many new offerings serve to dilute demand for Internet stocks by spreading the demand over the many options. In the past, an investor had few choices when investing in the online arena: AOL, Yahoo!, Amazon. Now we have dozens of choices. Unfortunately, most of them are not attractive.

First, when I write "Internet stock" I mean something very specific: a company that earns 99% of its revenue via an online business model. That's Amazon.com, eBay, AOL, Yahoo. When I write auto company, I mean a car manufacturing company, such as General Motors (NYSE GM). Perhaps, however, I should call it a "finance company," because GM makes more money on finance efforts than it does selling cars.

I believe that past definitions of businesses such as the above might need to be re-evaluated most, while "Internet company" as a definition should clearly mean an Internet-based company -- a company with a business that is founded and operated online. Many online companies will expand off-line, but they won't likely have the relatively expensive off-line infrastructure because they began and they focus online. Similarly, off-line companies will move online, but they won't be pure Internet companies unless they rid themselves of the baggage of their off-line past. Most will never do that.

So, "Internet company" is an untainted definition to me: it means a purely Internet-based business.

I agree with David that the term "Internet stock" is abused and that eventually all companies will have an online presence, so the definition will continue to blurr. But not all companies will be conceived online and earn 99% of revenue online, and that is what I mean by Internet company and Internet stock. It's an important distinction that I think will remain indefinitely. Wal-Mart (Nasdaq: WMT) will never be an Internet company by this definition. It will always have an off-line sales presence, for better or for worse. However, in the future I'm certain that we'll see companies strive to become pure "Internet companies" by ridding themselves of assets related to an off-line existence. Probably the market will reward management for such moves once the online business model proves most efficient for certain businesses.

Onto our topic...

Because the Rule Breaker holds a handful of online-based companies, many readers assume that we support anything Internet-related and believe in the valuations that we've all been seeing across the board. I certainly don't agree with this. In fact, the more online-based companies to come public, the more I see situations that raise serious eyebrows. DrKoop.com (Nasdaq: KOOP) recently came public with only $0.1 million in 1998 revenue and soared to over $500 million in total value based on what sustainable business advantage and on what profitability model? It's now valued at $323 million, still very high in my opinion. Meanwhile, a company such as Mpath.com (Nasdaq: MPTH) -- which does have an original business model and 2.2 million registered users, but less than $9 million in annual revenue -- was valued at nearly $1 billion on day one. It's now half that.

Salon.com will go public this week with a few million in revenue and a magazine-type business model, except it's online. How much would you pay for an off-line venture of this size? Forty million dollars, or over twenty times sales, is generous. Let's see what value Salon is given.

Another young company, Deja.com, plans to raise nearly $60 million for a business with $5 million in revenue and $8 million in losses. Deja's unique business model might grant it a high valuation when it comes public, but how many years will it require to merit the valuation? Will buying Deja.com at $800 million lead to a market-beating investment over five years? So far, that valuation has led to a 50% loss for Mpath investors. Similar losses or worse have befallen early theglobe.com (Nasdaq: TGLO), MarketWatch (Nasdaq: MKTW), and TheStreet.com (Nasdaq: TSCM) investors. (Is a site with 36,000 subscribers paying $100 per year worth over $1 billion? How about $735 million, the latest Street.com value? Thanks to a coming TV presence, perhaps the value could play out sooner rather than later. But -- there is a very large but attached at these prices.)

Then there is eToys (Nasdaq: ETYS). On its first day it was valued at $7 billion, more than Toys R Us while achieving a tiny fraction of the toy leader's sales and none of the profits. I sound Wise reciting that comparison, but the point to make is this: would you even buy an off-line toy retailer? If not, then what makes an online toy retailer that much more attractive that you'd pay such a monstrous premium for it? Do you want to invest in the business of toys at all? Toys are inventory-space demanding products that don't rejuvenate themselves well except once a year. New books and music give reason to return to Amazon's site almost every week. Toys? Uh, nope.

For the record, we probably wouldn't invest in the cut-throat book industry, either, either online or off. Fortunately, we perceived Amazon as much more than just an online bookseller, even when it only sold books. Will eToys expand in a way similar to Amazon? How? It would probably need to change its name and risk killing its brand.

In sum, I don't believe in over half of the online-based companies coming public, and I wouldn't invest in more than half a dozen of them right now -- if that -- and most of those that I would buy this portfolio already owns. So, we are not supporters of "everything Internet." We believe only in the best businesses, and those are few and far between. When the Internet gold rush mentality ends (and who knows when that will be), we're going to have hundreds of recently-public Internet-based businesses with valuations that could realistically contract for years. And we'll have the relatively few leaders that reward investors.

I know that people are looking at new online-based businesses and thinking how large they could be after five years of hypergrowth, which the Internet promises to deliver to many. However, that doesn't mean that one can buy anything online-based at any price and hope to beat the market. As with any investment, a Fool must invest Foolishly to beat the market. Calculate what you're paying for a stock as if you were buying the entire company. Would you pay $500 million for DrKoop and its single-digit revenue? How about $7 billion for eToys?

As more and more online-based companies come public, the attraction to every Internet-based IPO will subside after many of these companies report humdrum or even weak quarterly revenue. As a result, the online leaders (currently EBAY, AMZN, AOL) will attract the bulk of investors' attention again. The IPO market will become much more selective: the no-names will go unnoticed, as they used to be, while niche leaders with strong brands will be rewarded. In fact, perhaps the true leaders will be rewarded more later than they would be if they came public right now, because demand for quality is going to rise the more that we're barraged with subpar online-based IPOs. And we're being barraged right now.

Choose carefully.

The Big News
America Online (NYSE: AOL) will likely offer free Internet connection in the UK and other European countries to combat competitors like FreeServe, a free ISP in England. FreeServe launched last fall and already surpassed AOL to become number one, with 1.3 million users compared to AOL's 600,000.

Some AOL-watchers expect the company to announce as few as 70,000 new European subscribers in its latest quarter, compared to earlier estimates of 300,000. ISPs can charge users nothing in the UK and still make money by receiving a slice of phone charges. Most don't expect the free ISP model to last in Europe indefinitely, however, but in order to grab customers now a free ISP service appears necessary. AOL should move on the initiative in the next four weeks, so we shouldn't be surprised nor frightened by the sudden loss of this subscription revenue stream in the near term.

That's far from all at AOL...

America Online first expressed interest in the DirecTV satellite television business of General Motors -- Hughes specifically -- in mid-May. Today, our company announced that it will invest $1.5 billion in the space-based two-way satellite venture. This investment should give AOL's broadband and TV initiatives another medium of distribution and availability advantages over cable broadband if it launches in 2002, although satellite is still expected to be a small broadband player compared to cable and DSL. (The next Internet Report issue, out in July, covers Internet connectivity -- quite a topic.)

Jupiter Communications predicts that by the year 2002, 12% of online households will have cable modem access, 6% will sport DSL, and only up to 2% will use satellite. Others have much more hope for satellite, though, pointing out that in 1998 nearly two-thirds of new multi-channel video subscribers signed up with a direct satellite service such as Hughes. All in all, AOL's relatively small first investment in satellite compared to the 10-year potential should bode well for the company's mulit-tiered distribution plan (AOL Anywhere and AOL TV) if satellite sees moderate success.

Iomega (NYSE: IOM) is IO-nnovating again. The company announced an attack on the optical storage market and the promise of a new product, the ZipCD drive, for later this year. Iomega recently sold its twenty-fifth millionth Zip, so it has a massive customer base (larger than AOLs) that it needs to somehow leverage. New Zip products are one way. The ZipCD will store 650MB compared to 100MB for the current, basic Zip.

Iomega also announced a new business: information storage services targeted at corporations. With society increasingly moving towards service-oriented goods, the initiative sounds smart. We hope Iomega's management can make it very profitable. For the Iomega press release, visit the fool.com main page, enter IOM in the top left, get that information, and then click the "news" link.

One more bit of excitement: Excite@Home (Nasdaq: ATHM) debuted Excite Voice Chat today. The product allows consumers to speak to one another over the Internet as if on the phone, while paying nothing but the ISP charge. Bell companies frowned at the inevitable development. Excite users smiled. From the press release:

"To use Excite Voice Chat, simply click on www.excite.com and go to the People and Chat Channel, or go directly to voicechat.excite.com. At this Web site, users enter into Voice-Chat rooms, similar to existing Excite chat rooms, but can now have either live voice or text conversations with other people in the chat rooms. Excite users can talk with multiple people at once or hold private one-on-one conversations." Supposedly, the sound quality is clear.

Let's try it! If you want to chat, meet in a room titled "Fools" at 9 p.m. ET. (I'm assuming that we can name our own chat room.) I'll try my best to be there, too. If a "Fools" room isn't available when you get there, create it if possible.

Finally, Amazon (Nasdaq: AMZN) is practically expected to announce a toy store this month, and eBay (Nasdaq: EBAY) again has 2.2 million items up for auction at its site. It had 2.2 million before last week's blackout, after which it steadily declined to 1.7 million.

To close, it seems Foolish to share that this column was written outdoors (a first for me) surrounded by plants and music at a cafe. The diminishing ranks of the Wise, probably working from gray-halled offices and wearing white starched shirts -- that won't last. Anyway, Paris is celebrating an annual night of music (Fete de la Musique) and you can't walk more than a few blocks without hearing live music. So, at a small, outdoor cafe table, this column was quietly typed under the drum of music. (Fresh air was a necessity after being indoors all day.)

Technology: I'm immeasurably glad for it. Be Foolish, enjoy, and Fool on!

06/21/99 Close
Stock  Change    Bid 
------------------ 
AMGN  -  3/16    52.88
AMZN  +12 3/16  123.50
AOL   +3 1/4    115.75
ATHM  +5 7/16    57.88
CAT   -  5/8     60.88
CHV   -2 1/2     90.69
DD    -1 3/16    70.19
DJT   +  1/16     4.75
EBAY  +5 7/8    152.06
GT    -1 1/8     57.31
IOM   +  5/16     4.13
SBUX  +1 9/16    38.50
TDFX  +  1/2     15.75


             Day     Month  Year   History   Annualized 
R-BREAKER  +4.82%  -2.81%  30.07% 1205.48%   69.37%
  S&P:     +0.45%   3.62%  10.32%  208.54%   25.99%
  NASDAQ:  +2.61%   6.47%  19.96%  265.23%   30.43%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    115.75   12635.88%
   9/9/97  1320 Amazon.com     6.58    123.50    1777.12%
  5/17/95  1960 Iomega Cor     1.28      4.13     222.16%
  12/4/98   900 Excite@Hom    28.04     57.88     106.40%
  2/26/99   300 eBay         100.53    152.06      51.27%
  4/30/97 -1170*Trump*         8.47      4.75      43.91%
   7/2/98   470 Starbucks     27.95     38.50      37.72%
  2/23/99   300 Caterpilla    46.96     60.88      29.62%
 12/16/98   580 Amgen         42.88     52.88      23.32%
  2/20/98   260 DuPont        58.84     70.19      19.28%
  2/23/99   290 Goodyear T    48.72     57.31      17.65%
  2/23/99   180 Chevron       79.17     90.69      14.55%
   1/8/98   425 3Dfx          25.67     15.75     -38.64%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 254650.00  $252650.53
   9/9/97  1320 Amazon.com  8684.60 163020.00  $154335.40
  12/4/98   900 Excite@Hom 25236.13  52087.50   $26851.37
  2/26/99   300 eBay       30158.00  45618.75   $15460.75
 12/16/98   580 Amgen      24867.50  30667.50    $5800.00
  5/17/95  1960 Iomega Cor  2509.60   8085.00    $5575.40
   7/2/98   470 Starbucks  13138.63  18095.00    $4956.38
  4/30/97 -1170*Trump*     -9908.50  -5557.50    $4351.00
  2/23/99   300 Caterpilla 14089.25  18262.50    $4173.25
  2/20/98   260 DuPont     15299.43  18248.75    $2949.32
  2/23/99   290 Goodyear T 14127.38  16620.63    $2493.25
  2/23/99   180 Chevron    14250.50  16323.75    $2073.25
   1/8/98   425 3Dfx       10908.63   6693.75   -$4214.88

                              CASH   $9924.87
                             TOTAL $652740.50
 
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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