Valuation and other IR imponderables in a volatile industry
It's a crazy world out on the wild and woolly internet frontier, possibly the fastest-paced, fastest-changing industry that the world has known. It is a world with almost no predictability, where traditional valuation models are outdated, companies that lose money can be the most sought after, and investors are forced to compare companies that specialize in a bewildering array of products, services and business models. All this without much precedent. 'There's a lack of history to point to so we are all trying to understand what the future holds without much of a guide from history, and that's the hardest thing,' says Mark Rowen, internet analyst at Prudential Securities. Clearly, doing investor relations in this world presents some special challenges.
For starters, few internet companies make money and those that do don't make much in proportion to their valuation, at least based on traditional valuation models. Three or four years ago the answer to the valuation question was to look at Amazon.com, one of the first companies to be successful on the internet, and use its model to determine whether other internet companies would be successful. 'That just meant, if you keep losing money, you must be worth more,' says Joni Hanson, director of IR for Infospace.com. 'At some point the tides turned and people said, Hey, hey that was okay for a while but now you are out of my comfort zone. And you guys need to tell us what your plans are,' says Hanson.
According to Amazon.com's director of IR, Russ Grandinetti, valuing Amazon, or any net stock, is trying to understand the present value of future cash flows, and creating a framework to understand it by looking at what the drivers of value are and how the long term might look.
Barbies vs fridges
Until recently, analysts were on their own trying to figure out how to predict the future. But in recent earnings releases more companies are also working with analysts to come up with new ways to value companies, leading to a redefinition of the relationship between dot.coms and analysts. Companies are stepping up to the plate and giving more metrics, basically saying, 'This is how you judge my company, this is how you value my company.'
At Infospace.com, the corporate executives have endeavored to break down their businesses and revenue streams and give specific metrics for each division or each area of services. That way, analysts can start to understand quarter-over-quarter and year-over-year how the company is doing. Like so many internet companies, Infospace's products and services are a network of relationships, much more slippery to quantify and value than say Barbie dolls or refrigerators. 'We don't build software so it's not as if we could tell you how many boxes of software we are going to sell,' says Hanson.
Infospace's merchant services area, for example, provides merchants with online transactions as well as visibility. It offers tools for local merchants to get online and conduct transactions on the web; and it helps them enter into a network where they can be used and seen and trafficked. The company works through distribution partners and other local media networks like newspapers; part of its revenues takes the form of the licensing fees it receives from them. Each deal Infospace signs brings a guaranteed payment each month for it to resell Infospace's services, plus various other fees per month.
'So in merchant services we look at how many merchants are using our services,' explains Hanson. 'And how many resellers are reselling our services, how many products are in our merchant network. So those are the kind of metrics we are using to say how successful we are at getting our products integrated and adopted in the market.'
Such breakdowns of revenue streams are clearly useful, but it was not obvious at the onset whether they would really provide the answer. 'It took us a year to get there,' acknowledges Hanson. 'We were saying Why aren't people getting it? We get it. You really have to break things down and really give them measurables that they can understand and that they can accept. A lot of what people used to use were traffic numbers and we see more and more that's not appropriate anymore, because it doesn't accurately reflect how your business is doing.'
The take home message from Hanson is this: any help you can give analysts in determining the value of internet companies is very well received and very much appreciated. It's also likely to help build a positive perception in the market.
Info jam
But despite some companies' efforts in providing more metrics and more detailed breakdowns, Prudential's Rowen says that internet companies still do not disclose a huge amount of information, which makes evaluating the companies harder. 'I think it would better serve investors if they just released more information,' he says.
Companies are extremely selective in what measures they choose to release for two reasons. First, they want to release information that makes the company look good or, at least they can spin it in a way that looks good. But that involves some planning ahead. 'They are very selective and they have to be careful, because once they do disclose it there is an expectation on the part of investors that they will continue to disclose. So they don't want to disclose a measure that makes them look good one quarter but may make them look bad in following quarters,' says Rowan. Another factor, he notes, is that some of the information could give competitors an advantage.
Analysts like Rowen are looking for information that can help them compare companies. The valuation models Rowen uses include two traditional methods and two methods that the team at Prudential Securities has developed. The first traditional method, comparative metrics, compares price to revenue or price to gross profit. This allows for comparisons of say Amazon.com to Barnesandnoble.com. The problem is it does not tell whether there is a bubble around the entire sector. 'So if you are comparing a company to Yahoo you are not really sure if Yahoo is correctly valued or not,' says Rowen.
The second traditional method, discounted cash flow models, are problematic because if you change some of the assumptions such as the discount rate or the growth rate, you get tremendously different answers because you are discounting so far into the future. The two methods that Prudential developed include the customer acquisition payback period, which measures the amount of time it takes for a company to pay back its customer acquisition costs, and reverse discounted cash earnings analysis.
'We take the current value of the company and based on a rate of return we would like, we try to figure out what the future value of the company would be, or what the market is implying the future value of the company would be,' Rowen explains. 'Based on that we back into what the company would have to look like as far as revenues, profits and PE ratio to grow into that. Then we try to figure out whether the company can actually achieve those targets.'
Muddy waters
Even as analysts wade through the murky waters of valuation, more companies go public by the day, creating a huge amount of work for overextended analysts. According to Constance Melrose, director of investor relations for Earthweb.com, 'There is still a real shortage on both sides of the Street - both the sell-side and the buy-side.'
Investment banks and analysts are still struggling to understand which categories to use to group internet companies. Some exist exclusively on the web. But many others, even those that sell tangibles like clothing or furniture in regular storefronts have a growing portion of their business on the web. In addition to creating new valuation models for a sector that seems to defy physics, internet analysts are faced with a huge array of underlying businesses. Once upon a time the approach was to consider all the net companies to be alike. Now clearly this is not the case. Even within a sub-category, such as internet retailers, companies that sell merchandise or services to consumers, there is tremendous variation.
'Ultimately the economics of a travel agency are different from those of book retailers, so you have to understand the underlying businesses as well as the common aspects which are the web sites, the product development, the customer acquisition, and the marketing. There are some common things among businesses, and some underlying things that are very different,' says Rowen. This requires that analysts such as Rowen stay in constant contact with analysts working in related non-internet fields, for example talking to the specialty retail analyst when looking at an internet bookseller.
With scarce analytic resources, some analysts and institutional investors are more comfortable investing in the blue-chip internet companies, those with known names and greater visibility because they have been around long enough. 'It makes it very difficult for everyone else to get mindshare,' says Melrose. For newly established companies, which virtually all internet companies are, they have had to go out and create relationships because they are not already established.
Investment in coverage
One of the key considerations in getting mindshare is which bank takes the company public. 'In the internet space, a lot of coverage you get and relationships you have are to do with the investment banking side,' notes Infospace's Joni Hanson. At older companies like AT&T and Microsoft, where Hanson worked before joining Infospace, the relationships with buy and sell-side analysts are already well established. 'The influx of internet IPOs it changed the dynamics within the investment firm, and it changed relationships and the way you build those relationships with analysts.' When a company goes public, she continues, the choice of investment bankers 'has a lot to do with who covers you. So it's important who you choose in terms of getting coverage.'
For European internet companies the challenge can be educating investors about not only the company, but about the entire European internet market. QXL.com was the third European internet company to go public in October 1999. Vice president of communications Alison Cabot says since the company is listed on Nasdaq, but with low volume, as well as the London Stock Exchange, its greatest challenge is getting its message to the US. 'It calls for a lot of education about the European internet marketplace with regard to growth potential, internet penetration and convergence with technology,' she explains. 'You also have to understand who you are talking to - in the States, a more educated investor. On the other hand, Europe is quite progressive in terms of interactive technology: mobile phones, interactive TV and digital TV are coming along rapidly, becoming much more accepted by the consumer,' says Cabot. Meanwhile, the dual-listed company has to adhere to the regulatory requirements of two markets: 'We do have to be conscious about the global distribution of information; it's a legal process much of the time.'
Another challenge for the internet investor relations officer is managing expectations and communicating with retail investors and even day traders through the blitz of media attention. It is important to be clear with these investors that the future is uncertain. 'Internet companies are inherently risky investments, not appropriate to anything but a small part of an individual investor's portfolio,' says Amazon's Grandinetti. 'It's difficult to know with precision; the further out you look the harder it is to know where the company will be because it's hard to predict demand. Being frank with investors about what precision you do or don't have is important as well.'
Communicating with day traders can be the most prickly. Infospace's Hanson observes, 'It's harder to tell your story to them. You are only as good as your last announcement. We have press releases almost every day. Once we didn't put one out for two days and I can't tell you how many e-mails I got saying What's going on? Why haven't you put any news out? Is there something wrong with the company?'
Daily e-mail
According to Hanson, day traders e-mail a lot, and whenever she has sent e-mails back they have been posted up on message boards. 'I've consulted legal counsel a lot,' she says. 'Legal departments don't want you to put anything in e-mail, they would rather have you call. But if there is a rumor out there and you don't respond to it through e-mail it becomes rampant. You have to know how to structure your answers so it doesn't come back to get you,' Hanson continues. 'We refer everything back to our plan, which is a public document, and say that we are executing on that plan.'
Investor relations officers like Hanson are forging the way in a sector that is almost reinventing the capital markets. A new kind of relationship with analysts means cooperating on valuation models that drill down to different revenue streams, even while keeping competitive information closely guarded. Analysts meanwhile have invented new metrics - Prudential's 'customer acquisition payback period' and 'reverse discounted cash earnings' analysis.
Online investors, for their part, force investor relations officers to resort to controversial new methods of communication. For in this fast paced internet sector, a rumor unquashed is a rumor run rampant.