Internet stocks: Bubble or bonanza?

It sounds like a post-modern fairytale of rags to riches . . . the good fairy of the Internet waves her magic wand and garage startups are transformed like Cinderella into multimillion dollar enterprises seemingly overnight.

The `blue sky' potential of the Web has sent Internet share prices soaring and seen startups selling for hundreds of millions of dollars, while canny investors reap the profits.

There's no doubt the Internet has profoundly affected every aspect of our lives - from the way we do business to the way we shop - and numbers on the Internet continue to rise.

But fairytales are exactly that - and stock market analysts warn the Internet share bonanza is a `bubble' waiting to burst, with all signs pointing to a major share correction in the not-too-distant future.

`I personally believe it's a bubble and it will burst,' Macquarie Bank's chief investment officer, Greg Matthews, said. `It's impossible to predict the end of the bubble but I recommend long-term investors steer clear. The average price/earnings ratio was around 20/1 a few years ago. It's now around 140/1, which is frightening. We haven't seen those ratios since the Japanese bubble economy of the late 80s, just before it crashed.'

Geoff Barnes, an investment adviser at stockbroker Hartley Poynton, said the Internet is growing so rapidly that Net stocks can achieve meteoric growth.

`They offer blue-sky potential,' Barnes said. `Some provide Internet services and the Net is growing so fast they could feasibly have 10,000 new subscribers per month. The promise of revenue is not really there for three to five years but people believe the hype. A handful in the market will make it, but the rest won't.'

Sabela Media, a Sydney Internet company founded just 18 months ago by a pair of former OzEmail employees, is just one of those success stories.

The company has just been bought by New York-based 24/7 Media for $100 million.

Sabela, which provides advertisement-serving technology for clients like Ozemail, BMC Media, Looksmart and Big Pond, was founded by Gour Lentell and David Turner in June 1998 and funded with their OzEmail stock options.

Lentell, Sabela's executive chairman, said the com-pany had planned to list on NASDAQ later this year, but had now been acquired 100 per cent by a company already listed.

Lentell disagreed with the `bubble' theory, but acknowledged the current high valuations might not be sustainable.

`Companies have grown at phenomenal rates over the years,' Lentell said. `The high valuations reflect the potential for huge growth rates. I don't think the current growth is sustainable but I'm not sure the bubble is an appropriate analogy. That's been used in the past with things like property prices where there's no real change in supply or what you're getting, just demand. The difference with the Internet is that you're seeing real change and real growth. It's the question of how to value it that's vexing.'

The fact that investing in Internet stocks is highly speculative means that share prices are highly volatile and will often fluctuate wildly, as Australian Stock Exchange (ASX) figures show.

Internet development company LibertyOne has risen from 66 cents in November 1998 to a current share price of $1.34, down from a high of $2.70 in October.

Internet content company Spike Networks listed at $1.50 in August, immediately crashing to a low of just $0.61, before rising to a current price of $2.10.

Shares in another Internet company, Eisa, swung from 73 cents to $1.08, and back to 86 cents in just one month (December) amid intense speculation that the company would join forces with Rupert Murdoch's News Ltd to buy all or part of OzEmail. Industry insiders blame a range of factors for sharemarket wobbles earlier in January, which saw technology stocks in Australia and the US plummet then partially recover.

`Most of the wobbles were because of the interest rates scare,' Hartley Poynton's Barnes said. `That's the reason for the largest correction in the US. After that the bond rates dropped and in the technology sector there were a few large amalgamations like America Online (AOL) and Time Warner. That restored confidence.'

`The markets were very volatile running up to the Year 2000 computer bug,' added Macquarie's Matthews. `It's reactions to the big flows through funds in November and December in the US. The funds saved cash and then when it emerged that the Y2K bug wouldn't be a huge problem, they threw it at the market. In January people expected more money to be thrown at the market and when it didn't happen they panicked.

`The other thing that happened was individual stocks coming out with disappointing profit announcements or announcing actual losses. Any company with a stock announcement is likely to be hit hard.

Barnes warns investors to look at a company's assets and revenue to gauge how much the stocks are worth.

`High price/earnings ratios are a matter of concern because they are not an accurate reflection,' Barnes said. `They're hard to value because nobody knows their lifetime or revenue. It's speculative and dangerous.'

Matthews agreed, adding that potential investors should look at their profits in the medium-to-long-term future.

`Ask yourself what your profits over 10 years will be, minus a high discount rate that takes the risk into account,' explained Matthews. `If it's 16-20 per cent then it's paying you for the risk, but if it's only 10 per cent then it's only an average return, so why take the risk - why not invest in bank shares?'

Barnes recommends investors look for profitable businesses with company directors that have a good history of holding positions on boards and reputable dealings.

`There are always people who try to enter the market with the intention of making money for themselves as directors,' Barnes warned. `The Stock Exchange goes to great lengths to ensure the directors don't have a history of bankruptcy. There's always the risk that directors will want to make money for themselves without worrying about investors and it's easiest to do with technology companies because the projections can be so good. In cases like this the ASX and the Australian Security and Investments Commission (ASIC) would prosecute.'

One indication that the company is genuine is if the directors' shares are escrowed, ie they cannot be sold until after a certain period of time.

`Investors should look at the quality of the idea, the business model proposed and whether it's viable within the context of how the business should work. Most importantly, they should look at the people concerned and if they have a strong aptitude and knowledge. An idea is only as good as the people who have it,' Sabela's Lantell said.

Fluffy business models

Lentell believes the secrets to his company's success were experience and clear focus and vision.

`We had strong experience coming into this,' Lentell said. `We had a clear idea, vision and business model and world-class technology within that business model. We stayed focused on what we knew best. I think focus and clear vision are very important. There are a lot of fluffy business models without much under the hype. Time will tell which ones are actually sustainable.'

Matthews argues that marketing is a key factor in determining whether an Internet company will succeed or fail. `It's risky because they don't have cash but they've still got to pay their bills and you won't realise your investment until they make it big,' said Matthews. `There's a very low barrier to entry, so even if they have a good product and a good Web site, there's nothing to stop a competitor opening up. It's all about brand names and advertising.'

Analyst International Data Corp (IDC) predicts further Internet stock corrections for 2000 and a refocus on profitability.

`While the Internet boom is creating companies worthy of huge valuations, those are a very small minority,' said a recent IDC Pulse report. `It's wheat from chaff time and in Internet commerce there's a lot of chaff . . . Overall this year will mark a strong shift away from the 'red ink is good' Internet business model to profitability as a .com virtue.' IDC predicts online numbers will grow and free Internet access will become increasingly commonplace, but the e-commerce market will become more competitive.

The wheat-from-chaff effect will drive more consolidation in key e-commerce segments, including retailing, portals, travel and finance, said IDC Pulse.

`Retailing is a harsh realm with a continuing flood of new entrants in a highly competitive market. As in 1999, financial markets will continue to reward the online retail stars and starve the also-rans. Consolidation will continue.'

`Bricks and clicks' will replace pure .coms as a business strategy, as dominant companies in each sector realise they need real-world presence as well as a strong Internet strategy, according to IDC.

`The importance of a 'bricks-and-clicks' strategy is not news for bricks-and-mortar companies. Many have done so by adding an Internet channel presence,' said IDC Pulse. `But what 2000 will add is a flurry of deals in which pure-play Internet companies 'get real' by purchasing, merging with, creating joint ventures with, or forming partnerships with real-world companies.'

IDC predicts that in 2000 a new generation of one-stop shopping sites will move quickly up the Media Metrix and NetRatings charts, taking off as powerful consumer e-commerce magnets.

The new virtual malls would include the portals, which combine their own strong Internet brands with search capabilities, as well as startups like MySimon and Shopper.com that feature comparison shopping across hundreds and thousands of sites through so-called shopbot technology.

Macquarie's Matthews warns that when the market crashes, all technology companies will find it hard to raise capital.

`My advice to startups wishing to list on the stock market is to do it as quickly as possible' urged Matthews. `Once the bubble has burst, even good companies won't be able to raise capital. It will affect the good as well as the bad, because the market will be sick of it. Everyone will be saying 'those rotten Internet stocks all went bust and I'm not throwing any more money at it'. It's unfair but it's the way it works.'

Matthews believes the sharemarket is set for a major correction within the next few months.

`I thought it would happen by now,' Matthews admitted. `It should have already happened. Everything's in place. The interest rate rise in early February should cause it. The profit-reporting season in April when earnings statements come out should cause it. The market's already at bubble levels in terms of price/earnings ratios.'

Barnes recommends startup companies planning to list make sure they are honest and realistic in their projections and look for long-term investors to take bigger shares.

`Ensure the public knows exactly what the business is about,' Barnes advised. `Don't overstate the potential. It's easier to under-promise and over-perform than promise too much and never perform. Do due diligence and get independent expert reports. Try to find long-term investors who will take large stakes in the company to give a good, solid shareholder base. If you have 500 million shares, you don't want 500 million different shareholders. Escrow shareholder stocks, so people have the confidence that you're not interested in starting a bucket shop.'

The Internet is growing at a phenomenal rate and many startup companies will develop into successful enterprises, justifying the faith of both shareholders and private investors. But analysts predict that many companies will fail - and investors could be left footing the bill, rather than a glass slipper.

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