COVER STORY - Why e-businesses are only relatively overvalued.

Tim Waterstone tells the story that when he was trying to raise funds for his proposed bookshop venture, he made a long, detailed presentation to potential venture capital backers. At the end of his talk, one of the financiers asked: “But Mr Waterstone, what are you going to do about the problem of the browser?” The venture capitalist had failed to understand Waterstone’s idea that browsers were good: the more time potential customers spent in his bookshops contemplating their purchases, the more likely they were to eventually decide to buy something more than just the latest Jeffrey Archer paperback. So it’s ironic that today, many years later, bookshops are now having to deal with the problem of a different kind of browser – the one that enables Internet surfers in Warrington or Wichita or Waikiki to buy almost any book in the world – without having to wait for their local Waterstone’s or Dillons to stock it. Amazon.com may well be the biggest single shop in the world. But is it worth $20bn? In 1998 it had sales of just $610m and lost $125m. Its shares stand on a price/sales ratio of around 33 times. Barnes and Noble, on the other hand, has sales of $3bn, net income of $94m, but is capitalised at a relatively meagre $1.8bn. Just to be clear, Barnes and Noble has sales nearly five times that of Amazon.com and a valuation one tenth of its online rival. Barnes and Noble has a per share book value of $9.87 and trades at $26. Amazon.com is valued at 48 cents a share on book value and trades at $124. Look, too, at the appropriately-named Yahoo!, now capitalised at $36.4bn. At least the group is profitable, but it is still on a price/earnings multiple of well over 1,000 times. As Warren Buffet, doyen of investor sanity, said, “On the final exam (for a business valuation course), I’d probably take an Internet company and ask ‘How much is it worth?’ And anybody that gave me an answer, I’d flunk …” In the UK, Dixons has added at least £1bn to its market capitalisation since it launched Freeserve, its free-of-charge Internet service provider, which is now on the flotation starting-blocks. One would think an eight-month-old business valued at, say, the relatively modest (by Internet standards) figure of £2bn would at least be in a hard-to-enter market. But this simply isn’t the case. themutual.com is not only launching as a head-to-head competitor with Freeserve and its ilk, it is actually giving away shares in itself to service subscribers. How can that make sense? Professional investors and day-traders alike have been forcing up share prices of Internet-related companies to levels that defy corporate physics. Seemingly rewriting the rules of business valuation – “think of a number, then square it” – Wall Street has been endowing e-businesses with the kind of mass that gives them enough gravitational pull to bend light. These valuations, absurd as some of them may seem, matter to every business – and not just because the US economy may well come to a juddering halt the minute Wall Street decides that it’s been getting carried away with itself. The problem is that all companies suffer if one of the most important mechanisms for allocating fresh capital takes leave of its senses, and begins denying funds to traditional businesses. Moreover, it’s important to be sure that Wall Street’s e-uphoria isn’t ultimately driving traditional businesses to adopt Internet technology and e-business strategies to an extent that will ultimately prove unprofitable, inappropriate and even misguided. So are the laws of e-businesses really different? For a start, the capital requirements are all different. Whereas a conventional business would either build up its balance sheet over a number of years, or start with a huge injection of capital, before generating substantial revenues, e-businesses can get huge sales almost immediately – if they have the right proposition for the customer. In the old economy, if Tim Waterstone wants to reach an additional 20,000 potential customers, he has to make several very expensive decisions: where to locate a new store, how to fit it out, what books to stock (even a big traditional bookstore can only carry between 60,000 and 90,000 titles), how to market the store, what staff – most with some expert knowledge – to hire; the list goes on. And that bookstore will never service more customers than the 20,000 or so that live or work close enough to actually walk in and browse. For Amazon.com to reach an additional 20,000 customers it has to spend almost nothing. True, each of those potential new customers must be at least familiar with the Internet, and prepared to wait a few days for their book or CD. But with prices lower than traditional bookstores and, according to Amazon.com, 4.7 million book, CD, video and games titles on offer, it does have a fairly compelling business model. To service more customers, all Amazon.com has to do is log on to Dell.com and order an extra server. Charles Dunstone (see pages 34 to 38), founder of Carphone Warehouse, told FD that the company’s Web site cost the equivalent of two stores to set up. Currently, it is generating business equivalent to one store. By the standards of the naysayers, this makes terrible business sense: why not just build the two stores and get twice the income? But those two stores effectively have capped revenues. The Web site has unlimited potential revenues, and as its sales increase, the return on capital invested will go from good, to stellar, to unbelievable. In the new e-conomy, additional revenue does not come at the cost of additional investment. If pan-European mobile phone services really take off (Orange is already rolling out its brand across the continent), Carphone Warehouse will be able to sell to an additional 250 million customers, and all for the cost of a marketing campaign. Of course, there may be limits to how extendable this model actually is. The valuations accorded to companies like Amazon.com, Yahoo!, eBay and the others simply cannot be realistic – at least not for them all. But e-conomics does offer something much more tangible, something any company can benefit from: cost savings, new markets and huge economies of scale. The implication may be that these businesses, which keep overheads minuscule but generate cash-flows in double-quick time, are the ultimate expression of the “new paradigm” economics that has emerged to explain the ongoing bull run in Western markets. Gaining market share in this newly emerged and therefore immature sector is critical. FDs at these e-businesses still occasionally use Wild West or gold rush analogies to describe the need to get brand equity and market share on the Web. Grabbing land out west was a speculative venture back in the 19th century, and remains speculative in cyberspace today. But the analogy isn’t perfect: in the Wild West you might stake a claim and look forward to mining your land of its gold. On the Internet, you might have ‘first mover advantage’ to exploit new territory, but you might find that the gold under the earth moves to someone else’s claim later on. Amazon.com will have a hard time making a profit – near-zero margins are, after all, its unique selling point. But Dell, a conventional business, stars: it uses e-conomics to boost sales, gain global reach, invade new markets and generate cash with a minimum of outlay. Sales are easier to close on the Web; commissions are 25% lower; and the supply chain is tremendously efficient and responsive to the customer. But most importantly, Dell actually makes what it sells – it has and will keep a decent margin. And that’s the beauty of the new e-conomics for most businesses – they’re mostly Dells, not Yahoo!s. By applying the speed, efficiency and reach of the Internet, traditional businesses can be part, not of the hype, but of the financial success story on the Web. The world economy is not yet frictionless; but the Internet, and the way it has changed perceptions of value, is proving a vital lubricant. STAFF TURNOVER Revenue per employee shines a light – of sorts – on the differences and similarities between conventional and e-businesses. Of course, costs are only vaguely related to number of employees, and BP (with 98,900 employees) is very different from Dell (with 24,400) and eBay (with 138). But while BP could lose thousands of employees without seeing a major impact on its business, if eBay’s systems department leaves the company, it’s in serious trouble. The unanswered question is: how stable is a pyramid that’s balancing on its apex?

 COMPANY                REVENUE/EMPLOYEE Dixons                         $159,257 Yahoo!                         $252,800 Amazon.com                     $290,476 eBay                           $343,115 BP Amoco                       $690,596 Dell                           $747,540

Amazon.com Activity: On-line sales of books, CDs, videos; also auctions and gift sales. Founded: July 1994 Date of IPO: May 1997 IPO share price: – $3.00 Trading high: – $221.25 Trading low: – $2.79 Current share price: – $124.00 Current market cap: – $20.04bn Latest annual turnover: – $610m Latest operating profit (loss): – ($111m) Latest net profit (loss): – ($124m) Price/sales ratio: – 32.8 Price/earnings ratio: Number of staff: – 2,100 Our view: Amazon.com is probably the strongest brand in on-line retailing. Its premise is simple: sell books (and now CDs, videos and other gifts) more cheaply, including the cost of postage, than bricks-and-mortar rivals – and guarantee quick delivery. Amazon.com stocks an order of magnitude more titles than any conventional store could, roughly 4.7 million different books, CDs and videos. It survives on cash-flow, and may hit problems if sales growth (last year: 313%) slows – hence the move into other product categories. That said, it could be argued that Amazon.com is growing the bookselling market, giving people access to a wealth of new titles. It has also proved that on-line retailers can come from nowhere to dominate a market in a matter of months – but may find itself challenged by a newcomer in the same way. Margins will never amount to much since it adds no value to the products it sells. Supporters point to the reader reviews, articles and buying suggestions included on the Amazon.com site. But these features merely cement customer loyalty, and low prices are what keeps people away from traditional book retailers. Amazon.com does have one hope for continued stellar growth: as technology brings the Internet to more homes, its customer base swells accordingly; that technology is getting cheaper. Verdict: Hugely overvalued, but youcisÿ¯.