Wednesday, January 31, 1996
MARKET CLOSE
INDEX:
I. Market News: Fed Gives Investors a Boost
II. Heroes: Tivoli, Hi-Shear, Hechinger, Mylex, Harris Computer
III. Goats: Jabil Circuit, Helene Curtis, Shaw
IV. Investment Perspective: The Digital World---Part Seven
MARKET CLOSE
DJIA: 5394.94 +13.73 (+0.26%) -- RECORD
S&P 500: 636.01 +5.86 (+0.93%) -- RECORD
NASDAQ: 1059.80 +8.50 (+0.81%)
MARKET NEWS
The Federal Reserve, citing controlled inflation and slow economic growth, eased both the Fed Funds and Discount Rates by 25 basis points this afternoon. A somewhat expected move, the market was nonetheless nervous immediately preceding and succeeding the Fed's announcement at 2:15. Prior to the announcement, the DJIA dropped nearly 30 points very quickly. Immediately after the announcement, the Dow gained some 20 of those points right back as investors sighed in relief. But then, almost immediately after that, they started to think, "hey, why didn't they cut the rates by 50 basis points?" and the market dropped again. By the end of the session, however, calm was restored and the Dow regained all of its losses and then some, closing at yet another record high. Watching the Dow's reaction to the Fed's move was a classic study in market psychology---fear and greed, indeed.
HEROES
IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:IBM)") else Response.Write("(NYSE:IBM)") end if %> continues to do what many thought impossible just a few years ago---remake itself in the image of a network-based technology company. With the acquisition of Tivoli Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:TIVS)") else Response.Write("(NASDAQ:TIVS)") end if %> today, which shot those shares up $9 9/32 to $47 1/32, IBM brings into its fold another crucial asset to add to its Lotus Notes platform. Tivoli makes systems-management software for client-server networks---a far cry from IBM's Paleolithic mainframes it began with at the dawn of the computer age. Tivoli's systems-management products patch together makeshift UNIX/DOS/mainframe networks. With Lotus Notes as a communications product overlaying this "glue," IBM suddenly has a single-solution software product to offer for many companies' online needs. Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MSFT)") else Response.Write("(NASDAQ:MSFT)") end if %> and Novell <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:NOVL)") else Response.Write("(NASDAQ:NOVL)") end if %> should both take heed here.
Hi-Shear Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:HSI)") else Response.Write("(NYSE:HSI)") end if %> rallied $1 3/8 to $6 5/8 today after the government withdrew its appeal of a ruling in Hi-Shear's favor. The dispute centered on whether two contracts with the Navy were canceled because of "default" or at the "convenience of the government." Because the court ruled that they had been canceled at the government's convenience, the government became liable for damages related to contract performance. Hi-Shear says Uncle Sam owes it $62.9 million as a result. Why one-time potential settlements move stocks so much is a little strange; this does not change Hi-Shear's value as an ongoing concern that much, just gives it a little development capital.
Sickly home-improvement retailer Hechinger <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:HECHA, HECHB)") else Response.Write("(NASDAQ:HECHA, HECHB)") end if %> bucked up $1 1/8 to $5 3/4 in the class-A non-voting shares and $1 1/2 to $6 in the class-B voting shares today. A rumor of a possible buyout by a big retailer like Sears (in order to expand its Sears Hardware stores) is behind the movement. Sears strongly denies an interest in buying out Hechinger and prefers for now just to compete with it. A similar rumor a few months ago that Sears wanted to buttress its auto repair units by buying out Pep Boys <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:PBY)") else Response.Write("(NYSE:PBY)") end if %> amounted to nothing.
Profits remained the central preoccupation of the Street today. When Mylex <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MYLX)") else Response.Write("(NASDAQ:MYLX)") end if %> turned in better-than-expected earnings, the shares surged $3 1/8 to $20 3/8. News that quasi-Internet play Harris Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:NHWK)") else Response.Write("(NASDAQ:NHWK)") end if %> would turn a profit in the third and fourth quarter of this year caused those shares to rally $3 to $17. It's funny how investors like those profits---almost like that's what the companies are supposed to do, or something.
GOATS
Push-outs and cancellations caused shares of electronics capital equipment makers to get rocked today. Jabil Circuit <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:JBIL)") else Response.Write("(NASDAQ:JBIL)") end if %> got pounded for $3 1/4, closing at $6 3/8 today. The company received a cancellation of $60 million in orders from Quantum Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:QNTM)") else Response.Write("(NASDAQ:QNTM)") end if %>, meaning that their numbers are gonna be even lower than previously expected. Even beating earnings by 10% could not save semiconductor-assembly equipment maker Kulicke & Soffa <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:KLIC)") else Response.Write("(NASDAQ:KLIC)") end if %> from a similar fate, off $2 3/8 to $21 7/8 today. Check out MF Boring's portfolio write-up where he will share his thoughts on the conference call. We here at the News bureau cannot wait to read it.
Helene Curtis <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:HC)") else Response.Write("(NYSE:HC)") end if %> became less beautiful to the market today, down $8 1/4 to $58 1/4 on talk that the much ballyhooed takeover would not in fact come to pass. The stock previously rocketed upward on news that Roy Disney, progeny of Walt Disney, was agitating the company to sell itself and "enhance shareholder value." This kind of value enhancing has always struck us as odd, as it basically results in shareholders becoming non-shareholders in very short order. Helene Curtis might agree with this assessment and want to continue going it alone as a shampoo and deodorant powerhouse.
Carpet-maker Shaw Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:SHX)") else Response.Write("(NYSE:SHX)") end if %> unraveled today, losing $1 1/4 to $12 7/8, after Home Depot announced that it would no longer buy products from the company. Shaw's recent entrance into the retail arena is what Home Depot uses to justify its position, as it does not want to buy from a competitor. Merrill Lynch analyst Pamela Singleton said to Dow Jones today that although a big name, Home Depot is really insignificant when it comes to Shaw's revenues. Rival carpet-bagger Mohawk <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MOHK)") else Response.Write("(NASDAQ:MOHK)") end if %> rose $1 to $13 5/8 on this perceived competitive advantage, however.
INVESTMENT PERSPECTIVE: The Digital World, Part VII: AOL -- Brands and the Business Plan
VI. AOL: Building the Brand
The frenzied manner in which companies have bent over backwards to offer Internet access leads many people to think that this is potentially lucrative, or as prospectors used to say, "Thar's gold in them there hills." This is a dramatic misconception, as Internet connectivity, software and Web-hosting have low costs of entry, but as a result, low margins.
We discussed in the fifth installment of the "Digital World" how Internet Service Providers (ISPs) are particularly vulnerable in this sense, as many large companies will soon be willing to offer Internet connectivity at a loss, hoping to make up the money by generating transactions and offering new services. Browsers are a dime a dozen as well, with every company behind one virtually giving them away in order to try to become the industry standard and lock-up the market for servers and secure transactions. Hosting a Web-page remains a questionable undertaking as the Internet, by its very construction, is a chaotic medium that suffers from *too much* content and the inability to track usage accurately. No advertiser is going to sink the big bucks in a site until they can be sure that there's a potential pay-off. Without demographics and accurate, historical usage trends, advertising on non-proprietary sites will remain a hard sell.
America Online's response to this dilemma is similar to how off-line companies deal with markets characterized by low "moats"; they build brands. By acknowledging that brands have power and building on this concept, America Online escapes from the rigorous process of competing by price alone. For instance, a dramatic price cut by Prodigy right now would not help the ailing service much; it has been surpassed in both content and functionality and will not be able to gain users again until it corrects this deficiency.
America Online's approach to building a brand has been to promote actively its innovative content. The company realized roughly a year ago that the traditional environment for large online content providers was bankrupt. Having Time simply repackage its print product for online distribution, for example, was a dead idea. America Online creates a situation where it can build a brand by programming, bringing on new content via the Greenhouse program and partnering with large players to deliver foot traffic and guide the online content.
Dead content that did not change on a daily basis could not compete with the analog world. Programming means timely content and marketing this in an effective manner every single day, emphasizing this very process to their partners. It is the Greenhouse partners that have taken this to heart the most, as America Online's Greenhouse partners account for five of its twenty most popular areas---competing with traditional giants like MTV, ABC and Time. America Online has created new ways to link up with potential content providers that surpass the tired old model whereby the online services "create" all the content. It is only because America Online has stopped focusing on creating content that it has been able to effectively program it---much like the television networks or radio stations, which generate very little of what they put out to the world.
VII. Two New Models for Partners -- The Greenhouse and Joint Ventures
There are two primary models America Online uses to develop content providers for its service---the Greenhouse and co-operative joint ventures. The Greenhouse takes companies that would otherwise not have the marketing or distribution ability to function on their own and gives them a place on its network and a low-cost loan to begin. By doing this, America Online creates new online companies that use start-up capital to generate innovative content that America Online would not be able to do on its own. In return for this seed capital, America Online receives the right to buy 19.9% of its Greenhouse partners if it desires.
The first Greenhouse offering was located on America Online's Personal Finance channel and was called The Motley Fool. The Fool was Greenhouse before Greenhouse even existed. When Ted Leonsis was brought to America Online via an acquisition in early 1995, he saw the success two brothers operating out of a shed were having and realized that dozens of other companies like this could be out there. America Online let go of its desire to create and own all of its content, instead putting its clout behind start-ups that could focus much more on their content offerings, programming their site and cultivating an audience as well as advertisers. If any of these companies become successful enough to receive more money from third party venture capital concerns or even have their own initial public offerings, this only raises the value of America Online's stake.
The second model is through joint venture programming. This began after America Online recognized that almost all classic content and technology companies had completely failed online. By taking a stake in the content that was offering on its service, America Online put itself in the position to exercise some control at the development stage, sharing its wisdom with the big-cap companies that wanted to tap into the online market. Some examples of these partners are New Line Cinema with The Hub for young adults, Time/Warner with an expanded Health Channel, Capital Cities/ABC with new fashion and lifestyle sites, the New York Times expanding its @times business, Viacom with its MTV, VH1 and Nickelodeon sites, American Express, Intuit, Hachette, Bertelsmann and Simon & Schuster.
The Greenhouse and joint venture programs allow America Online low-risk content ownership while it focuses on what it does best---building the network, enhancing the software, providing the service and programming the content. Greenhouse partners bring new ideas and commitment, joint venture partners deliver the content and cash and America Online delivers foot traffic and interface. The synergies of this sort of arrangement are readily apparent compared to the Soviet-style model where the Online Service Provider (OSP) creates almost all of its content (like Prodigy) or the anarchy-model where the OSP just throws up everything someone provides it and lets it sink or swim on its own (CompuServe, MSN). By owning content, America Online allows its gross margins to expand beyond where just providing the service would leave it.
VIII. Offline Online
By getting into bed with its content providers, America Online enhances it prospects for generating crucial offline revenues through transactions, services and advertising. America Online only had $40 million in offline revenues in fiscal 1995---a number many believe will double or triple in the next few years, driving earnings because of inherently higher margins.
America Online is getting serious about advertising. With network television generating 100% of its revenues from advertising, newspapers getting 80% of their money from advertisers and magazines pulling in 50% of their money from advertisers, the potential expansion of revenue mix in the direction of advertising is huge. Generating 10% of AOL's revenues and 20-30% of its earnings from advertising dollars seems like a reachable goal.
Greenhouse partners, for instance, will soon be required to generate at least $25,000 a month in advertising revenues. By making its split of advertising money 80% to the partner and 20% to America Online instead of the reversed model it uses for usage, this is another carrot for many Greenhouse partners to dedicate time and effort to chasing down the advertising dollars. If the 50-some-odd partners achieve this goal, this would mean an extra quarter of a million dollars in AOL's coffers on a monthly basis---or $3 million a year. The best part is that this $3 million would be *pure* profit, money America Online gets simply because it gave these partners a helping hand. Given that America Online made about $20 million in the last fiscal year, you can see how much this effort alone could add to its bottom line.
America Online also makes money any time you buy something from one of its partners, getting 10% of the take. As more and more content providers like The Motley Fool are available exclusively in a digital format, the potential from the America Online store becomes significant as well. Estimating these numbers is difficult as the digital market place is still in flux, but between its OSP and its investment in 2Market, which is building a Web-based retail product, transactions could boost future earnings as well. With proto-banking concerns like America Online as well as online brokerages and credit card companies allowing bill paying and other transaction services via its network, America Online's bottom line will get padded as consumers have access to more convenient products and services online.
IX. Leveraging Off the Infrastructure and Software -- Digital City
Advertising and transactions are not the only new channels of profitability for America Online. If the company were simply content to focus on these two channels and the tired old usage model, I actually might start to believe all the hype about how the Web will overtake OSPs. However, the development of higher-level products and services which maintain margins by building the brand name and leveraging off of the infrastructure and software expertise America Online brings to the table has got me curious as well. Three initiatives strike me as both novel and brimming with potential in the next few months: Digital City, Century 21-like deals and the Global Network Navigator (GNN).
Digital City is America Online's attempt to smash the network of regional newspapers that has dominated the local advertising market for centuries. The first Digital City is Washington, D.C. and twenty more are slated to debut by March. The Digital Cities focus on providing comprehensive information on attractions and goings-on in various locales rather than trying to create something for the entire country to use. Because of the critical mass of subscribers America Online brings to the table, it can bring users to a service like this in a way that local players cannot.
America Online is already larger than the Wall Street Journal, USA Today and the New York Times combined; in fact, larger than the five largest dailies in the United States together. America Online, if it were a newspaper, would be the second-largest newspaper in every city it serves based on the addresses of its subscriber address. To turn these people into revenue dollars, America Online wants to put Digital City "hubs" into all of the regions where it has a significant concentration of users and then allow "info-preneurs" to create smaller Digital Cities for towns and villages across the nation. Both national and local advertisers could tap into the Digital Cities the same way they do regional dailies.
The most salient example of how America Online's subscribers assist its endeavors and give it a crucial boost over local papers trying to start similar services is the Washington Post's Digital Inc. offering. Their service only garnered 8,000 subscribers during the period that the Washington D.C. Digital City became heavily used by AOL subscribers in DC---its fourth largest market. Local players will not be able to compete effectively with the bevy of software development tools that America Online brings to the table. With the ability to create "pseudo-broadband" offerings via CD-ROM with its existing development staff, papers like the Post will find it an arduous struggle.
X. New Networks, New Brands: Century 21 and GNN
Sometime in mid-1996, a new group of users will be using a private network within the overall America Online system to access news and information they otherwise would not be able to get---Century 21 real estate agents. Announced on January 10th, Twenty-On Online will create a value-added network using the America Online software interface and network for a private company. This is the first deal of its kind in the online world; an established provider of online services is custom designing a product for a partner with very specific needs.
The private network will allow Century 21's 80,000 real-estate brokers to bring together their 6,000 sales offices in a convenient manner for the first time ever. Imagine cross-country broker-to-broker referrals, a daily news report for company news across the United States, centralized training data and live interactive events as well as crucial information available 24 hours a day through keyword searching. Using its own software, infrastructure and know-how to duplicate this value-added network for other corporate clients will be even easier for America Online after this watershed one is in place.
The Global Network Navigator (GNN) is another online product that leverages off of America Online's infrastructure and software assets. The Internet Service Provider (ISP) is priced at or below the prevailing competitor and reportedly garnered 75,000 users during its month-long free trial---about one-quarter of the number Netcom Communications exploded into the market with. GNN, because of its relationship with AOLNet, is free to concentrate on service, while AOLNet worries about building the necessary POPs. Because this ISP will own the network through which it delivers services, its cost structure will be inherently lower than most of its competition. Even though I believe that the market for Web-only services is much smaller than the market for brand-name, value-added online services, America Online has positioned itself to play both sides of the game.
XI. The Valuation -- The Positive Side
Throughout this article on America Online, I have been pretty positive on the company---gushing at times. This is because the business has done everything right and appears to be doing more right going into the future. My comments about the business and my beliefs about the stock do not necessarily *have* to intersect---a fact a number of detractors who have written that the Evening News has turned into a "positive profile" of America Online stock seem to overlook. It's possible to have a great company that is greatly overvalued, like Coke, in spite of brand name and so on. Or you can have a great company that is misunderstood and generates a ton of cash, like Coke. It takes two sides to make an argument. I will try to highlight the positives and the negatives when it comes to valuing America Online.
With negative trailing earnings from its rash of acquisitions, valuing America Online gives most investors symptoms ranging from heart palpitations to outright shock. "It doesn't have a P/E!" is the rallying cry of many an investor. The eight acquisitions America Online made in the past two years have tallied $190 million, mostly in stock, and led to numerous one-time charges for acquired research and development "in process," meaning that America Online had to pay its acquired companies' bills. Many have questioned this practice, but it is a standard in the accounting world, given that IBM (with its Lotus acquisition) among others have taken similar charges.
The number and variety of the acquisitions that have cost short-term earnings should be viewed before making any calls on the stock: Has America Online been smart or stupid in its buying frenzy?
- Redgate Communications (2Market, shopping catalogs) August 1994
- Booklink Technologies (Web browser) December 1994
- NaviSoft (Web publishing & development) December 1994
- ANS (commercial ISP) January 1995
- Wide Area Information Servers (Internet Search Engine) May 1995
- GNN (Web information service) June 1995 (recently had 75,000 members in six weeks compared to Netcom's 300,000)
- Ubique Ltd. September 1995
The online, multimedia and Internet nature of these properties suggests that America Online is blurring them together in its business plan. None of them seems all that excessive to me or outside of America Online's core competencies, so this checks out.
Another valuation question comes up when discussing how America Online expenses its subscriber acquisition costs. The company amortizes the cost of grabbing subscribers over 24 months rather than taking the hit on the bottom line all at once. Many believe that this is aggressive, although it is in absolute accord with FAS 86 and SOP 93-7 standards. As America Online estimates that new customers will stay with it for about 40 months, the 24-month amortization does not seem outrageous if you believe America Online's numbers.
For an online service, becoming cash-flow positive is a matter of hitting a "critical mass" number of subscriber. The build-up to critical mass is scary and cash-flow negative. Subscribers are not "counted" until they are on for 45 days or more. The average revenue per subscriber (someone on more than 45 days) right now is $17 and trending upwards. With these numbers, there are a couple of ways to figure out how much money America Online is worth.
The most straightforward is the market cap = annual subscriber revenues model. With this, you take the average life (40 months) times the average monthly bill ($17) to get $680. Then multiply this by the number of subscribers (5 million, last count) to get a market cap of $3.4 billion. The logic behind this is straightforward; it is the subscribers and the money they spend that ultimately determine the value of any medium. With this kind of approach, you get a ballpark figure for what the company can earn in the next five or ten years and what it might be worth to an acquirer. If you take the $3.4 billion and divide the current number of shares, you get about $47 a share, a few hairs under where America Online closed today.
Another way of doing this is by looking at those annualized revenues and applying an appropriate margin, based on what assumptions you make about how much it will cost America Online to deliver its services. If America Online, for instance, can maintain a 3% profit margin (which would be down from its trailing 4.2%, accepting the fact that expanding the network is expensive), you have $100 million in earnings---or about $1.40 a share, surprisingly close to current consensus estimates of $1.60 a share for fiscal 1997. America Online, based on my calculation here, trades at 30 times future earnings---not bad for a company that quadrupled its subscriber base last year.
XII. The Valuation -- The Negative Side
Change any of these assumptions, though, and the value deflates dramatically. If subscribers are only going to stick around for 20 months, for example, you have a stock worth $23 1/2 based on the subscriber revenue-market cap approach. If the margins dip lower, heading toward 1.5%, you have a company trading at 60 times next year's earnings---not quite as positive as before. Expensing subscriber acquisition as long as America Online does leaves little room for error. If the rate of subscriber acquisition slows, all of the optimistic assumptions about subscriber longevity and margins get thrown out the window.
More important here is the lack of clarity about where the Internet goes from here. "Somebody else will come" has been the rallying cry for months of those short the shares of America Online. First it was IBM's Interchange, then Microsoft's MSN; now it is MCI Communications, IBM or AT&T again in various business combinations with other providers. If another big player comes along and slows some of America Online's momentum, you could see the same thing that happened to CompuServe happen with America Online---an outdated service, unfit for casual conversation within a few months.
These negative possibilities, while compelling, are hard for *me* to buy into---although I am open to counter arguments. The "somebody else" argument in particular plays into the core misconception about America Online in my mind---that it is only an OSP. America Online is much more than that, with software and infrastructure behind its core competency, programming content. With joint ventures and the Greenhouse program, America Online has the widest variety of truly interactive options going, bar none. Sure, there might be more on the Web, but can you talk to other users about it as you look at it? America Online remains a medium for communication, making new interactions possible.
XIII. Conclusion
Let's look at an example of why I think the hand-wringing about the "someone else" point is overdone: Microsoft was supposed to crush America Online last summer. Many intelligent people failed to perceive the flaws in its strategy and its offering. MSN depends completely on Microsoft's "Windows everywhere" strategy. Microsoft now is positioning MSN as the ultimate Web service provider, hoping that the army of PCs under the Wintel dominion continues to gravitate toward it in this new market as it did in the old operating systems and applications market. MSN, though, is nothing without Win'95 and mass consumer acceptance of Win'95 is not happening as quickly as many had hoped. With most businesses going straight to NT (good for Microsoft, incidentally, as NT nets $225 v. $65/75 for Win'95), MSN loses potential users. Although Microsoft's Internet Explorer has stolen browser market share from Netscape (25% of hits in October '95), this is technology, not content. Win '95 will not hit the critical mass equivalent of AOL's current 5 million subscribers for a number of years; by then, it may be too late. With the Department of Justice still looming over Microsoft, it will also continue to reign in its desires. The irony for Microsoft is that if it does win online, it has serious legal troubles, and if it remains a niche player, it is safe.
Technophiles and MBAs will continue to see more risk than reward in shares of America Online. It is this very kind of disagreement in the stock market that creates opportunity, however. Technophiles misunderstand that the Web is about content, not technology. Whiz-bang networking OSs and open browsers do not content make. Roughly half of AOL users access with 9600 baud or below; these people are not ready for sophisticated Web Browsers unless they have a lot of time to kill. Even at 14400 baud, let's all admit it---the Web sucks. MBAs will continue to see subscriber accounting practices as "cooking the books." Expensing subscribers over 24 months, estimating a "lifetime" of 40 months is aggressive---no one will argue with this. Given the revolutionary nature of the content possible, though, it is not inconceivable. Also, the recent NBC/MSN marriage of offline and online heralds similar unions in the works for America Online, arrangements which could boost the value of the company as an ongoing concern, bringing advertising dollars to bear quicker than anyone anticipates. The success America Online has had is enviable and hard to deny; you literally have to close your eyes to the positive factors in order to be pessimistic about AOL's opportunities.
Should you run out and buy shares indiscriminately? Indisputably, emphatically NO! This is a very volatile stock because there are so many questions to be resolved about the exact form the Internet will take over the coming months and years. America Online does present a nice package of network, content, online services and savvy for investors willing to take on risk and looking for a one-stop Internet investment. This is definitely no slam dunk, however; take the time to learn as much as you can, be patient, and make Foolish decisions.
Byline: Randy Befumo (MF Templar)