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Net2Phone -- A Trick*

By Bill Mann (TMF Otter)

Trading at $54 3/4 as of October 25, 1999

An interesting situation arose from the valuation of newly public Net2Phone <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NTOP)") else Response.Write("(Nasdaq: NTOP)") end if %>. It works like this: IDT Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IDTC)") else Response.Write("(Nasdaq: IDTC)") end if %> sold off 45% of the total shares of the company in July, maintaining a 55% stake in the company. Net2Phone proceeded to scream out of the gates following the IPO and now has a market cap of $2.8 billion. IDT, however, has languished over the same period and has a market cap of $750 million. But IDT owns 55% of Net2Phone, a stake that would be worth $1.5 billion itself. Is the market telling us that the rest of IDT's holdings are worth negative $750 million? It hardly seems possible. Is IDT severely undervalued?

No, I believe that Net2Phone is way overvalued. About three weeks after the IPO, the company enjoyed one of those fast 500% gains (from $15 to $92) that only seems to happen to Web companies that capture the fancy of the public. In so doing, they turned what is a pretty good business story into a rampage. The stock has settled recently at about $60, still 300% above its low of the year. To my mind, this company has much more reason to fall than it does to rise from this price level. A company with as good a plot line as Net2Phone should continue to have tremendous peaks and valleys in share price. However, the weight of market measures such as the vanishing margins in Net2Phone's core business will doom the company to mediocrity.

Net2Phone is an Internet telephony company, allowing customers to make low-cost calls using their personal computers or telephones. Using Net2Phone, a customer can call from anywhere in the world to the United States for a flat rate of $0.10 per minute, from the U.S. to the Ukraine for $0.40 per minute, from South Africa to the U.K. for $0.099, and so on. These are great rates and have gone a long way to building Net2Phone's brand as a cheap source of international telephony rates.

But there is a certain craziness about its valuation. Net2Phone is priced currently at 59 times sales, a level that means that this company could walk on water for the next few years and still fail to meet investor expectations. Add this to the fact that Net2Phone is expanding its net losses at a much faster rate as it is growing revenues (43% vs. 27%). But beyond all of this is a factor that is more external than qualitative on the part of the company: Net2Phone is little more than an arbitrage player in a market that is in price free fall. Further, Net2Phone's increased participation in the market will do nothing but cause it to fall faster, removing the only edge the company has. In essence, the company is cannibalizing its own market.

I have no doubt that Net2Phone can continue to build its brand, but I am completely convinced that it is in a dead-end market. Why? For several reasons, but mainly because the price inefficiencies the company is exploiting are disappearing so quickly through increased competition and deregulation that it is going to have to rely on its market power in order to derive even minuscule margins. And although it may have 30% of the global Voice over Internet Protocol (VoIP) market, the barrier for entry by substantial telecommunications companies and incumbent carriers is so low that I almost completely discount this as an advantage.

Net2Phone is depending on its ability to bypass "accounting rates" administered by the International Telecommunications Union for its competitive advantage. The concept of accounting rates is simple. It is the price that one carrier has to pay another to complete a call. So if you use MCI and call France, part of the rate you pay is a charge that Telecom de France levels upon MCI to complete the call. In many countries these accounting rate payments are a major source of revenue, and so they keep them extremely high, sometimes in excess of $4 per minute.

Net2Phone's parent IDT and thousands of other companies have used advances in technology to set up direct private circuits on the most trafficked routes, something that has caused a ferocious price competition. For example, the cost of calling from the U.S. to Israel has dropped by more than 80% in the past year; to Bogota, Colombia by 60%, and to Beijing by 75%, as more competitors set up their own bypass routes and then cannibalize each other for customers. Still, for the time being, Net2Phone's customers tend to be calling from international points to the U.S., not the other way around, so they are not yet as heavily affected.

But it would be folly of the worst kind to think that the incumbent carriers are not aware of the revenues they are losing to VoIP and other bypass carriers. Fortunately for them, they have an easy recourse: They can set up their own VoIP systems and charge their existing customers directly on existing invoices. These large carriers are not too pleased about the revenues they are losing and can staunch the flow by using their market power to offer competing products.

Industry pundits are almost unanimous in their belief that the arbitrage opportunities for Internet carriers are coming to an end, with a time period of two years or so for the companies to reinvent themselves. In this time Net2Phone will have to find new ways to differentiate itself and add value to its basic business of really cheap phone calls. Can they do it? Well, sure, I think Net2Phone is a great company. But let's add up the variables.

• Currently at 59 times annual sales
  
• Dwindling rates and razor-thin margins
  
• Low barrier to entry for established carriers
  
• Two-year freshness on current business model
  
• Significant expenditures needed for new business development
  

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Net2Phone Company Information:
Trades on Nasdaq under symbol NTOP