Dynamics Driving Internet Deals

In a Young Industry, Buyers Are Banking On the Firms' Value-Enhancement Potential

By Joan Harrison
Mergers & Acquisitions Sept/Oct 1999; Page 49

In the past few years, the Internet market has grown tremendously, and the number of mergers and acquisitions among Internet companies has kept pace with this rapid growth. As experts in the field point out, even though the industry is in a relatively early stage of the market life cycle, it is behaving more like a later-stage market, in which brisk m&a and IPO activity normally takes place.

Andrea Neakem, a principal at Broadview Associates in Fort Lee, N.J., notes that the market has quickly moved through the emerging-market stage, in which you normally see a lot of private equity. "There is still private equity today, but there also are a lot of IPOs and m&a, which you usually see in the late high-growth or mature-market stages," she says.

Since many Internet companies are highly valued, they can afford to use their stock as acquisition currency, and they have the luxury of opting to grow via acquisition versus growing internally, which can be a much slower process. Given the exponential rate at which thesector is growing, many companiesare choosing the quicker route to growth. "They have the ability to acquire as opposed to build and can afford to buy these companies now. That probably has accelerated the industry's movement into the high growth stage," she comments.

Since many Internet companies are not making money now, she adds, they don't have the earnings dilution pressures that worry other acquirers. "At some point they will start making money, but right now they don't have to worry as much about doing deals. That may be another reason why you see more m&a in this earlier-stage market than you would normally see in it," she notes.

Adding to that point, Jeff Anderson, a principal at Bond & Pecaro Inc, a Washington, D.C.-based consulting firm specializing in the communications, media, and new-technology industries, says that "typically you see more m&a activity going on in a more mature stage, when companies have more consistent revenues and operating profits." Also driving the flurry of m&a activity is that the abundance of venture capital that is now available to do deals is providing more liquidity for companies to be able to grow and expand through acquisition. Anderson cites a recent study by PricewaterhouseCoopers which tracks the quarter-to-quarter venture capital industry. In the first quarter of 1999, venture capital funding for software and information services companies was $1.5 billion, about a 60% increase over the first quarter of 1998, he says.

Also, acquirers are flush with cash because of the great economy and the high stock market valuations of their companies. "Now, Internet companies are attracting huge interest, particularly those that have been able to assemble a critical mass of users," he says. "Branding has been critical as well - market leaders are difficult to dislodge. There seems to be a particular importance to the first-mover advantage here compared with a lot of other industries," he notes.

Many Internet Companies Buy And Build Their Way to Growth

Many companies have accepted the Internet as an efficient and necessary medium through which to conduct business, and they must continually look for different ways to expand their distribution channels and expand their customer bases, he goes on to say. "They are doing that in different ways. Some are choosing to grow internally and others are expanding through acquisitions."

One avenue to growth on the Internet that exploits the connectivity of the Web is contextual selling - placing ads for products or links to web sites on a related company's web site. According to The State of Online Retailing a report on Internet retailing published by Boston Consulting Group, Amazon.com Inc, the Online retailer of books, videos, and CDs, recently cemented a partnership with OnRadio, a network of Internet radio stations, because research suggests that consumers develop an impulse to buy CDs when listening to the radio. Amazon, an active acquirer, is expanding its business with a strategy that links both internal development and growth through acquisition.

Valuation Models Have Not Kept Pace With the Firms' Growth

Some companies that are starry-eyed over the growth potential of Internet companies have chosen to buy them, even though they may not be generating revenues and profits. Many are keeping the Internet business separate from their traditional business, so that it won't impact operating profits, Anderson explains. He feels that even though there is a lot of m&a activity in the market, the industry is not consolidating. According to a study conducted by Keenan Vision, the number of e-commerce companies is expected to grow from about 17,500 in 1998 to about 45,000 by the end of 1999 - almost 160% growth!

Anderson believes that M&A also follows the value-enhancement potential of companies, not just the amount of time that an industry has been operating. Yet, while the growth of Internet businesses has exploded, the traditional valuation models have not kept pace with these changes, and it has been difficult to establish relevant benchmarks for valuing these companies.

"The only way to value most of them is on their 'potential,' because many have miniscule revenues and no operating profits," he says. People or companies looking to invest in or buy Internet businesses mustlook at valuation metrics that give an indication of the company's potential value - such as the number of subscribers, in the case of Internet service providers (ISPs), the number of unique visitors or daily page views, in the case of a portal, or the viewer conversion rate, in the case of e-commerce companies, he explains. "Eventually they will have to make money, their growth rates will come down, and the traditional measures of valuation will begin to apply," he says.

As an example, he says, in the mid-1980s, when the cellular telephone service market was emerging, the only asset of value that the cellular service providers' possessed was the licenses that allowed them to serve a particular portion of the population. The companies were valued based on their "value-per-population" rates, or number of potential customers. The companies then started to build their infrastructure and expand their customer bases, he says. When they began generating consistent revenues and operating profits, and established a track record, the traditional valuation methodologies could then be applied.

Internet Leaders Seem Capable of Supporting Their Present Values

"In the Internet industry, the potential is so difficult to measure. You know that the market potential is huge, but can a particular company achieve revenue and operating profit levels that will sustain its value? We just don't know." Anderson feels that market leaders eventually should be able to support their current, high valuations. "Many analysts believe that the No. 1 leader in the market will garner most of the revenues and profits." This statement is supported by the fact that although there is a proliferation of online retailers, revenues are still concentrated in only a few mature sites. According to The State of Online Retailing the 10 largest sites account for 500% of revenues; computer goods, entertainment, travel and discount brokerage account for over 80% of the online retail market.

But even market leaders like Amazon would have to experience dramatic growth over the next several years to support their valuation, says Anderson. For example, he determined that the mid-1999 enterprise value of Amazon is about $19 billion. Based on that figure, he wanted to figure out what kinds of growth levels the company would have to achieve in order to support that value.

Last year Amazon had $610 million in revenues. The company would have to grow its revenue by 200% in years one through five and 100% in years six through 10. It would have to achieve a small operating profit margin now, growing to a mature rate of about 35% over five years - a very high rate for the retail industry. Anderson says he assumed a discount rate of 15% and an exit multiple at the end of the 10 years of 40 times operating cash flow.

From 1996 to 1998, he notes, Amazon's net sales grew at a compound annual rate of approximately 525%. But in 1998, the growth level decreased to about 315%. "So, although the growth is still dramatic, it is decreasing, and I think that is an important point because, in the example, it shows Amazon having to sustain a very high level of growth and operating profit over a very long term just to justify its market capitalization and enterprise value as of today," he says.

In valuing Internet companies, he explains that you have to look at each sector separately. If you look at Internet service providers, he notes, there is much less of a premium ascribed to their enterprise values. Traditionally, they have provided access to the Internet but now are starting to branch out into other areas. He says that these types of companies are "more mature" in that they are getting predictable monthly fees from subscribers. As a result, their multiples of valuation are lower, he comments. They trade more in the 5 to 7 times trailing revenue range, he says.

On the other hand, if you look at the portal sector, like Yahoo!, those types of companies are richly valued and can run in the 29 to 37 times trailing revenue range. E-commerce retailers fall in the 30 to 36 times multiple range, he notes. "But multiples for such businesses as eBay, Priceline.com, and Amazon substantially exceed this range, and reflect a radically different marketplace for goods and services or enterprises that have reordered the retail distribution pipeline," he says. Business-to-business Internet services on average have multiples of about 12 to 13 times.

Anderson believes that as long as the number of deals involving Internet companies increases, transaction multiples also will rise. That will continue until the industry matures, and companies begin to realize more consistent revenues and profits, he comments. According to CyberValuation a report published by Anderson's firm, as the Internet industry reaches the mature stage, valuation multiples will start to decline to reflect lower anticipated growth rates. Huge multiples will then be reserved for those companies that continue to create new Internet products and services or that can "radically rearrange the business paradigm."

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