This is my personal blog. Travel, financial and political observations. Notes to myself and my friends. Content development for my monthly newsletter, Porter Stansberry's Investment Advisory (www.stansberryresearch.com).

Thursday, March 23, 2006


The myth, if you’ll recall, began in 1995 with the Netscape IPO.

The first Internet software stock to go public priced at $28 per share in August 1995, closed at $59 on its first day of trading and reached $171 per share by December, sporting a market capitalization over $1 billion.

By the top of the mania in 2000, Yahoo! had achieved a market cap of $150 billion.

The myth was that the Internet would change everything because the Internet would produce new levels of productivity and efficiency. Buying things from Amazon.com would cost less, allowing Amazon to sell at lower prices. Investors buying Internet stocks were told to throw out the old ways of valuing a business because, in the new economy, capital efficiency would make a mockery of low P/E ratios.

The Internet has changed some industries. Newspapers, in particular, have seen their revenues cannibalized by net advertising, which offers specific customer targeting and tracking and which, generally, costs much less. Internet advertising revenues reached $10 billion in 2004. According to Price Waterhouse Coopers (PWC), in the first six months of 2005, total ad revenue for websites reached $5.8 billion, 25% higher than for the same period in 2004. I personally know of financial websites that were able to raise their ad rates by 60% in 2005.

Meanwhile, newspapers have seen large single digit revenue declines.

So…the Internet did change everything in the print ad business. And, I bet, in time it destroys TV advertising too, with an assist from Tivo.

But what about the other stuff – the promise of far great capital efficiency? What about the promise that the Internet would make our lives easier, cheaper and vastly more profitable…?

It’s not happening.

While companies like Amazon and Google have offered users discounts and lots of free services (free shipping, free email, free data storage), the costs haven’t truly been removed – or even lowered – for any of these services. Who’s paying for them? Shareholders.

In early March Google announced it would have to spend 19% of net sales on capital investments – mostly the services and data warehouses required to give essentially free unlimited storage to email users who pay nothing (directly) for the privilege. These costs are the manifest result of the web’s low switching costs – something that’s always made it a troubling medium for business. When the Froogle search engine can tell you where on the web to buy that hot new widget at the lowest possible price, how can widget venders earn a profit? Only by spending huge amounts of money on user perks like free shipping and free email storage.

The result is that investors continue to subsidize Internet businesses in the same way they subsidized Netscape. The only difference is that the damage is hidden from the income statement because the required spending is put in the capital budget, where they hope you won’t see it.

Alas, I looked.

To make the study more interesting, I didn’t just look at the major internet stocks (Yahoo, Ebay, Amazon, Google), I also threw in smaller Internet businesses I know well (Digital Insight, Akamai) and I looked at another handful of stocks that are either very well-know (MSFT, GM, Dell) or have been recommended in my newsletters (BL, NOK, BUD).

[All $ figures below are in millions. Capex% refers to the percentage of capital spending, as measured against cashflow. "FCF Mult." refers to the companies market cap as a multiple of free cash flow.]

Cashflow Capex Capex% FCF Mult. '05 Rev. Growth
MSFT $16,605 $812 5% 18 9%
RTN $2,515 $338 13% 10 9%
NOK $4,900 $718 15% 22 13%
DELL $4,839 $728 15% 17 13%
BL $48 $8 17% 4 -7%
EBAY $2,000 $338 17% 31 42%
YHOO $1,700 $408 24% 35 40%
AMZN $733 $204 28% 28 17%
DGIN $57 $18 32% 31 16%
AKAM $83 $27 33% 77 44%
LXK $576 $201 35% 11 -12%
GOOG $658 $245 37% 245 86%
BUD $2,800 $1,100 39% 19 -1%
GM $13,000 $7,700 59% 2 -1%
VZ $22,000 $15,000 68% 14 6%

Some interesting things pop out right away.

First, the Internet companies aren't very efficient with their capital spending. Second, there are manufacturing companies that are surprisingly efficient -- Raytheon (RTN) and Nokia (NOK). Third, lots of capital spending doesn't ensure revenue growth (BUD). And fourth, telecommunications (Verizon, VZ) is incredibly capital intense. You have to wonder what that will mean in the future, as more and more businesses compete for the same home connection. Telecoms could end up in the same situation as the airlines. It's probably better to own the equipment makers.

Now...about those Internots...

In almost all respects except for its medium, Amazon.com is a catalog retailer, the Sears Roebuck of our day. There are many other companies in the direct sales retail space. Two I know well are Dell and Blair (BL). Both Blair and Dell (despite their enormous respect size differences) have a website business and a catalog presence. And both spend around 15% of their free cash flow on capital investment each year. Amazon on the other hand spends 28% of the cash its produces each year on investments. That’s a lot of spending to produce only marginally more growth. (Dell grew sales at 13% last year; Amazon 17%).

But the Google example is much more startling. Google, like Microsoft, is a software company. It sells access to its software through its Internet site (Google.com), which generates advertising revenue through tracked sales links and paid-for search results. You would think that a totally centralized software operation, based completely on Internet connectivity would prove to be a far more capital efficient business than Microsoft, with its multiple products, multiple versions and its mix of hardware devices (the Xbox.) But you’d be wrong…

Microsoft only spends 5% of its free cash flow on capital investments, while Google is spending 37% -- putting Google on par with one of the huge industrial stocks in our survey, Budweiser. Is Google’s outstanding growth rate (86%) worth this rate of investment? I can’t imagine how. Not when switching to another search engine provider is as simple as forwarding a few of your favorite email files to someone else’s server.


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