An Investment Opinion

You're probably going to see this on the television news tonight or hear about it on your favorite

morning radio show on the commute to work tomorrow, because I'm lifting the idea from a press

release I read today. An America Online/Roper Starch "cyberstudy" (I thought we stopped creating

words using using the prefix "cyber" sometime in 1996) released today shows 44% (+/- 3%) of the

1001 adult respondents who subscribe to an online service believe their Internet connection is a

necessity. The majority of the respondents replied affirmatively to "feeling good about being online"

questions posed in the survey. Most people believe that the online medium has improved their lives.

That's pretty powerful stuff, considering that over one-quarter of those surveyed have been online

for a year or less. Their enthusiasm isn't just the result of newbie excitement about getting "wired" on

the "'net." The more time a person has spent online, the more they have integrated online access and

content into their lives. However, I would bet people thought the same thing about television in the

1950s and radio in the 1920s. Just how different will the Internet be from TV's influence on

American society and world culture? Sure, the Internet is supposed to improve democracy and

unshackle information blah blah blah, making for more perfect political unions. But online political

forums can be really tiring to read and dulling to the soul in the factiousness of the debate. Some

people would contend that the world has become more fractious because of new media and that the

general level of the cacophony created by mass media has risen with each new innovation.

Well, maybe this is blasé, but I've come to the point where I view the machine on my desk as pretty

much an appliance. It's a stack of circuit boards and semiconductors, and it does allow me to do

things I never did before. Such as make trips to the bookstore on a weekly basis, whereas before

that wasn't a viable option because I loathe shopping malls. Such as buy a car online, which I did

earlier this year. Such as look up SEC filings rather than rely on occasionally unresponsive investor

relations departments to send me those filings. I definitely appreciate that. But no longer do I marvel

at the medium. No longer is the subject of how the Internet is changing the world a subject I want to

talk about at a party. It's actually a boring topic.

What does this mean for investors? Not to worry, it means a lot. It means that after almost five years

of using this medium for communication, it's no longer a novelty. It's mainstream and it's the way it's

going to go for the rest of our lives and beyond. It means that eventually PC companies will no

longer be fast-growers with great economics if managed right. They'll basically be television

manufacturers. America Online (NYSE:AOL - news) and Yahoo! (Nasdaq:YHOO - news) will

be like ABC and CBS and not akin to ham radio as they were in the beginning. AOL started as a

platform for the distribution and play of video games, and Yahoo! was someone's list of bookmarks

or "favorite places," for crying out loud. Now their market caps are multiples of the equity market

value of Capital Cities/ABC when that company was acquired by Walt Disney Co. (NYSE:DIS -

news) three short years ago.

Some people will say this is the result of mass investor delusion, that this is a bubble. While I'm quite

ready to say that valuations are inflated, I'm not so skeptical to pass off as wildly overvalued

anything that trades at 50 times book value or 20 times revenues. A company's value is driven by the

value of the free cash flows it can produce over its lifetime. It's not driven by how much equity is on

the balance sheet today or how many dollars of revenues it's generating today. Those are heuristics

that serve as data points in assessing the value of a company. They don't tell you on their own what a

company is worth.

Yesterday, I was told that I had hyped Amazon.com (Nasdaq:AMZN - news) because I compared

the company to GEICO Direct Auto Insurance, a unit of Berkshire Hathaway (NYSE:BRKa -

news) . This person told me that GEICO's business model all but assures it of making a profit, while

Amazon.com's model is much different. Let's leave aside the notion that "all the rules have changed

because of the Internet." They haven't. Companies will still be poorly managed and a select few

companies will be very well managed, no matter what the medium of commerce is. If established

competitors could just come in and crush entrepreneurial ventures, you'd be going down to

Montgomery Ward this weekend rather than Wal-Mart (NYSE:WMT - news) . And you'd be

shopping at Ace Hardware rather than at Home Depot (NYSE:HD - news) . You'd also be

reading this data delivered to you through a Bell Labs router on your Digital Equipment Corp.

computer with IBM Windows 98 as your operating system.

You might have picked up your computer at your favorite warehouse club at a severe discount, but

don't try to tell that to people who want to sell Amazon.com short based on its low gross margin and

the impossibility of the company to avoid the inevitable pricing pressures that will ruin all Internet

retailers. According to such people, you can't make money on gross margins of 22%, and forget

about it if you try to make money on gross margins of 12%. All of this ignores the very real fact that

there are companies that make tons of money on gross margins of 20%, 15%, and under 12%. And

these companies are very much cash flow positive, too. If you're having a tough time with that one,

check out Costco's (Nasdaq:COST - news) numbers and the way it moves its inventory. Look a its

cash conversion cycle (days in inventory plus days in receivables minus days in payables) and then

compare that with all sorts of other companies. While you're looking at companies with gross

margins under 12%, take a look at B.J.'s Wholesale (NYSE:BJ - news) .

The very best Internet retailers have a very good shot at staying around. I won't say they will stay,

because I don't know what jackass might come along five years from now and wreck a good

franchise. The Internet is a fact of life and it's going to stay. And look out when midband and

broadband pipes start to become commonplace for consumers. The way we invest, the way we

communicate, the way we gather information to understand what's going around us, and the way we

do a lot of things has been irrevocably changed. But that doesn't change the fact that human

capabilities and outcomes are spread across normal distributions. In other words, not every retailer

that operates on the Internet is going to be an incredibly well-run company. Not every retailer that

has to deal with the fact of 10% gross margins will be a success. Not every Internet portal will be a

good information aggregator just because it's called a portal in the company's press release.

Investors should realize that there are companies that will strike it huge on the Internet because they

have the human talent, financial capital, the right products or services that customers want, and a

rapidly growing market penetration in American, and eventually worldwide, homes. Low margins are

a red herring, and the fact that a company might not be making money today doesn't mean that it will

never make money. Arguments predicated on the perfection of competition on the Internet and the

total destruction of competitive advantages born of brand names or goodwill that a company can

build with its customers are pretty much at odds with the history of commerce over the last two

hundred years. New companies will take advantage of new technologies and learn how to become

preeminent in whatever industry in which they operate.

So get used to the fact that the Internet is here to stay and that it doesn't break all the rules that apply

to human endeavors and that it will fulfill the rules of perfect competition that we suffer through in

Econ 101. (Barron's had a great piece on this recently). Maybe competition will approach this

condition more closely, but it won't ever get there while there's a service element to be overlaid onto

a commodity good that is being sold. Whatever its effects on society and all the endeavors of the

members thereof, for ill or for worse, the Internet brings incremental changes to how we already live

our lives. It doesn't change everything, and it doesn't revoke time-tested truisms of the way things