Stick to the Net

Jan 22 1999

Market capitalization is more than just a simple measure of a company's value - it's one of the most strategic and powerful weapons a company has. In the Internet sector, where investors have bid up stock prices dramatically, that's especially true.

Companies with hefty market caps can outgrow, outspend and outmarket their competitors. For instance, Justice Department issues aside, Microsoft 's giant market cap clearly helped it defeat Netscape. In the browser wars, when Microsoft decided to give Internet Explorer away for free, the company annihilated Netscape's billion-dollar Navigator business in less than a year.

Netscape was left scrambling to redefine its business and defend whatever market position it had left. And, in the end, Netscape decided to sell out to America Online , a corporation with a much higher market cap.

By boosting the valuation placed on these companies, investors have rewarded online businesses for the unprecedented opportunities they are perceived to have. Through relative market-capitalization analysis, we can see that investors are rewarding these online businesses for the leverage of their business models, their startling growth and the vast market they're positioned to exploit.

Clearly, investors are paying significantly more for online companies than for their physical-world counterparts. Be it Amazon.com having a larger market cap than Sears - let alone Borders Books and Barnes & Noble combined - or Yahoo trading for more than Viacom , investors have chosen to arm Internet companies to the gills.

But the huge market capitalizations have a dark side. I'm more worried about how Internet companies are going to take advantage of their market cap heft, rather than the relative richness of their valuations. It's comparable to a prince who inherits a throne by divine right and fancies himself a ruler and general at the ripe age of 12.

Some Internet executives are going to have similar ideas. Whether they admit it or not, a number of these players don't quite know what to do with the power the market has granted them.

I fear many Net companies this year are going to make a series of unsound decisions in an effort to defend their turf. One clear indicator of delirium will emerge as Internet firms begin to emulate their physical-world counterparts.

One possibility is that online businesses, in an effort to leverage their market-cap dominance, will start to believe they know how to run a brick-and-mortar operation better than their real-world competitors. I predict that in the next 12 months at least one Internet company will buy retail store outlets or print publications, or even launch an amusement park or television channel. Some corporations may begin to expand their scope to include a physical-world presence.

If you see Internet companies doing this sort of thing, beware. It is an unsound and inappropriate strategy.

Just because Net operations may have exceeded brick-and-mortar firms from a valuation standpoint doesn't mean they are any better-suited to take on the challenges and inefficiencies of physical-world businesses. Internet companies must shy away from these tempting investments. Not every business needs its own sales force - there are large and existing sales teams out there to leverage.

InfoSpace, for instance, negotiated with real-world Yellow Pages companies and used their partners to sell InfoSpace's wares. Whenever possible, Internet companies should piggyback off of the infrastructure already in place rather than take on these inefficiencies.

Contrary to the widespread belief among Internet companies, not every business needs its own data center, for instance. Firms that are providing infrastructure services seem to think they should build their own. This seems extremely counterproductive, since there's already an overcapacity of data centers out there.

Let me remind both investors and Internet companies that the point of investing in the Net is to evade the inefficiencies of the physical world - not to emulate them. Online businesses should stick to their knitting and use their money intelligently.

If these players forget their roots, it's up to investors to remind them of what they are expected to do and, perhaps more importantly, not to do.

Danny Rimer, an Internet analyst with Hambrecht & Quist, maintains research coverage of AtHome, BroadVision , Concur, CNET , InfoSpace, Inktomi , Netscape, Pilot Network Services , USWeb and VeriSign . Rimer can be reached via e-mail at drimer@hamquist.com.