November 9, 2000

More than half the market value of internet stocks, or $1.75 trillion, has vanished in the past six months. About 16 percent of all publicly traded internet companies have failed this year. In September, internet layoffs reached 6 thousand, the highest monthly decline in positions from existing web companies yet.

Some of the problem could be anticipated from the failure of e-commerce to rebound rapidly following last year's deeply discounted and largely free shipment Christmas season. Instead of 1.1 percent of retail trade by the end of this year, as Gartner, Forrester, and others forecast, e-commerce will barely reach 0.8 percent of trade.

What has happened to e-commerce is two fold. First, the use of equity capital to purchase customers has proved too expensive and not sticky enough (in terms of getting repeat business after the special deals end) to justify the costs. With only a few exceptions, such as Ebay and the subscription portals, costs per additional dollar of sale could not fall enough to justify the cost of acquiring those sales.

Second, competition has increased so fast that company growth has slowed before cost advantages from size and being first have been exploited. As a result, the number of months of operating capital needed before cash flow turns positive has been far more than most venture capitalists thought. As a result, the venture community, despite substantial infusions of capital for their own account, has become increasingly unwilling to bet on e-commerce.

However, a second problem has been in the failure to recognize the foundations for much of the web advertising. In the first half of this year, almost 40 percent of the ad dollars on the web were generated by web sites trying to be noticed. So far, there is little evidence that these ad dollars are effective (although using content for developing leads to aid in more traditional sales has showed some success).

In effect, the web was attracting equity capital to finance advertising that was supporting web sites. Now that some of these sites are failing, that portion of the web advertisement dollar is vanishing. Indeed, the result is a growing consolidation of ad placements on the internet. A lot of those free Clark Howard sites will vanish in the next year.

Furthermore, some of the most ardent competitors have been traditional retailers who have web enabled their activities. Clearly, some costs have occurred. The internet ventures continue to detract from profits in some traditional retailers such as Sears to the home improvement providers. Nevertheless, the combination of service departments and internet transactions have proved to be formidable. I used to mention that the race was to see whether Walmart would become like before Amazon became like Walmart. So far, Walmart is winning.

Despite the burst in the e-commerce speculative bubble, internet technology should continue to grow strongly. This is why those companies that build the internet continue to maintain strong market values even as those applications on the are valued sharply downward.

Indeed, some hot embers still burn in the technology ashes. Fiber optics, wireless communications, and internet infrastructure continue to quicken the hearts of venture capitalists. However, those consolidators of business services and materials are seeing their market values fall almost as quickly as the commerce investments, despite business transactions that are ahead of the Gartner, forecasts for 2000.

Early this year I estimated that the internet economy would become 15 percent of GDP before its growth slows to those experienced by more traditional economic sectors. That would justify a valuation of almost $5 trillion for this technology. Therefore, the $2.9 trillion valuation that was reached early this year did not appear to be excessive. Except, my assumptions are based on the total potential of the internet economy. There never was any justification for assigning two thirds of that value to currently existing enterprises.

Have we now overdone the shakeout in new technology values? We are currently valuing the sector at a quarter of its potential according to my estimates. This is not cheap, but neither is it excessive. Furthermore, those companies that soon will be creating positive cash flow probably have been punished more than justified by current conditions. The discounting and special deals last Christmas created unusual, but unsustainable, growth. Reality has returned to the sector. Growth will be slower but its destination in terms of importance to the economy probably has not been changed. It will just take a bit longer to get there.

When the price to next year's earnings for a Dell or a Microsoft falls below the ratio paid for all stocks on the Standard and Poor's index, as happened recently, I would bet more on the future of these leading technology companies than I would on the economy.

I know the plunge has been painful, just as the surge was exhilarating but unsustainable. However, a base of reality has been reached and some companies already are trying to bounce off that base. Internet technology is too powerful to be stopped by a plunge in the stock values of many of its users.


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