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M&A Fever Aside, How to Evaluate the Fundamentals

(Editor's note: Paul Noglows is a senior Internet analyst with Hambrecht & Quist in San Francisco. There is a disclosure at the bottom of this column indicating H&Q's relationship to companies mentioned in this column.)


A cascade of deals including


investments in



and its


Internet/online service,


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taking a 43% stake in



, and


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proposed mega-acquisition of



have turned the Internet arena into a high-stakes game of "Who gets bought next?"

Given the prevailing environment, it may come as some surprise that I still look first at operating fundamentals when trying to come up with Internet stock recommendations rather than trying to divine the next takeover target. While much of the recent runup in the stocks is directly attributable to the current takeover speculation, such speculation should not cloud the fact that their underlying businesses need to be evaluated on an ongoing basis.

So how does one go about evaluating these companies?

I believe the historical metrics used to measure performance among traditional tech and media plays are not always relevant when trying to measure the performance of Internet stocks. Even so, it is worthwhile to analyze comparables both within the sector and across industries (revenue/market capitalization, cash flow, per subscriber/per user multiples). While I plan to present this analysis in future columns, I think it is useful to first identify and focus on the operating fundamentals -- things like alliances, audience, usage, international activities and management -- that underpin and drive those numbers.

While some number-crunchers may consider these measures simply too warm and fuzzy, we in the H&Q Internet Research Group believe these metrics provide the best insight into a company's competitive position and are integral to picking winners in the Internet space long-term. Further, we believe increasing investor focus on these metrics has been the primary driver behind the sector's dramatic appreciation year to date -- the

H&Q Internet Index

is up 64.7%, compared with the


12.8% rise and the

Nasdaq Composite's

19.6% gain -- and should be more closely scrutinized going forward even after the current deal frenzy settles down.

Alliances and acquisitions

. While the din surrounding the most recent round of investments has become deafening, the early-stage nature of most Internet companies means that alliances and acquisitions will remain a key metric for evaluating Internet stocks. While press releases trumpeting new partnerships will continue to flood the market, it is important to take a hard look at the "meat" behind the alliances being signed.

While many companies are throwing around significant sums of money trying to gain distribution --


has signed a flurry of high-priced deals with a range of partners, including

America Online


($20 million),



($16 million) and



($15.5 million) -- it is important to differentiate between these deals and other partnerships that potentially have true impact on the long-term strategic positioning of the companies involved. A good example is

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SportsLine USA's


partnership with


, whereby the network broadcaster took a 12% ownership stake in the sports online service in exchange for more than $62 million worth of promotion and content (it last week trimmed its stake to 10.8%). NBC's recent investments in CNET and SNAP! and Disney's 43% stake in Infoseek also fall into this category.

Outright acquisitions also can dramatically change a company's operating outlook. AOL's acquisition of


, the maker of ICQ, an Internet chat and messaging application that has built a community of more than 12 million registered users, will allow AOL to pursue a multiple brand strategy on the Web. Similarly, Yahoo!'s acquisition of

Four 11

, a free-email provider, provided a key building block in the development of Yahoo! into a true Internet portal. Likewise, Lycos' acquisition of


, a home-page community that provides home-page building tools to its users worldwide, has resulted in a dramatic increase in traffic to the Lycos site.


. Another key metric for measuring Internet stocks will remain a company's ability to effectively increase audience for its services in both frequency and reach. When examining the specific growth rate of a particular service, it is important to always keep in mind what it has already built. While AOL continues to add members at a healthy rate of about 300,000 users per month, it is already building from a huge installed base of more than 12 million members worldwide.

As services such as AOL and



(which attracts more than 30 million unique users per month) attain critical mass in terms of users, the advertising and electronic commerce opportunities afforded them are greater than those players who are still in the early stages of building their audience bases (albeit sometimes at higher rates of growth). Nevertheless, we should not ignore or discount the explosive and potentially threatening impact of certain new entrants.


. Perhaps the most obvious and tangible metric for analyzing the progress of Web companies is to track usage rates on a quarterly basis. While these metrics vary significantly from company to company, some of the key parameters include number of transactions, average order size and the amount of time spent online during a specific period of time. Repeat usage is also highly significant, as the cost of customer acquisition is measured against the lifetime value of the customer. Hence, justification for exclusive real estate deals and aggressive advertising campaigns is highly dependent upon heavy repeat usage.

Moreover, content sites are highly dependent upon ramping traffic usage as a means of attracting advertisers. Heavy repeat usage is critical to aggressively ramping page views over time. A number of the market leaders on the Internet are demonstrating very impressive repeat usage rates. At

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, 58% of sales are from repeat customers.



customers trade on average 25 times per year.


. We believe the international market will be a key determinant of success for Internet stocks. Because the Internet experience varies little from country to country (as opposed to significant programming differences inherent in broadcast and cable TV), Internet companies have a very real opportunity to expand their services meaningfully overseas. We believe companies that are aggressive on this front will benefit from traditional first-mover advantages and will be able to ink deals with established local partners (such as AOL's and Lycos' deals with German media giant


) before the market becomes overcrowded.

AOL management has made it clear that it believes Japan will ultimately prove its biggest market outside the U.S. and that the international strength of the


service was the major impetus behind its purchase of the company earlier this year. From a business-to-business online services perspective,


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agreement with

British Telecommunications

to build, develop and manage a U.K.-based Certificate Authority is a significant example of an alliance built to exploit international opportunities with the right local partner -- marrying product expertise with geographic knowledge and deep and relevant pockets.


. While this may seem like a no-brainer, management remains the key link in any Internet stock story and its performance must be reassessed regularly. We rate management teams on their ability to quickly adapt to changing markets, their fundamental understanding of both their service offering and end users, and their ability to keep an open mind with regard to opportunities as they present themselves. Finally, we are big believers in managements that can map out a clear path to profitability.

While H&Q was one of the first to espouse the need to "Get Big Fast," today's investors increasingly expect profits to follow on the heels of dramatic top-line revenue growth. I would give extremely high marks to the management teams of America Online, Yahoo! and Lycos, which have distinguished themselves on the above points time and time again.

Paul Noglows is a senior analyst in Hambrecht & Quist's Internet Research Group. The opinions represented here are his, and not those of

. His column is not a recommendation to buy or sell stocks or to solicit transactions. H&Q has investment banking relationships with, CNET, Lycos, SportsLine USA and VeriSign, which are featured in this column. In addition, Noglows currently has buy recommendations on America Online, Lycos, SportsLine USA and Yahoo!. H&Q currently has buy recommendations on, CNET and VeriSign. Noglows welcomes your comments at