Net Value: Marketwatch Says Nuts to Brazil

The Internet's first hot new offering of the year gets a price boost.
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Gauging that Brazil could clobber just about anything but an Internet IPO,

BT Alex. Brown

and

Donaldson Lufkin & Jenrette

late yesterday decided not only to proceed with

Marketwatch

(MKTW)

-- but also to bump up the offering price and rake in $47 million. However, the valuation is high according to a popular methodology used by Wall Street. That could cause problems over the coming weeks -- unless South America first sends things in the same figurative direction.

Let me emphasize up front that Marketwatch is a terrific service. It offers a rich, well-executed array of market news, commentary, data and investing tools. Much of the journalism is top-notch. In my work, I consider Marketwatch as essential a read as

TSC

and

The Wall Street Journal

.

But this is about the IPO. Its high valuation is nothing new for Internet stocks. However, as I'll explain shortly, the context is a bit different this time.

Not that the valuation will matter to immediate performance. Most retail investors who buy Internet stocks read only press release headlines, not prospectuses. Since November, the modus operandi has been primal word association. This one is: "

CBS

(CBS) - Get Report

." "Marketwatch." "Buy."

That buzz is amplified by MKTW being one of the first major IPOs to offer direct retail participation via the Internet (though available shares will be "limited").

DLJDirect

and

Wit Capital

are, as the prospectus designates with trademarked moniker, "e-Managers" -- e-cch!

Indeed, yesterday's price increase is only the latest bump up. It had already been raised Wednesday to $14 to $15 from the originally projected $10 to $12. The stock opened at 90, rose as high as 110 and is currently trading around 98.

The underwriters are just doing their job, of course, which is to maximize revenue for their clients and themselves. (That's why they call it the "sell side" rather than the "do-investors-a-favor side.")

But the valuation is inconsistent with Wall Street's popular valuation method of "comparison with peers."

For example,

CNET

(CNET) - Get Report

, whose focus on original news content and related services is similar to MKTW, currently trades at 22 times its annualized third-quarter revenue of $14 million.

At its offering price of 17, MKTW would have been valued at 28 times its third-quarter revenue of $1.8 million, annualized.

Bear in mind that IPOs are priced at a sizable discount to what the underwriters think they will fetch in the aftermarket. At 98, MKTW is valued at 158 times annualized third-quarter sales.

Ziff-Davis'

(ZD)

December registration for the so-called tracking stock of

ZDNet

nominally values that enterprise at five times annualized third-quarter revenue (see footnote below).

And

Lycos'

(LCOS)

October

purchase of the

Wired Digital

news and information service was at four times forward revenue.

Unintended Consequences

Normally, Wall Street analysts avoid comment on new issues until the underwriters issue their initial "research reports" (usually about a month after the IPO). In particular, stepping on the IPOs of others isn't considered good form.

But some analysts may do so inadvertently, emboldened by the yellow flags on Internet stocks raised Tuesday and Wednesday by

Morgan Stanley

and

Deutsche Bank Securities

, not to mention a slightly schizoid backpedaling by

CIBC Oppenheimer

of the $400-call-on-

Amazon

(AMZN) - Get Report

fame.

Negative front-running of BT Alex. Brown, DLJ and

Salomon Smith Barney

probably wouldn't take the obvious forms -- such as a report on Marketwatch itself. But it could well happen via innocent mention in other missives or media quotes about the Internet sector and Internet stocks.

A Question of Risk

My objective isn't to bash the IPO. But given the fact that there's plenty of gush around about the positives, here are two of the less obvious but important negatives. They won't matter to the IPO -- but they could haunt Marketwatch down the road.

Narrow Ad Base

Marketwatch's revenue stream isn't well diversified. Although the prospectus proclaims that in the past year "more than 100 organizations have advertised on our Web site," revenue is concentrated among a smaller number of advertisers. According to the prospectus "As of Dec. 31, 1997, four customers comprised 53% of our gross accounts receivable." The prospectus doesn't disclose the percentage of revenue for the top four; it reveals only that "As of Sept. 30, 1998, one customer comprised 11%."

It appears that the concentration arises among the seven online brokers with "premiere placement" sponsorships. Of those, only DLJ Direct is first tier. (Note that DLJ is joint manager of the IPO). The others are

Datek

,

First Trade

,

Mr. Stock

,

ScoTTrade

,

Trading Direct

and

Web Street Securities

. Absent are

E*Trade

(EGRP)

,

Schwab

(SCH)

, etc.

A merger or acquisition for these weaker players, especially likely in a prolonged market downturn, could significantly nick MKTW's revenue.

In addition, E*Trade's initial success with a portal format may signal a trend among the majors that will present new competition to Marketwatch. The prospectus discussion in "Risk Factors-Competition" doesn't deal with this.

Also of note is that

Data Broadcasting

(DBCC)

, which owns 38% of Marketwatch and provides the service's market data and much of its operations support, accounted for 4% of ad revenues in the nine months ended Sept. 30. DBC is committed to more than twice as much ($500,000) in 1999 and in 2000. That's 7% of MKTW's annualized $7.2 million revenue run rate as of Sept. 30.

A Wink of the Eye

Much is being made of CBS' commitment of $30 million to promotion of Marketwatch. Sounds great. But there are two big problems.

First, it's not a freebie earnings-wise. The accounting for it creates marketing expense. Yup. As the prospectus details: "Promotion and advertising provided by CBS under the Contribution Agreement will be recognized as an expense and capital contribution during the period in which the services are provided based on the rate card value of such services."

The financial statements show this CBS noncash promotion accounting for 50% of Marketwatch's total third-quarter marketing costs of $3.2 million. And those were 177% greater than total revenue.

Second, the $30 million is over five years from October 1997 ($25 million remained as of Sept. 30), and the prospectus reveals that "The timing and placement of these advertisements and promotions are subject to CBS's discretion. ... CBS also makes no guarantees to us as to the demographic composition or size of the audience that views these advertisements or promotions."

Six million dollars a year doesn't buy much exposure on network TV, and lack of control over placement could effectively reduce even that value. The prospectus also says: "CBS could discontinue promoting us in the manner that it currently does." In fact, last week's extensive cross-promotion deal between

AOL

(AOL)

and CBS TV news might downgrade some of Marketwatch's exposure on CBS.

In addition, CBS' discretion in the timing of promotions holds the potential to impart some unpredictability to marketing expense recorded by MKTW in each quarter.

To top it off, in return for the license to use the CBS name and logo on its Web site, Marketwatch pays CBS 8% of annual gross revenue up to $51 million and 6% of gross above that.

A positive is an informal arrangement whereby Marketwatch reporters contribute reports and on-air appearances to CBS radio and TV news. Compensation is the identification with Marketwatch.

Certainly the CBS name alone is of great value to Marketwatch. But it's likely that Marketwatch will have to spend more on marketing than the affiliation might at first seem to suggest.

Footnote: Based on a $115 million proposed aggregate offering price and the prior estimate that 20% of ZDNet shares would be offered.

David Simons is managing director of Digital Video Investments, an institutional research firm. He has been involved in computer and online services for 25 years as entrepreneur, adviser and investor. At the time of publication, neither Simons nor his firm had any position in stocks mentioned in this column, though positions can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column by sending a letter to commentarymail@thestreet.com.