The Anglo File: Freeserve IPO Imminent

Dixons Group is getting ready to spin off Freeserve, and analysts have wildly different valuations for the ISP.
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LONDON -- Billed as either the greatest Internet IPO on the British Isles or a disaster waiting to happen, the flotation of

Freeserve

, the Internet service provider of the U.K.'s

Dixons Group

got underway this week as marketing began in earnest.

The bulls and the bears are lined up on either side and have wildly different valuations for the spinoff. Even John Clare, Dixons' CEO, publicly admitted in April he didn't have a clue how to value Freeserve.

Freeserve was one of the pioneers of the subscription-free ISP business model in the U.K. Because U.K. Internet users pay for metered phone calls as opposed to the flat-rate telephony service in the U.S., Freeserve saw it was possible to scrap the subscription and instead rely on a slice of the revenue from the phone charges, as well as money from advertising and e-commerce.

The result: In a little over 12 weeks Freeserve overtook

America Online

(AOL)

as the U.K.'s largest ISP. Its success, in turn, forced a majority of other ISPs, including

British Telecom's

(BTY)

, to adopt the subscription-free business model.

According to a report this month by the U.K. consultancy

Fletcher Research

, 45% of people who connect to the Internet now use either Freeserve or British Telecom's

ClickFree

service.

Freeserve's success led to Dixons' decision to float 18.25% of the ISP's shares on the

London Stock Exchange

and New York's

Nasdaq

market.

Pick a Number, Any Number

How much is that business worth? In the press release, which can be downloaded from Freeserve's

Web site, Dixons says: "The float is expected to value the company at nearly 2 billion pounds

$3.14 billion." But Dixons seems to have arrived at this number by sticking a pin somewhere between the valuations of analysts, which range from 500 million pounds to 2.5 billion pounds.

Analysts use AOL as a comparison and then apply a discount; the discount varies according to the analyst's bullishness about Freeserve's prospects going forward.

In the Red Corner

On the bull's side,

SG Securities

puts Freeserve's valuation at about 3 billion pounds, based on a figure of 1.4 million active users (the number of users Freeserve gives in the prospectus is actually 1.25 million) and a price of 2,160 pounds per subscriber.

SG, which has a strong buy rating on Dixons and no investment banking relationship with the retailer, says the share of phone call revenue it receives underpins the cost base. As a result, it sees operating profits of 2.6 million pounds from Freeserve in the financial year ending March 31, 2000 and 9 million pounds in fiscal 2001. However, as costs level out and advertising and e-commerce revenue take off, SG sees profits of at least 28 million pounds in fiscal 2002 and 48 million pounds in fiscal 2003.

Many believe, however, the cash cow of metered phone call revenue may be headed for the abattoir. Oscar Castro, manager of the

Montgomery Telecommunications Fund

, says: "There's no way to avoid

flat-rate access to the Internet and the telcos recognize this." Already BT ClickFree offers its customers free calls to the Internet on weekends and

X-Stream

, another subscription ISP, offers free calls if the customer switches his or her local provider from BT to a small independent operator.

This leaves an awful lot resting on the explosion in revenue from e-commerce and advertising predicted by SG. Alas, there is little evidence of this so far.

And In the Blue Corner

Dixons announced earlier in the week that Freeserve lost 1.04 million pounds on revenue of 2.73 million pounds in its first eight months of business. And there are questions whether this can get much better.

Iain McDonald, analyst at

Charterhouse Securities

, which has no investment banking relationship with Dixons, notes the very speed of Dixons' success with Freeserve highlights its fundamental weakness -- the barriers to entry in the market are very low. As such, there are now about 80 subscription-free ISPs in the U.K., and some are backed by big names such as book retailer

WH Smith

and the U.K.'s most popular newspaper

The Sun

.

As a result of this increase in competition and the spending needed to retain customers, McDonald predicts Freeserve's operating profit in fiscal 2003 will be only 2.18 million pounds on revenue of 23.6 million pounds. McDonald has a reduce rating on Dixons.

That is unlikely to deter the Internet bulls, however, and many expect a strong debut for Freeserve. For one thing, there will be very few shares available and Dixons has promised it won't sell any of its remaining stake in Freeserve for at least a year after the flotation.

The market has already shown its enthusiasm for Freeserve by lifting Dixons' share price to 1185 pence on Thursday from 599 pence on Sept. 22, when the ISP was launched.

Dixons is also targeting retail investors, or at least those who have access to the Internet. Members of Freeserve will be allowed to register to buy shares; the minimum investment level is set at a low 250 pounds. Luddites who still rely on the post and telephone are not welcome. This is unsurprising, since Dixons realizes those who buy online are more likely to buy online using Freeserve if they have a stake in the company.

And finally, there is no reason to believe that investors here won't adopt the same attitude over Internet IPOs as their American cousins have: Buy now, ask questions later.