The Anglo File: No Free Ride for Potential Freeserve Investors

A suit against AOL Europe shows the Dixons unit isn't afraid to throw its weight around.
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Dixons, the leading Internet service provider in the U.K., is looking a little like the schoolyard bully by suing the AOL Europe unit of America Online (AOL) for slander. And if the stratospheric valuations that analysts are placing on a potential spinoff of Dixons' ISP subsidiary are correct, then it will certainly be the largest kid on the block.

Dixons began offering free access to the Internet in November of last year and in only 12 weeks overtook AOL U.K. as the largest ISP in the country. Freeserve now has around 1.1 million active members, compared with AOL U.K.'s 600,000 members.

Freeserve's business model relies on revenue from a slice of the local call charge that users must pay to stay online and for advertising and e-commerce.

Needless to say this predatory pricing, or nonpricing, has irked the competition and Freeserve has alleged that representatives at AOL Europe's

CompuServe U.K.

subsidiary were at one point telling its customers that the free Internet service provided by Dixon's

Freeserve

unit would be only temporary.

Dixons didn't return

TSC's

calls, but AOL U.K. said in a statement, "CompuServe and Dixons Freeserve are currently agreeing the terms of a settlement arising out of this complaint and are confident of an early resolution."

The suit is a sign that the subscription ISPs are a little frantic over how to stop the free ISP juggernaut that is storming through the U.K., leaving nothing standing in its wake. That Freeserve is the pre-eminent ISP in the U.K. is unchallenged. Its business model has thus far been so successful that Dixons' share price has more than doubled since Freeserve began operations in November, reaching a high this year of 1564 pence, compared with a low of 473 pence in 1998.

Dixons' shares have suffered from the selloff that swept through the Internet sector this week and they ended Tuesday down 8% at 1230 pence.

With British investors showing the same level of infatuation with Internet stocks as those in the U.S., it came as no surprise last week when Dixons said it had appointed

Credit Suisse First Boston

and

Cazenove

to look into strategic options for Freeserve, one of which would be a stock market listing.

Analysts estimate that at least 40% of Dixons' current share price is attributed to the Freeserve operations.

Salomon Smith Barney

last week placed an outperform rating on the stock and raised its 12-month target price on Dixons to 1700 pence from 1500, and the bank reckons Freeserve is worth 750 pence of that price. Salomon has had an investment banking relationship with Dixons within the past three years.

Salomon values Freeserve in two ways: as an ISP and as an online service provider, like a portal. AOL has a valuation per subscriber of $8,075. Assuming Freeserve will have 2 million subscribers by April 2000 and it is worth a third of AOL, then this translates into a market capitalization of $5.4 billion.

Alternatively, using an advertising model and comparing Freeserve to other portals such as

Yahoo!

(YHOO)

, the figure is somewhat less. The size of the online advertising market is forecast to be $200 million by 2003. Assuming Freeserve snags 30% of that market and basing a valuation on Yahoo!'s forward sales multiple of 92 times, then this translates into a market cap of $3.1 billion.

Whatever the model, these are impressive sums indeed for a company that Dixons itself expects to just breakeven some time this year.

Nainish Bapna, an analyst at

Nomura International

in London, believes the IPO would be helped by the unprecedented level of interest from institutional investors in the U.K.

"Day-traders in the U.S. have done much to bid up Internet stocks, but here the fund managers are likely to get into the action," Bapna said.

Isabelle Payet, an analyst at the British equity research firm

Sutherlands

, believes a value of at least $3.5 billion is not unreasonable for a company that is well placed to take advantage of e-commerce sales and commission on sales from e-commerce.

"Dixons has many stores around the U.K. and this will help them get distribution costs down for e-commerce," Payet says.

Putting the Free Back in Freeserve

Yet there remain concerns over the ability of Freeserve's business model to sustain these astonishing levels of growth.

Currently, Freeserve users in the U.K. don't pay a subscription to the ISP but are charged for making local calls. However, as competition in the British telecommunications market becomes even more frenzied, it is only a matter of time before free local calls become the norm.

Fletcher Research, a London-based consultancy, has problems with the comparison of Freeserve to AOL. "There are a few differences between the two -- for example, AOL subscribers pay a pretty handy monthly fee, which brings in $2.2 billion of revenue per year. AOL can also add on other e-commerce purchases to these regular bills, making the transition from ISP to e-commerce powerhouse far easier," Fletcher says.

The amount of money from online advertising is still open to question. Estimates range from a paltry $130 million to $205 million by 2003. Assuming Freeserve takes home 30% of the high end of the range, its share would still amount to only $61.5 million.

Armageddon in Internet stocks notwithstanding, a partial flotation of Freeserve is likely to be a success, leaving it well placed to take litigious umbrage at anything its smaller competitors might say.