The Industry Handbook: The Internet Industry

Let's face it, the current climate for internet portal companies is a cold one. In the wake of the internet market crash, portal players are taking a closer look at their business models. The pressure is on to transform users into paying customers - converting them into hard cash. While seeking to reduce churn and reach new markets, they are also searching for new revenue streams - ones that actually produce the goods.

The first web portals were online services, such as AOL, that provided access to the web. Others were search engines like Alta Vista and Excite that offered users ways of finding the information they were looking for on the web. But by now most of the traditional search engines have transformed themselves into multipurpose web portals to attract and keep a larger audience. At a consumer internet portal like Yahoo!, a whole host of information and services can be found. Check email, update you investment portfolio, shop for a car or vacation, do research for a term paper or even join a discussion group. Portals users can do it all.

Users rarely have to pay a dime for portal services. In a bid to replicate the broadcast TV revenue model, portals supply free content and services that will attract enough users to make a profit from advertising alone. Indeed, as online usage continues to increase - thanks at least in part to the vast amount of free information and services that are offered - this appears to make sense.

Yet at the same time, it costs money to service such a vast pool of freeloaders. Costs associated with attracting and keeping users - namely the costs of marketing, sales, content purchasing and production, plus reliable delivery - could actually eliminate bottom-line gains from greater usage. Over-reliance on the advertising as the prime, and more frequently, the sole revenue stream can be a risky proposition, especially given the volatile nature of the advertising market.

A portfolio of revenue-generation sources appears to be the way forward, and portal operators are starting to open up to new models. The search for real revenues has led the move toward charging for content. The big challenge will be to significantly expand paid services without alienating users who've come to expect portals to be free. Meanwhile, portals are pitching themselves as eCommerce sites, hoping to enjoy some of the same successes of online retail portals like Amazon.com.

Key Ratios/Terms

Click-Through Rate (CTR): Measures what percentage of people clicked on the ad to arrive at the destination site. As such, the CTR is regarded as a measure of the immediate response to an online advertisement.

"Stickiness" Factor: Otherwise known as the average time spent per user on a web portal, this metric directly relates to the loyalty of users, which translates into brand and market power.

Burn Rate: The rate at which a portal is spending its capital while waiting for profitable operation. Most internet companies, still in their early stages of development, tend to spend cash faster than they can generate revenue.

Alliances: Who are the portal's customers, allies and distribution partners? Obviously, this is a difficult factor to measure. But without a strong network of alliances, especially distribution partners, which are key to audience reach and expansion, a portal will have a hard time surviving.

X-Rated: The dirty secret of the internet, porn portals account for vast amounts of traffic and enormous revenues. This sub-industry offers lessons for the whole internet industry: when users really value online content, they pay for it.

Analyst Insight
Survivors of the dotcom crash range from loss-making portal operators with extremely questionable merit, to a handful of firms able to squeeze out some profits. Given online companies' brief track records, combined with the sharp swings in growth trends and profitability, investment decisions can be challenging, to say the least.

One thing is for sure: the biggest portals attract the biggest advertising revenue. The bulk of web advertising spending consistently goes to sites with the highest volumes of traffic.

Reliance on the advertising-supported model as the prime revenue stream for portals can be risky. Ad spending has a big discretionary component that is subject to the whims of often fickle and volatile advertising buyers. Shifting consumer demand and corporate investment levels have a big impact. For a lot of portals, this translates into unpredictable revenues; in down markets, non-advertising internet players tend to enjoy better valuations than advertising specialists. In a nutshell, investors should keep a close eye on current trends in advertising, and try to monitor the pulse of leading advertisers.

Analysts typically rely on comparative ratios to gauge value. One measure has gained general acceptance: the ratio of stock price to annualized sales, or revenue per share. The popularity of the price to sales ratio (reflects the belief that it's more important for internet portals to grow revenue than profit; revenue is a proxy for marketplace acceptance and market share.)

EV/EBITDA is another common, albeit increasingly criticized, industry yardstick. EV, or enterprise value, is equivalent to the company's market capitalization less any long-term debt. Earnings before interest, tax, depreciation and amortization (EBITDA) is calculated as revenue minus expenses (excluding tax, interest, depreciation and amortization). (For more insight, read EV Gets Into Gear.)

Both price/sales and EV/EBITDA, comparisons are not as straightforward as traditional price-earnings ratios (P/E ratio). Earnings means essentially the same thing regardless of industry or sector, but revenue and EBITDA demand closer consideration of the nature of the business.

Consider Yahoo!, a multipurpose service portal, and retail portal Amazon.com. Comparing the two can be tricky. Retailers' revenues and expenses differ markedly from those of service providers. Amazon immediately pays out of revenue the cost of merchandise and shipping. Yahoo doesn't sell merchandise; its revenues come from selling ad space to those who do. The costs of supporting additional content, advertisers and usage are tiny compared to paying for books and CDs. Expect Yahoo! to enjoy a premium valuation over Amazon.

But simply comparing portal stocks against one another says nothing about their intrinsic value. When there is a major correction in the overall stock market, or simply in the internet sector, portals that appear under-valued relative to peers can be battered just as hard, if not even more. Indeed, the news and sentiment that so heavily impacts portal stocks can wipe out quantitative measures of valuation. With empirical value carrying less weight than in other sectors, internet investors will find that it pays to be cautious.

Porter's 5 Forces Analysis

1. Threat of New Entrants. You do not need to look far to realize that the cost of entry has fallen fast. It used to costs an arm and a leg to launch a portal. The price of computer software and servers and network bandwidth - of which portals consume a substantial amount - was enormous. Yet costs are falling fast, as off-the shelf systems can now do what only customized technologies could do just a few of years ago and at a fraction of the price. At the same time, brainy web developers, which were scarce at the height of the internet market boom, are now much easier for new entrants to find and have become more affordable keep. However, the apparent success of companies like Amazon, is not based on their low entry cost into book retailing, but the very large sums of money spent on promotion and growing their business. Entering a new market with a new brand still calls for deep pockets.
   
2. Power of Suppliers. Portals generally have little power over suppliers. Basically, this is because they don't actually own much. Most of the information and services they deliver to users is supplied by outside companies – stock brokerages, new magazines and the like. Expect content suppliers to enjoy growing power, especially considering portals will not able to give content away forever. At the same time, internet portals rely on telecom network operators for a steady diet of internet bandwidth. Granted, the telecom bandwidth business is getting increasingly competitive and prices are falling fast. But once systems are hooked up to telecom operator networks, it can be awfully difficult to switch to a new supplier.
   
3. Power of Buyers. Internet portals have two sets of buyers: visitors and advertisers. Both enjoy considerable power over portals. Competing sites are just a click away; URL book-marking makes the job of switching to other sites even easier for users. In fact, portals are in constant danger of a mass desertion of users to other sites because in most cases, customers make no financial commitment to the service. Portals' heavy reliance on advertising dollars means that ad spenders can squeeze increasingly better terms for banner space.
   
4. Availability of Substitutes. Internet portals must defend themselves from a raft of substitutes. The most obvious are other websites that offer the same, or similar, information and services. Most portals do little more than aggregate information and services that already exists on the internet; original content suppliers represent a readily available set of substitutes. In most cases, they are just a click away. There are more, less obvious substitutes as well, such as television and magazines. Television's clear, moving images never suffer slow connections; magazines can be rolled up and carried on the bus. Don't forget that the good old telephone directories - both white and yellow pages - are still very convenient business search tools.
   
5. Competitive Rivalry. Feeble barriers to entry, a slew of substitutes and steadily increasingly buyer power combine to create a disturbing impact: fierce competition and industry rivalry. Portal competitors now must lure customers with lower prices and heavy investment in more exciting content services. All of this tends to drive industry profitability down, threatening the survival of players who can't compete.

Key Links

• Internet Week - Industry news and analysis
• Traffick - The information portal for the portal and search engine industry
• Nielsen/NetRatings - Provides a listing of the most-visited Internet sites, updated weekly and monthly