The Internet Is Not Utilities (As An Investment)

So I am late to this party (because I don’t blog on weekends), but James Altucher’s column “The Internet Is Dead (As An Investment)” is just too tempting an invitation for rebuttal. Fred already provided his take here, stating our (at USV) belief in the transformative nature of the Internet and taking on Altucher’s comments about business models. My own point of departure is this quote from the column:

The days of infinite margins, 1,000% productivity gains, and growth of market throughout the universe are long over. Internet companies now should be treated, at best, like utility companies that get bought at about 10 times earnings and sold at 13 times earnings. Even then, I’m not sure I would give the Internet sector the same respect as the monopoly-protected utility sector.

Let me take the points here one by one:

The “infinite margins” are of course hyperbole, but we see companies in our portfolio that have gross margins above 80% and EBITDA margins of 30% and better. This is a result of having mostly fixed cost of operations with virtually zero marginal cost for additional users or customers.

The productivity gains misses the mark as most interesting Internet business do something entirely new (e.g., Facebook) as opposed to being more productive at something existing.

Growth of the market is still very much happening. There are now about 1 Billion folks on the Internet and that is likely to double over the next decade. There are still way more ad dollars offline than online relative to where attention is actually spent.

The utility analogy applies only to a few companies that operate at the plumbing level of the Internet where there is in fact fierce competition and businesses are capital intensive. For instance, the CDN market has proven to be a tough place to make money. But again, the interesting businesses, such as Amazon, operate primarily at the application level. They deliver value directly to the enduser and are beneficiaries of the competition at the utility level.

To be regulated as a (local) monopoly is a highly restrictive form of profit protection and one of the reasons why utilities trade at those multiples. For Internet businesses there are dynamics that can allow for both rapid growth and protected profits. The most powerful of these are network effects and data assets, which can provide not only sustainable competitive advantage but often have a winner-take-all effect as well (in which the number 1 in any area is much bigger and much more profitable than the rest of the field).

Now I come to think of it – I hope that many readers will follow Altucher’s advice. I sure hope that I get another opportunity to buy more Internet stocks than I already own. So please ignore all of the above and dump your holdings, especially GOOG and AMZN.

The days of infinite margins, 1,000% productivity gains, and growth of market throughout the universe are long over. Internet companies now should be treated, at best, like utility companies that get bought at about 10 times earnings and sold at 13 times earnings. Even then, I’m not sure I would give the Internet sector the same respect as the monopoly-protected utility sector.

Let me take the points here one by one:

The “infinite margins” are of course hyperbole, but we see companies in our portfolio that have gross margins above 80% and EBITDA margins of 30% and better. This is a result of having mostly fixed cost of operations with virtually zero marginal cost for additional users or customers.

The productivity gains misses the mark as most interesting Internet business do something entirely new (e.g., Facebook) as opposed to being more productive at something existing.

Growth of the market is still very much happening. There are now about 1 Billion folks on the Internet and that is likely to double over the next decade. There are still way more ad dollars offline than online relative to where attention is actually spent.

The utility analogy applies only to a few companies that operate at the plumbing level of the Internet where there is in fact fierce competition and businesses are capital intensive. For instance, the CDN market has proven to be a tough place to make money. But again, the interesting businesses, such as Amazon, operate primarily at the application level. They deliver value directly to the enduser and are beneficiaries of the competition at the utility level.

To be regulated as a (local) monopoly is a highly restrictive form of profit protection and one of the reasons why utilities trade at those multiples. For Internet businesses there are dynamics that can allow for both rapid growth and protected profits. The most powerful of these are network effects and data assets, which can provide not only sustainable competitive advantage but often have a winner-take-all effect as well (in which the number 1 in any area is much bigger and much more profitable than the rest of the field).

Continuations

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Continuations

The Internet Is Not Utilities (As An Investment)

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