That old joke, “How do you stop an elephant from charging? Take away its credit card,” has never been more topical.
Alan Greenspan’s elephant gun, which initially sprayed everything but the Nasdaq Stock Market, finally hit its target. Once-rampaging e-commerce companies have taken it between the eyes.
That many start-ups have been gunned down, losing their access to capital, is not necessarily a bad thing. Since the start of the Internet boom, a few truly innovative businesses have received funding, as have some really stupid ones. That’s capitalism. Creative destruction wasn’t meant to be any more painless than it sounds.
Wise Grasshopper
But pain is not death, and the fun is just starting. With the initial round of Internet funding over, it’s now time to do some homework. Will the winner be e-commerce or portals, service providers or incubators? Choose wisely, grasshopper; the wrong guesses will end up in Chapter 11 of business-school studies. I’m sticking with infrastructure. It is unique, with the elements necessary for long-term success.
For a short part of my career, I pretended to be an investment banker (until I realized you had to be nice to people). The only thing I was good at was positioning companies for their initial public offerings, because I figured out that investors needed to be fed three bullet points in 30 seconds. Fortunately, the bullet points were always the same. A company needed:
- A monster market into which to sell.
- An unfair competitive advantage.
- A business model to leverage that unfair advantage.
Value was some form of intellectual property. Companies needed to own patents, trade secrets and software platforms because big markets attract lots of players on the margin. Capital flows to capture expected better returns from a new marketplace; companies must have something special or risk being marginalized.
Many of today’s struggling business-to-consumer companies lack pieces of this formula. Take eToys. Selling toys is certainly a monster market, but eToys used its lavish amounts of capital to build its brand. It did so by buying ads and by buying customers with super-slim margins. And you thought only Santa gave away toys. The only competitive advantage eToys held was its early access to capital, the result of its May 1999 public offering. Revenues grew from $23 million in the last quarter of 1998 to $107 million in 1999; losses grew faster, from $10 million in 1998 to $75 million in 1999.
That’s a lot of toys, a lot of cash and a whole lot of traffic. The company had 1.7 million customers and was the second-most-visited retail site the last holiday season. As a result, eToys bought more servers and more high-speed connections. In the middle of the company’s success, Amazon decided it too would sell toys (heck, it’s just a few more servers), and went from zero to $95 million in toy sales by the last quarter of 1999. More infrastructure sold, but (oops) so much for competitive advantage.
Business-to-business companies are also lacking some important things. Trading exchanges for pulp and polymers are all the rage and are certainly monster markets. But where is the intellectual property? Where is the barrier to entry? How can these companies maintain margins once more players with more money pour in?
Without a piece of intellectual property, margins are suspect. Compaq used to command 45% gross margins on its personal computers; now it barely squeaks out 20%. Even owning intellectual property is not enough; one must have an innovative business model to maximize returns. Qualcomm figured out that despite its patents on certain next-generation technology, selling cell phones was a losing proposition in the face of giant competitors such as Motorola, Nokia and Ericsson. Instead, it retreated to a horizontal strategy, and it is now licensing its technology to all phone vendors.
This is the great thing about infrastructure. From fiber-optic components to Web switches, infrastructure lends itself naturally to intellectual property. Owning even the tiniest horizontal sliver of protected technology means wide licensing and a very profitable venture. This in turn pays for new research and development to fund even more innovative slivers.
Infrastructure also benefits from crazes in other Internet fields. The first step at any dumbidea.com is to buy the tools of geeks: servers and switches and caches and load balancers and optical add/drop multiplexers. More bandwidth is needed to handle the traffic. WorldCom puts in more fiber, Sycamore sells more optical access equipment, Exodus hosts more Sun servers and Intel Pentium boxes running Linux. Oracle sells more databases, Vitria sells more business-process software, Inktomi sells more caches, Foundry sells more switches, Cisco sells more routers. The infrastructure market booms.
Like it or not, technology is now the backbone of the U.S. economy. The loss of the dot-coms’ access to capital may slow infrastructure spending, but not for long, as old-economy names from General Motors to Merck ramp up their Web presence. If you think global Internet traffic growth is in any way going to slow, think again. The world economy is increasingly based upon U.S.-created intellectual property. Investors will provide access capital again to innovative entrepreneurs who solve real problems for large markets.
Pain of Doubt
The stock market rewarded those who invested early in Internet companies and suffered the pain of doubt; it also penalized those who came late and thought it was a one-way trip up. This market is one margin call away from sending most day traders back to their day jobs, if they had them in the first place.
Long-term investors will be rewarded. Over the next three to five years, it will be a stock picker’s paradise. No longer will stocks go up just because they were mentioned on CNBC and stuffed into IRAs. Look for intellectual property, look for horizontal layers and smart business models, and stick with infrastructure.
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