Online Business Rebounds - This Time its for Real

Just when you thought you had heard all you needed to know about the "new economy", the internet is suddenly proving itself a real force in business.

Rupert Murdoch, once the most famous of internet sceptics has ignited Australia's internet sector this week with a bid for realestate.com.au, the nation's biggest online real estate company.

Through his Australian business, News Ltd, Murdoch has launched a $120 million takeover offer for about 56 per cent of Realestate.com.au that News Ltd does not already own. The bid represented a 19% premium to Monday’s (1 August 2005) last traded price of realestate.com.au of $1.68.

On July 18 Rupert Murdoch began his internet shopping spree with the $766 million purchase by News Corporation of the online dating, gaming and entertainment group, Intermix Media for a 2006 price earnings ratio of 71 times. Murdoch formed a new division of News Corporation - Fox Interactive Media - to carry out the Intermix Media deal.

Locally, John Fairfax and Company has also entered the field - in a more modest fashion - with the purchase of online dating company RSVP.com for $38.9 million on July 11.

Murdoch's early reticence on internet investing is understandable. After the late 1990s excitement of the dot-com boom, he realised like many others that the web can be just as good at destroying shareholder value as offering investment opportunities.

Now, five years after the NASDAQ crash, the new economy is back in fashion '” but this time, rather than rumour, results rule.

Earlier this year, the domain names registration company and former stockmarket darling Melbourne IT announced an 82 per cent lift in profit for the full year. In March, online advertising company eMitch announced it had doubled its interim profits; and, in April, the recently listed US search company Google capped off a dream run as a newly listed company by having its debt raised to investment grade by Standard and Poor's.

Google entered the public company landscape earlier this year with an opening price of $US85. Outstanding quarter-on-quarter profit results since have sent its share price soaring to about $US291.61 as at 1 August 2005.

Is it any wonder the online world is back in favour with investors? While venture capitalists were licking their wounds and decrying the online industry as a disaster, consumers around the world were licking their lips as they used the internet to buy.

With more people using the internet, market research confirms a real "new economy" based on internet activity is taking shape.

* Since 2000, according to the Roy Morgan Research Single Source database, the internet has been the only media channel to experience an increase in consumer use. Television, magazines, newspapers and cinema were all flat and radio suffered a downturn. Not only have traditional media failed to achieve growth; the increase in internet use has caused them to decline.

* A surprising 20 per cent of consumers who use the internet at least once a month also watch less television. Around one in 10 read fewer newspapers and magazines and listen less to radio. In the US, time spent on the internet has reached the same level as the time spent reading a newspaper. This is important for the advertising industry, which is often considered a barometer of economic health.

* In the US and Britain, online advertising has reached around 4 per cent of total spending on advertising. This is important in Britain for two reasons: at 4 per cent, it outstrips spending on radio advertising; and online spending is now four times greater than at the height of the dot-com boom in 2000.

* In Australia, spending on online advertising, at almost 2 per cent of total advertising, is climbing rapidly and keeping pace with the rate of rise in the US and Britain. Already, more is being spent on online advertising than on pay television or cinema.

Stuart Simson, chairman of the resurgent online advertising agency eMitch, says the growth in online advertising is being driven by the increasing use of the internet and the accelerating adoption of broadband (high-speed) internet.

And, if broadband is the name of the success game in the online industry, the signs are good. Nielsen/NetRatings data shows that, in September 2004, almost 41% of all home internet users were broadband-connected. It also shows that, compared with Britain, France, the US, Germany, Sweden and Hong Kong, Australia has the fastest growth rate of broadband penetration. (Broadband growth in Australia was 87 per cent over the 13 months to September 2004).

The industry regards a 50 per cent level of broadband home access as the "tipping point" (critical mass). Australia is widely tipped to reach that as early as next year.

For advertisers, broadband users are an attractive market. Far more internet savvy, they spend more time online, viewing more pages, and thus more engaged. Broadbanders are experienced in navigating online and are in a position to appreciate engaging, and creative presentation of, advertising. Broadband enables better viewing of rich media formats and, in particular, streaming ads online. This is fertile territory for advertisers looking for better ways to reach and motivate high-value spenders.

Exploiting the boom in internet advertising, Seek, Australia's largest online recruitment service, recently conducted an IPO (initial public offering) to cash in on its growth in recent years '” growth that has occurred at a time when employment advertising in the print media has been relatively flat. The ANZ Job Advertisement Series shows online employment advertisements in Australia have increased by a compound annual rate of 38 per cent over the past two years and 47 per cent in the year to February 2005.

The Seek $2.10 offer price was set through an institutional bookbuild process. By July 3 Seek has soared to $2.59 enjoying a market capitalisation of $728 million.

One shareholder not looking to cash in was Kerry Packer's Publishing & Broadcasting, which, instead, consolidated its dominant 25 per cent stake in Seek. PBL's shareholding has roughly quadrupled in value since it made its $33 million investment in August 2003. PBL's retention of shares is a gesture of its confidence not only in Seek but in the future of online advertising.

The sharemarket remains highly sceptical of "tech companies", however a close examination of the ASX indices shows that in the 12 months to July 1 the IT index rose by 34 per cent against a 20 per cent improvement in the 'small cap' index.

Online business comes both from advertising and direct customer payments. The leading internet business, Yahoo!, in addition to billions of dollars in advertising revenue, also has 8.4 million paying customers worldwide. On 19 January, announcing Yahoo!'s 2004 financial results, chief financial officer Susan Decker said: "We are attracting more and more users to Yahoo!'s network of services and driving their usage deeper with more relevant products and services. This deeper usage is the real magic behind the surpassing of our financial objectives."

Yahoo! revenues were $US1.078 billion for the fourth quarter of 2004, a 62 per cent increase on the same period of 2003.

The internet is also thriving as a search and research tool, with Google and Yahoo! the major beneficiaries. In Australia, almost six million people consider the internet the most useful source of information when selecting travel or holiday bookings.

As the first generation of internet investors rue the demise of early entrants into online shopping (such as dStore, Greengrocer.com and Wineplanet), the number of people grocery shopping online has more than doubled in the past five years to 381,000.

Also, the internet is increasingly recognised as an alternative retail channel for people buying products and services other than groceries. The number of online shoppers increased 121 per cent over the past five years and continues to grow rapidly.

Similarly, in the four years to 30 September 2004, the number of people banking online quadrupled to four million.

Despite these compelling figures, the internet is a complex place where success is not guaranteed. Internet and IT related stocks remain volatile with speculative traders influencing trading patterns.

Businesses that failed in the tech-wreck did so either because they had a lousy business idea or a bad business plan. Just as technology cannot always be seen as the saviour of business, it should not always be seen as the destroyer.

And the online market is not always "pure". Many bricks-and-mortar corporations have developed online strategies, becoming known as multi-channel players. They link a website to their bricks-and-mortar operation and replicate what they do in the traditional economy.

This is particularly applicable in the retail sector where the multi-channel model has enabled the giant US book retailer Barnes & Noble to be the only serious internet competitor to the pure-play Amazon.com. But neither Barnes & Noble nor Amazon has recognised the opportunity to create a totally different experience for various customer types. By failing to differentiate between those who will pay a premium for a premium service and those who just want the cheapest price, each company is giving away profit.

Twenty-four per cent of the population, known as neo-consumers (Neos), don't expect an automatic discount. This affects two of the major determinants of online profitability '” order size and margin. If an online bookseller, for example, can double its order size and increase its margin (by not giving it away as unnecessary discounts), its probability of profitability and success soar.

A McKinsey & Company survey suggests only 8 per cent of internet shoppers are searching for a discount, and 80 per cent of book shoppers typically visit only one site, and usually not the one with the lowest prices.

Spring has returned to the online sector. It is leaner, more realistic, profit focused and ready for a lucrative future. Investors enjoying the new sunshine must remember that greed and speed leads to bleeding. So follow the rules in an orderly way and stay economically healthy.

ACTION PLAN

Investors have clear rules to look for when they are evaluating online businesses:

1. The market in which the dot-com operates should have at least double-digit growth '” even as the cycle slows, the market for an online business may well keep growing.

2. Strong revenue is necessary but, by itself, not sufficient '” many victims of the dot-com crash had outstanding revenues but could not turn a profit.
3. Profit is essential '” if you are not a venture capitalist, don't invest in any company that does not demonstrate a good profit track record.
4. Look behind the profit '” with a small company; ensure the direct costs (salaries etc) are not being kept artificially low to give the impression of profitability.
5. Give high marks to a company with more than one source of revenue '” for example, eMitch as well as being an online advertising agency has revenue from Final Five, a recruitment process.
6. Look for a disciplined business plan '” do management have a clear rationale for why they are in the business they are in? Are they disciplined about sticking to what they know best? Leave room in this judgment for alternative revenue streams, but don't accept too many.
7. Favour a business with a great, or at least fresh, idea '” often great online ideas seem a little ahead of their time and not entirely intuitive. But remember, the higher the early-entry return, the higher the risk. If you are conservative, wait for the profit track record
8. Look for businesses that appeal directly to, or benefit indirectly from, neo-consumers (check website: www.customerstrategy.com.au) '” Neos dominate internet usage and spend more than anyone else in society. Any business reaching and motivating Neos will be in a position to generate higher margins, better frequency of order and larger order size, all of which are critical elements of profitability.

Ross Honeywill (ross@customerstrategy.com.au) is an internationally published author, a director of the consumer think tank Centre for Customer Strategy and managing director of the Neo Group

NOTE: The source of all consumer data (unless otherwise noted) is Roy Morgan Research Single Source