NYSSA Forum Program (1999 - 2001)


Forum Home Page


NYSSA Forum Program

Reference List


Investment Dealers’ Digest, Oct. 23, 2000


Cover Story

New Economy, Bad Math

Street analysts take a deserved rap

for their e-commerce valuations


By Avital Louria Hahn


                The rise and fall of Amazon.com Inc., the bellwether e-commerce stock that has lost about 80% of its value over the past year, has sent Wall Street analysts into a tizzy. When the company’s shares plunged 50% this summer, analysts turned on Amazon CEO Jeff Bezos, the former Wall Streeter they used to idolize. Now, they complain, Amazon is providing ambiguous information about its future revenues, refusing to control its costs and overstating the value of its investments.


                Amazon’s smoke and mirrors never much bothered analysts before. Indeed, without any solid facts, Wall Street analysts could spin just about any kind of story they wanted on the company’s prospects. As long as investors kept buying the tale, no problem. But the shift of sentiment has been swift and brutal, and now Wall Street analysts and the e-commerce companies they follow are having a “credibility problem,” according to Gary Lutin, who heads the eponymous investment firm, Lutin & Co. He also has organized an analyst group grappling with the problem of Internet valuation.


                “The practices that have been observed in some cases are sufficiently questionable,” says Lutin. Analysts shoulder a good portion of the blame. Should an analyst have an inaccurate interpretation of a company’s data, analysts are now wondering, is it the company’s responsibility to correct him? But, asks Lutin, do analysts even call back the company to ascertain what exactly the numbers mean? When Bezos told analysts in a September conference that online sales would grow 50% per year over the next 10 years, some took that to mean Amazon’s online sales would grow by that much. Others said that Amazon did not say what percent of that growth it would capture.


                Amazon, and the analysts who’ve pumped up its stock, may be taking the heat now. But they can’t be blamed for getting the ball rolling. That ignominious award goes to Internet pioneer Netscape Communications Inc., an unprofitable company that was awarded an unheard of $2.2 billion market cap at the end of the first day its shares traded in the public markets: August 9, 1995.


                Netscape’s initial public offering, which was posting a $4.3 million half-year loss when it went public, forced Wall Street analysts to change their entire world view. The stock had opened at $75 after being priced at $28, which itself was more than double the price that underwriters Morgan Stanley & Co. and Hambrecht & Quist Inc. suggested. When it finally closed the day at $58.25, analysts were baffled. If they followed their normal way of analyzing stock prices—looking at the price, dividing it by the earnings and coming up with a price-to-earnings ratio—Netscape seemed outrageously overvalued. If Internet stocks were too expensive, that meant analysts have to they tell investors not to buy the hottest stock around.


                Just as important, it meant that no more Internet companies would find their way to the IPO market—a prospect that investment bankers surely were determined to avoid. The alternative was for analysts to totally recast their analytical tools, cross their fingers and hope for the best. Out of that process came such new terms as forward multiples—a way of justifying high stock prices based on expected future growth—and a revamping of the discounted cash flow model, which projects future revenues.


                “Starting a couple of years ago, you just couldn’t justify stock prices using P/E valuation,” says Kris Tuttle, managing director of research with Wit SoundView Inc. “Yet you wouldn’t want to be out of the market during those years, which made people look for alternative ways to justify valuations.”          


                But you also wouldn’t want to be in Internet stocks this year. Hundreds of billions of dollars of wealth in Internet stocks have disappeared since the Internet bubble finally burst this spring. The greatest carnage was in the heavily hyped e-commerce sector, where growth, market share and brand name became the more important indicators of a company’s prospects than that old-fashioned notion of actually making a profit. Many companies in that sector, if not bankrupt, are off 90% of their highs. The Nasdaq, where most of the Internet stocks are traded, has lost about 40% since its high on March 10.


                Much of the e-commerce meltdown actually began in 1999, before this year’s full-scale Internet crash. And even in the bullish first quarter of 2000, e-commerce stocks like 1-800-Flowers.com Inc. and barnesandnoble.com Inc. had been sliding for months. But when the sector’s darlings, such as Amazon and Priceline.com Inc., finally succumbed to the rule of gravity, the Wall Street analyst community took note. 


                Hypervaluations are nothing new, of course. Historically they’ve existed for the first few years of any young, emerging industry, explains Michael Parekh, managing director and Internet analyst for Goldman Sachs, e-commerce’s most important underwriter. He points out that a similar phenomenon occurred in the biotech boom of the 1980s. But he concedes that the earlier boom was not of the same magnitude as what occurred in the Internet mania, during which stocks soared several hundred percentage points on the first day of an IPO, even without any earnings to show for it.


                Then there are the cases that make the history books: the Holland tulipmania of the 1600s or the South Sea Bubble. Most analysts don’t like to make such a comparison, but given the greater size of today’s capital markets, the total dollars lost in those crashes were probably puny compared with today’s Internet rout.


                Now the Internet’s early, outrageous days of growth are over. Companies are maturing, and Darwinian selection is weeding out dozens of e-commerce, mostly business-to-consumer, companies. Bankruptcies of dot-coms are now as commonplace as IPOs once were. As a result, more and more analysts, including Tuttle, are returning to the basics of analyzing companies’ fundamentals. Instead of looking at what might happen, they look at what has happened, with some sober adjustments for emerging companies.


                As the market looks back at the frenzied hype of recent times, it is clear that some analysts were more than just optimistic. “The meteoric valuations of business-to-consumer stocks in the Internet’s heyday were what drove everyone off the beaten track of traditional P/E valuations” is how Wit’s Tuttle captures the detour that just about everyone—bankers, analysts, investors—had taken from the somewhat sane company valuations employed four or five years ago. What emerged was a system that allowed one to justify almost anything.


                “There is serious problem with the way analysts are working today,” says Eric van der Porten, a hedge-fund manager at Leeward Investments LLC. To point out how easy it is to poke holes in much of what still passes for analysis, he picks apart a June research report on Amazon by Donaldson, Lufkin & Jenrette analyst Jamie Kiggen. Just before Amazon’s stock took its June dive, Kiggen made Amazon one of his top picks, with a price target of $140, a value he derived by assuming that each Amazon customer would spend $2,400 at the retailer. Even if that were true, says van der Porten, “it would take 30 years before [Amazon begins] to see a return on its investment.” Kiggen could not be reached for comment.


                Noticeably, DLJ was one of the managers of Amazon’s controversial $600 million European convertible bond issued in February—its last visit to the capital markets. Van der Porten blames the faulty analysis on Street analysts’ focus on corporate finance revenues instead of their historic role of serving investors. “Far too many are beholden to investment banking interests, and too much compensation is driven by investment banking,” he says.


                That’s a widely acknowledged problem, which the Internet only worsened. Wall Street in recent years scrambled to win the mandates for Internet stocks, with top-tier investment banks Goldman Sachs and Morgan Stanley Dean Witter leading the way. As more speculative companies could tap the capital markets for their funding, the rules quickly shifted. “We ended up with the criteria of venture capitalists as opposed to the criteria of mature industries,” explains Goldman’s Parekh. “What we are trying to assess is the opportunities around these new markets, the value propositions of these new products and services, the business models of these companies, and most important, the management teams, because that’s really most of what you have at the early stages of those industries.”  (Morgan Stanley analysts declined to be interviewed for this article.)


                The Internet certainly brought with it a new set of problems, including “the fear of instant global competition,” explains Parekh. While the previous generation of technology companies, such as Oracle Corp. or Cisco Systems Inc., typically had three or four years to develop a product, build the U.S. market and build profitability, then use the revenues for expansion, the Internet compressed the time frame, he explains. “The minute your site is up there and accessible to the world, you have to scale your business in every level to a much larger market from day one,” he adds. Knowing how brutal the environment would be, analysts might have been more cautious, instead of so giddy, about the future.


Method in the madness


                That isn’t how it worked. To understand just how wild things got, it’s perhaps best to start back with the Old Economy, old-fashioned method of determining whether a stock’s price is too high, or too low: the P/E ratio. Typically forward-looking, price-to-earning ratios usually are based on next year’s earnings forecast. Microsoft Corp., for example, is expected to earn $1.90 per share in 2001. Given the stock price of $61 last Thursday, its P/E ratio of 32 remains high by historical standards. And that’s after the stock has dropped by about 50% from its 52-week high.


                The historical average P/E for the Standard & Poor’s 500 over the past 50 years is 15. The S&P 500 is trading at a P/E of about 30 today. Even with its 40% downturn, the P/E ratio for Nasdaq is still about 100.


                Indeed, profitable tech companies like Microsoft also became overvalued due to the new math designed to sell IPOs of unprofitable Internet companies. With Internet stocks profitless, growth, not earnings, became the only way stock price of any tech company was judged. “Wall Street switched to revenue multiples because everyone was losing money and there weren’t any earnings to value off of,” says Laurence Goldberg, a senior e-commerce investment banker with Credit Suisse First Boston. “People used revenue multiples as a sort of a proxy for very high growth, emerging companies that don’t have earnings yet.”


                One widely used methodology in recent years is known as the relative price-to-sales calculation. That method takes the company’s price per share, multiplies it by the number of shares outstanding, and divides it by projected revenues, not earnings. But instead of looking one year ahead, as was typically the case in a P/E analysis, analysts looked five to 10 years out, given the fact that the Internet—particularly e-commerce—was just getting off the ground. According to that method, Netscape traded at about 68 times price to sales, or a P/E of 343 after a hypothetical “E” had been plugged in, when it went public. Many that followed in its wake priced even higher. Soon after it went public in 1998, eBay Inc. had a P/E of 1,000, and today, at $53 per share, it is trading at 620 times earnings and has a 46 price-to-sales ratio. (eBay is one of the few profitable Internet companies.)


                Now analysts say that methodology was flawed. That’s because the price-to-sales formula was too easily manipulated. First of all, the projections of revenue growth were, by and large, wild guesses. Such intangibles as brand names or the much-ballyhooed first-mover advantage were also ascribed a value, with little evidence of their worth. And there was a feeding frenzy: Once growth numbers for a leading e-tailer company, such as Amazon, were accepted, other companies’ market values were derived from those numbers.


                If, for example, a company traded at 10 times its price-to-sales ratio, and a similar Internet company traded at 15 times, an analyst could with no qualms raise his price target for the lower-valued stock, saying it should rise to the level of its peers. Of course, that’s precisely why the whole house of cards tumbled. Once one company’s stock collapsed, so did those of its peers. 


                Another commonly used Internet valuation methodology was an adaptation of the traditional discounted cash flow (DCF) method, which has also been used by Wall Street for traditional, profitable companies. DCF was recast to ascertain the value of certain Internet companies, including Amazon. This methodology projects the future cash flow over several years and discounts it back at about 5% or 10% to reflect factors like interest costs.


                Some of the more cautious analysts, like Jonathan Cohen, formerly an Internet analyst at Merrill Lynch & Co. and now head of European M&A at Wit, have used this analysis. But as with the other methodologies, there was still a lot of guesswork involved. For example, in 1998 Cohen had a $50 call on Amazon, based on this analysis, while Henry Blodget, then an analyst at CIBC Oppenheimer, used the same approach to come up with a $400 price target for Amazon, which it met within months. (Cohen left Merrill, and was replaced by Blodget.) 


                How could the two men have had such vastly different projections? According to Blodget, it all boiled down to whether you thought, as he did, that Amazon was really an Internet company, or whether it should be compared with a traditional retailer, as did Cohen. While Cohen looked to Wal-Mart Stores Inc. to figure out a valuation for Amazon, Blodget found parallels with Yahoo! and eBay, companies that grew faster than retailers because of the Internet. While Blodget, who is still bullish on Amazon, correctly predicted the $400 high, it is Cohen who looks plenty smart today: Amazon is trading at about half the $50 call he made.


                But analysts got caught up in Internet mania early in Amazon’s life. “We were trying to figure out what percentage of all retail sales could go online, what percentage of that market can Amazon take,” explains Goldman’s Parekh, who also used the DCF methodology. “And if they have that percent of the market, what would be the margins from that over a five- to ten-year period? If those are the margins, what would be the implied operating income and net income, and if that’s the net income over a five- or ten-year period, we discount it back at different rates, what does this imply for enterprise value?” he asks.


                There’s an inherent limitation to this method, he explains: “You can put in assumptions to make either a bullish or a bearish case because you are projecting financial sensitivities out five or ten years.” Even if two analysts were using the exact same model, a small difference in their assumption can make a huge difference in the projected stock price, adds Blodget.


A closer look


                After this spring’s Nasdaq correction, analysts’ calls were examined more closely. “It was the catalyst that forced people to re-evaluate the practices that had been used for justifying ratings of stock prices,” says Wit’s Tuttle.


                Amazon survived the correction, but finally, one analyst broke the spell. On June 22 Lehman Brothers convertible analyst Ravi Suria rattled the Street with his outspoken assessment of Amazon, which he said had “the financial characteristics that have driven innumerable retailers to disaster throughout history.” Suria, who judged Amazon as a retailer and not as an Internet company, did not see good prospects for the company’s survival and noted that the company’s debt-to-asset ratio had deteriorated. The company’s stock lost close to 30% in one day.


                By then most e-commerce stocks had been bludgeoned in the market. But it wasn’t due to a slew of sell reports from Wall Street analysts. Suria’s report was an anomaly in that regard. Its timing—so crucial on Wall Street—was impeccable because it hit the market when investors were ready for such sober news. Indeed, a similar report from rating agency Moody’s Investors Service was virtually ignored a year earlier. Moody’s had placed a Caa1 rating on the company. “Caa1 means that if you had to liquidate the company today, it is not anticipated based on the current outlook that all the debt obligations would be covered,” explains Russ Solomon, a senior analyst with Moody’s.


                “[Amazon] has a lot of intangible assets like customer base and information about customers,” noted another Moody’s senior analyst, Marie Menendez. “Those are good things to have. But in terms of risk, looking at the fundamentals and the fact that it’s a very early-stage company, and [looking] at the fact they have chosen to finance themselves through debt rather than through equity—all of that makes the company, from a credit perspective, highly risky.”


                Amazon’s debt load has only increased since that report was written. And after Suria’s now-famous call, the rest of Wall Street’s analyst community finally followed suit. A string of analyst downgrades, including Lehman’s own Internet equity analyst, Holly Becker, followed.


                Although the analyst community is starting to shift its perspective, there is still plenty of speculative analysis on Internet companies. On Aug. 22, for example, Salomon Smith Barney analyst Tim Albright kept a buy recommendation on Priceline.com Inc. with a $130 price target. The stock closed that day just under $25. Albright lowered his rating a month later.


                Prospects for Priceline, which were already iffy, have since gotten worse. The company, which gained notoriety (and Wall Street support) by offering the unique Internet service of name-your-own price discounts on groceries, gas and airline tickets, was unable to get suppliers to provide the requested discounts. Instead, it was subsidizing the discounts for groceries and gasoline, sold separately under a Priceline unit, WebHouseClub Inc. from a $373 million war chest it raised for that unit. Priceline was forced to close WebHouseClub down on Oct. 5, by which time it had used much of the cash. Priceline’s stock sank to $5, and a class action suit followed. The suit, filed on behalf of investors who bought the stock between July 24 and Sept. 26, charged that the company disseminated misleading information as to when the company would become profitable.


                It may take such actions for change to occur. What makes the Priceline and Amazon situations so troublesome is that these two were long considered to the have winning models on the Internet, where brand and market share are so highly regarded.


                As the Internet correction continues, Goldman’s Parekh sees it as an end of the first stage of a business cycle, signaling a return to more sane valuations. Indeed, more analysts are now abandoning the doctored-up business models that allowed one to justify almost anything, to more traditional models based on the classic price-to-earnings ratio


                “People finally realize that they want order, that the markets don’t work without it,” notes Lutin.


                Many Wall Street analysts nonetheless complain that the sell-off is overdone. Amazon-bull Blodget is one of them. “It’s important to step a good way back and look at the fact that five years ago there was one Internet company and that was AOL, and it was worth a billion dollars, and now five years later there are about 400 companies with a collective value of $750 billion, which is an extraordinary value-creation period, and that is after the brutal shakeout we have had,” he says. Given the fact that the Nasdaq is down 40% from its highs, and many Internet stocks have sunk to tiny fractions of their former worth, that means hundreds of billions of dollars in market cap has been lost.


                And with it, a lot of good will. “Everyone went from looking at the glass from being totally full to being totally empty,” says CSFB’s Goldberg. “Investors only want to talk about stories where you can show a model where the company is going to be profitable within a year,” he says. “And they need to get walked through exactly how this is going to happen, because they don’t believe it anymore.”


                Meanwhile, Moody’s Menendez, who has proven to be something of  a seer in the e-commerce field, recently published a report on prospects for online retail sales in the coming months—that important pre-Christmas rush. Menendez believes that this year, “consumers are likely to shop a name they know,” and that will most likely mean brick-and-mortar stores or even catalogs.


                On top of that, she throws cold water on the conventional wisdom regarding the supremacy of e-commerce. “E-tailers were initially founded on the theory that a virtual storefront would be much less expensive than a chain of brick-and-mortar stores,” notes Menendez. “The prodigious amounts of marketing expenses by e-tailers have proven otherwise. Relative to gross margins and sales, the 1999 advertising expenses of many pure-play e-tailers was actually greater than the combined advertising, marketing, catalog and rent expenses of traditional retailers last year.”



Material presented on this page was distributed to participants in a "Forum Program" conducted for public educational purposes, co-sponsored by Gary Lutin with the New York Society of Security Analysts ("NYSSA") Committee for Corporate Governance and Shareholder Rights from January 1999 to July 2001.

For additional information, send an inquiry to admin@shareholderforum.com.