Please feel free to forward this newsletter to as many friends as possible. I have a personal goal of having one million readers. I can achieve it with your help.

the Software View: Software market dynamics (Part III)

Welcome back, gentle reader. A reader of mine, Joe Gilbreth, shares these thoughts concerning piracy and market share. "Mark, an early example of "free" products achieving market share comes from piracy. My perception is that WordStar, for example, was widely pirated, but that this only increased sales. Of course, they lost focus and went down the tubes, but the principle worked.

I have always laughed at the extreme claims of dollar losses from software piracy. I'm sure there are cases where these are valid; I would think grand scale piracy such as whole countries would be genuine losses, but domestically not that much. For many companies, I think piracy did them more good than harm, just by increasing the user base. Analogous to real estate's "Location, location, and location," in software it's "Market share, market share, and market share."

For those of you with Internet and World Wide Web access and a Netscape Navigator web browser, please point your browser to:
http://www.softwareview.com/
Scroll down the page and you will spy a link entitled, "Current views web log (fresh news daily! Click reload, clear the browser cache)" The daily news page is also known as a "web log". It is en vogue and the fashion of these days to call it that. Click on the link, click "reload" on your browser or clear your browser cache to ensure that you always receive the freshest, hottest daily news concerning Java, Linux, XML, and the software industry! The link never changes, but I will be updating the HTML file page behind it every day. Please, do take a gander at it every day.

Also, some important news, gentle readers. the Software View is now an Associate Internet World Wide Web site of Amazon.com. I would like to extend my sincere, heartfelt gratitude and thanks for your patronage. I am offering links to books, et cetera that you can purchase from my web site. I would greatly appreciate it if you would purchase software industry books from my web site. Help support my newsletter and web site by purchasing items from Amazon.com from my web site. Here is the URL (Uniform Resource Locator):
Click here

Now, dear readers, on with this week's episode of the Software View!

With this issue, I continue a multi-part exploration of the dynamics of Internet software markets.

STOCK MARKET VALUATIONS OF INTERNET COMPANIES

Oh, the inhumanity! Are stock markets like the NASDAQ insane? When Netscape held its Initial Public Offering, its shares shot up like a rocket. Individual and institutional investors valued the company at $4 billion, even though it had never yet made a profit and they were giving away their core software product, the Netscape Navigator Internet browser. Yahoo! is a very popular cyberspace gateway, a search engine company, and an Internet portal. In the first half of 1998, Yahoo! made $71 million in revenue. Its stock has soared more than 500 percent. It reached a 52 week high of $156.25 per share. As of August 25, 1998, the NASDAQ stock market valued Yahoo! at $9.1 billion. Amazon.com is the famous Internet bookseller and the e-commerce success story which also offers music online. Amazon.com has never made a profit. On May 15, 1997, Amazon.com's Initial Public Offering price was $18. Its stock has soared 360 percent since. It reached a 52 week high of $104.75 per share. As of June 26, 1998, the NASDAQ stock market valued Amazon.com at $4.7 billion.

One factor contributing to the incredible valuations given to these profitless Internet companies is the fact of scarcity. Yahoo! has only 46.3 million shares outstanding. Amazon.com has only 49.5 million shares outstanding. Any individual and institutional investor who wants to participate and own a piece of companies who will be leaders in the future Internet software economy, will buy these stocks at any price. The small amount of shares available to be purchased for both companies drive their stock prices into the stratosphere.

In weeks an Internet stock can double, then triple - even though nothing has changed at the company. Partly it's just Internet mania, but Wall Street machinations are behind much of the rise. What has been going on with Internet stocks is best explained by an old Wall Street maxim: "A stock and a company are not always the same thing."

Two phenomena are behind the Internet stocks' amazing ride. The first is that a lot of investors decided they had to own the stocks. Their infatuation was part of a larger mania for a small number of premier Internet stocks - Amazon.com and Yahoo! - that seized the market this spring. The rest of the tech sector was looking pretty ugly, so for portfolio managers, Net stocks became the place to put money (no Asia worries, no desktop personal computer worries, no earnings worries). As the quarter ended, it became a self-fulfilling prophecy. Portfolio managers want to show that, yes indeed, they own the hot stocks in the hottest sector.

But the demand isn't coming from just professionals. The average number of shares of Internet stocks that change hands in any trade - the "print size" - is around 500, which means that individual investors are buying. Some are no doubt hoping they've gotten in on the ground floor of the next Intel or Microsoft or Wal-Mart, and some have already gotten rich owning Amazon or have heard tales of others who have. (In early June Amazon.com founder Jeff Bezos made the short list of Seattle stock billionaires.) And sellers? (What are those again?) It's tough psychologically to sell something that seems to soar higher every day.

The other force propelling Internet stocks involves a trip to the darker side of Wall Street, where the short-sellers live and use lingo like "stock loan," "fail to deliver," and "buy-in." For example, let us say there are about 48 million shares of an Internet company outstanding, of which only about 16 million trade (or float). As of June 15, about 8.7 million shares, or 54%, were sold short. That's a big number, and it creates a perverse dynamic that can push a stock (and has pushed many others) to incredible heights.

One way to think about it is that roughly 25 million shares (16 plus the 8.7) of an Internet stock have been sold, but only 16 million shares are available. That's possible because some institutions that own an Internet stock will lend their stock to Wall Street houses like Goldman Sachs and Morgan Stanley Dean Witter - a so-called stock loan. In turn, those houses lend the shares out to short-sellers, who sell them in hope the stock will fall. But if the stock rises enough instead, the shorts may incur such large paper losses that they have to cover. Or the real owner may demand the return of his shares. If the borrower can't find replacements - what's called "fail to deliver" - the broker will "buy in" shares at whatever the market price is in order to return them. Obviously, that drives the price yet higher.

J. William Gurley writes, "I want to repudiate any lingering notion that the Internet is over-hyped. It is here. It is real. It is important. It likely represents one of the most significant commercial and social discontinuities of the century. In that light, investors and participating executives have a crucial need to understand the dynamics that are emerging in the marketplace. Yet many questions still remain.

ARCHITECTURES, LOCK-IN, AND INCREASING RETURNS

Ferguson and Morris are credited with authoring the concept of architectural ownership, although it is rumored that the boys in Redmond had discussed the concept years before they were introduced to the public in Computer Wars. Over the past 40 years, the complexity of high-technology products, as well as the integration between these same products, has increased dramatically, necessitating the establishment of standards. Historically these standards have been set by government entities or independent industry organizations. This ensured that everyone was starting from the same page. However, as the pace of technological evolution has accelerated, these standards have been increasingly set by the marketplace. In certain circumstances, single companies have emerged as the owner and director of such standards. Such is the case with Intel's control of the x86 microprocessor architecture and Microsoft's control of the desktop personal computer operating system. These are the most apparent examples of architectural ownership.

As you may well know, architectures are extremely profitable. This is the result of two phenomena. First, after the marketplace decides on a standard, customers become increasingly "locked in" to that standard. This is the consequence of training on, and investment in, products that adhere to the chosen standard. The second thing that makes architectural ownership so valuable is a concept economists refer to as "increasing returns." As a potential architectural owner gains market share, the likelihood that they gain control increases.

ADAPTIVE FINANCIAL MARKETS

When Microsoft and Intel gained control of their respective architectures, the financial markets were a bit naive with respect to the value of architectural control. This is why Intel and Microsoft have represented such great investments over the past ten years. However, the market "learns" over time. Remember, the purpose of a well-functioning capital market is to equalize the risk-versus-return proposition of all potential investments. If the market currently perceives that "some company" will gain control of an Internet architecture, it should adapt by increasing the valuation of the potential architectural owners. Hopefully this helps to explain the seemingly irrational valuations of companies such as Netscape, Yahoo!, and Amazon.com. (Note that this also implies investors will likely not be as well rewarded for successfully predicting architectural owners as they were in the past.)

We can explain this same adaptive behavior in another way. We all know that it is very difficult to compete with and dislodge an architectural owner once that company has taken control of the standard. Yet as we said before, "the market" aspires to minimize abnormal profitability. The way "the market" deals with this apparent problem is by raising the early valuation of the potential winners. In other words, "the competition" is brought forward to the present. This way the net present value of "investing in the Internet" is more in line with other financial assets. Unfortunately, these types of investments are likely to be all-or-nothing bets. In a very real sense, public equity holders are adopting the investment profile of a venture capitalist. The problem is they have also adopted the risk profile of a venture capitalist. The typical venture capitalist has one winner for every ten investments, heightening the need for diversification.

ADAPTIVE COMPETITIVE MARKETS

Just as financial markets are adapting to the heightened understanding of increasing return economics, so are the actual competitive markets. The complexity and breadth of the Internet warrant the need for worldwide standards. Nonetheless, we find it highly unlikely that the World Wide Web Consortium (W3C) will successfully shepherd the evolution of the Hypertext Markup Language (HTML) standard. The Internet market is progressing much too quickly for a consortium. Besides, the key players, Netscape and Microsoft, are all adding functionality and proprietary HTML tags to their Internet browsers that differentiate their offering, and as a result, unofficially extending the HTML standard. This results in a chaotic market, which is high in functionality but low in compatibility. As Network World columnist Mark Gibbs noted, " ... HTML is a quasi-standard and damn irritating if you are trying to create a specific image for your Web-based business."

When Microsoft and Intel grabbed control of their respective architectures, the concept of increasing returns was not well understood. When the starter fired the gun to begin the race, no one else was at the starting line. This is not the case today. The executive team at Netscape was well aware of the potential to own the "Internet applications programming interface (API)." In fact, their prospectus notes, "The Company's goal is to make its software the de facto standard for navigating, publishing information, and executing transactions on the Internet and private IP networks." This time the starting line is a little more crowded. Several companies will vie to control the protocol, and those that lose will lose big.

Individual, private software developers can download Sun Microsystems' Java^TM Development Kit for free. Why? Because Java has the potential to become the de facto programming language for the networked age and the standard for executable content on the Internet.

If you believe everything we have written so far, it should start becoming clear why companies like Netscape and Sun Microsystems are currently so willing to give away software for free. In an effort to grab the standard, companies are willing to accept long periods of lackluster profitability. Once again, the market is seeking to minimize excess profitability. Since the cash flows for the winner are so bountiful, the negative cash flows that can be rationalized up front may end up being enormous. This will also lead to lower returns for investors relative to what was earned for holding past architectural winners.

We predict that over the next 12 months we will witness the largest windfall giveaway of software, content, and access that the market has ever seen. In an attempt to "lock in" customers, companies will make "surfing the net" a relatively inexpensive experience. This is good for consumers, but could be bad for investors. Because of their addiction for control, Microsoft needs to own the Internet protocol and has substantially greater resources than their competition. Microsoft's Internet Explorer browser is dropped from the sky like American propaganda leaflets were during the Gulf War. Microsoft will try to carpet bomb the world with their Internet browser. Suffice it to say, giveaway economics will make valuation difficult.

In reference to Netscape's or Sun Microsystems' ability to control the "Internet API" and thus own an architecture, to think that the market will not matriculate to a single dominant design is to ignore the lessons of the past 15 years. Controlling the communications language for the Internet reeks of the perfect increasing returns opportunity, and Netscape and Sun Microsystems know it.

To put it simply, we find high valuations for companies that give their product away completely rational. However, contrary to popular belief, we doubt that the browser market will remain fragmented, or that browsers will remain free once the architectural owner establishes the de facto market standard.

Yahoo! is valued more highly than most media companies (like Dow Jones Incorporated or Knight-Ridder Incorporated). The company has won the Portal Wars by using its search engine, selling advertising on its Internet web site, being the first Internet company to turn its name into a brand, being one of the few Net companies that can claim to have operating profits - i.e. black ink - to back up its buzz. Some 40 million people visit Yahoo! in any given month. The recent MTV music awards were projected to reach only 24 million people worldwide. We are talking about a huge audience here. In a recent survey conducted by Intelliquest, Yahoo! is the third most recognized Internet brand among Internet users. The company even scored ahead of Microsoft. Yahoo! offers a full-blown package of information and services. Yahoo! offers finance, real estate, health, search, news, personalization, travel, shopping, calendar services, e-mail, chat, and auctions. Industry analysts, individual and institutional investors are all betting that Amazon.com will be the early e-commerce leader. On June 11, the amazingly popular online bookseller began selling music online and has plans for a giant online video store as well. The company offers one-click online electronic purchasing, purchased companies like Junglee, Planet All, and Internet Movie Database Ltd., and announced a joint venture to be the premiere bookseller on Yahoo!'s fourteen international web sites. Thus, the seemingly irrational stock market valuations granted to these Internet companies are totally justified.

"Behold this mighty nation, its rules and its wise men listening to Malthus! It is mournful, mournful ..."
- Samuel Taylor Coleridge

Who is Malthus? And why did Coleridge consider it such a grievous mistake to listen to him?

Thomas Robert Malthus, a part-time clergyman and professional predictor, is best known for his late seventeenth century work titled An Essay on the Principle of Population as It Affects the Future Improvement of Society, with Remarks on the Speculations of M. Goodwin, M. Condorcet, and Other Writers. And while title terseness was clearly not one of Malthus's better traits, innovative, nonlinear thinking was.

In An Essay, Malthus argued that the world was doomed to overpopulation because the number of humans on the planet was growing at a geometric, nonlinear rate, whereas the food supply was limited to an arithmetic, linear progression. As a result, Malthus urged the leaders of his time to denounce fertility and to embrace moral restraint. Fortunately for us, Malthus was wrong.

However, we come here to praise Malthus, not to ridicule him. After all, he is the father of nonlinear thinking. And it was not the use of nonlinear thinking that failed Malthus, but rather the lack of use of his own, self-discovered tool. You see, the food supply expanded at an exponential rate as well, owing to the advances in farming productivity.

By now, you may be wondering what, if anything, this has to do with investing in high tech stocks. Well, it is our belief that high tech investors are frequently misled by the folly of linear interpolation. Therefore, if we could identify an event which we knew to be nonlinear, we could leverage Malthus' brilliance and hopefully outwit the market.

THE SIGMOID CURVE

It just so happens that we have a particular nonlinear event in mind. It is a generally accepted principal that new products diffuse along an S-shaped curve, also known as a Sigmoid. The seminal work that first sought to quantify the dynamics of new product diffusion was Frank M. Bass's 1969 paper, A New Product Growth Model for Consumer Durables. Bass argued that potential adopters were influenced by either mass media or word of mouth. Therefore, in order to account for word of mouth influence, Bass developed an equation that was a function of the penetration of the potential installed base. Inclusion of this variable resulted in a nonlinear equation.

High technology products are even more prone to diffuse in a nonlinear pattern. This is because, as the usage of a product grows, so does the infrastructure that allows for more uses and more users. Think about the how the videocassette recorder (VCR) proliferated. As the number of available videos and video stores grew, the likelihood of adoption for each individual user grew exponentially.

Now, as we said before, we think most investors wear "linear-blinders," and we think this represents opportunity. Take a look at the chart in the middle of the next page (for those readers with an electronic copy, draw an elongated S-curve on a sheet of paper and connect the endpoints with a straight line). The dark curved line represents the typical Sigmoid, or diffusion curve that most new products follow.

We think most linear investors expect a new product to diffuse along the straight line that connects the two endpoints (line 1). There is a known installed base, and sales will gradually approach that level. Mr. LI (Linear Investor) plugs his unit expectations into his earnings model, and is quite pleased with what he sees. He is a buyer of the stock.

As real sales begin to emerge along the curve and not the line, Mr. LI becomes disconcerted. To compensate, he "redraws" his linear expectation along the bottom of the S-curve (line 2), assuming that the error must have been either in his acceptance rate or his assumptions for the size of the potential market. Now disappointed, Mr. LI dumps his shares at a loss.

Low and behold, just a few short months after Mr. LI bailed out, the new product takes off and so does the stock. Mr. LI once again takes notice and comes up with a new linear expectation that extends almost straight up into the sky (line 3). Convinced now that he was right about the product in the first place, Mr. LI gets back on board.

Now, just when he thought he had it all figured out, guess what happens to Mr. LI. The latest earnings figures are in line, but the stock sells off sharply. It seems that most investors had come to expect upside earnings. Expectations had passed reality. Now Mr. LI has to adjust his model one more time (line 4). This is probably the first time since the product began to diffuse that his expectations have been anywhere close to reality. Not that it matters. He has already lost money on the stock twice.

Now let us look at a few recent real world examples: Last July, most Apple investors had come to the conclusion that PowerMac was going to be a flop. Apple just didn't have enough native applications. The new product transition was failing, and Apple's shares approached a 52-week low of around $25. By November, native applications began to appear and PowerMac's were in short supply across the country. Apple stock soared past $40.

In September 1994, Novell was in dire straits. The switching costs to the new version were too high, and no one was adopting the product. Stock price: $15. By February, the stock slipped up past $20. That represents a 25% return in just five months. The product diffused after all.

You have probably already guessed our last example. Do you remember the stories in all the trade press last November about how corporations were not adopting Pentium? Intel's stock back then was trading below $60. It's funny how these things play out. Did anyone really think we were never going to switch to Pentium? Today's stock price is above $80.

The trick is to buy the stock when everyone first becomes disappointed and redraws their linear expectation too low. The product is typically waiting on infrastructure; patience is the key. Of course, this works much better for replacement products than for new ones. If you jumped on the Newton story after the first big disappointment, you would still be waiting.

We recognize that hindsight is always 20-20, and that there are likely doubters in the audience. Therefore, as an experiment, we would like to offer the following prediction. In about three months, we suspect the headlines will read "Yahoo! gets competition from Microsoft" or "Amazon.com gets competition from Barnes & Noble" and that shares of Yahoo! and Amazon.com will slip down on the news. What a great opportunity that will be for nonlinear thinkers like you and me."

To be continued ...

Sincerely,
Mark Kuharich

Join my free e-mail newsletter called the Software View by clicking here or sending mail to thesoftwareview-owner@west-point.org