Bridging the gap between old and new

The extraordinary rush to the Web services market has left most established firms behind, and has opened the door to start-ups that focus solely on Web business.

3 min read
The Internet boom is increasingly driving spending in the information technology (IT) arena. Lines between traditional IT projects and e-business projects are blurred as more companies move large portions of their business to the Web.

The extraordinary rush to this "virtual" market has left most established firms behind--at least temporarily--and has opened the door to start-ups that focus solely on Web business. These firms--Scient, Viant, Cysive, and Proxicom--have grown steadily and have even had to turn down business, unable to hire talented hands fast enough.

The crowd on Wall Street loves growing companies, and investors have gobbled up their initial public offerings, driving stocks higher. Most of the Web-focused IT service companies' stocks are trading between six-times (for example, US Web/CKS) and 32-times (take into consideration Viant) last quarter's annualized revenue, compared to less than three-times annual revenue for most other established IT service firms.

Of course, the established firms are not standing still. These firms will eventually come around, just as they did in the 1990s when client/server was the buzz and start-ups like Cambridge Technology Partners were the new kids on the block. However, as a percentage of revenue, Web business still holds a smaller role, at around 5 to 15 percent of the total for these firms.

So how do we make sense of the valuation gap between these two generations of IT service companies? This can be explained in part by looking at supply and demand issues, which can often exaggerate a stock's valuation.

Stock in Web solutions companies tends to trade in small numbers with very few block trades (a possible sign of limited institutional investor interest). Stock in these companies is also known to be subject to large price swings, a phenomenon familiar to some of the more popular Internet issues this year. Yet supply and demand is a short-term problem, as some companies are considering secondary stock offerings to satisfy investor demand.

Thus the value of these Web solutions companies can be analyzed by looking at four factors: growth, profitability, amount of capital invested, and risk.

Revenue and earnings for some of the larger IT firms are growing at a rate of 20 to 25 percent, while Web solutions companies boast growth rates of more than 100 percent (of course, these firms are starting from a much lower base). Most new Web service companies haven't yet turned a profit, but are expected to make money sometime in 2000. However, these nascent firms claim gross profit margins of 45 to 55 percent--well ahead of the 30 to 40 percent boasted by most of the larger, established firms.

So what costs are keeping the new Web solutions firms in the red, while their bigger, entrenched competitors report operating profit margins in the range of 10 to 15 percent? While the much smaller Web solutions firms need to spend on infrastructure to support their skyrocketing growth, much of the difference lies in spending for advertising, marketing (brand awareness), and recruiting.

In the spirit of the Internet, investors value market and "mind share" over bottom-line profitability--at least for now. Over the next couple of years, as the industry matures, those same investors will require operating profit margins consistent with 50-percent gross margins, or operating profit margins of 15 to 25 percent.

Spending by Web solutions firms isn't significantly different than that of traditional IT service companies. Both teams need to spend on standard equipment like office supplies and computer hardware. And both types of companies will still need to invest in recruiting and training to keep their workforce competitive.

As business continues to boom in the Web services sector, investor risk is low compared to other areas, such as enterprise software implementation, application maintenance, custom software development, and many other areas suffering from spending shifts to prepare for the year 2000.

Each of these four factors can be quantified and put into a discounted cash flow model. After developing a few models, it should become clearer to companies and investors why these stocks are trading at their current levels.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker. He can be reached at wrloomis@leggmason.com This information is based on sources believed reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security. Opinions expressed are subject to change. Additional information available on request.