The Nothing New New Economy.

Who wins with the Internet?

At the end of April, during the stock market meltdown, I was going through the mail and came upon the latest issue of the Red Herring, the monthly bible of the technology finance community. This once thin monthly review of the business of technology has grown to phone book girth and, for that reason, didn't make it into the bag with the ThinkPad and related gear. The stock market was already weak and the sheer size of the Herring, bulging at some 600 pages of ads and insights, made me wonder if the tide was finally going out on technology stocks.

The Herring and other successful technology journals document the rise of investment in technology companies over the past decade. But the real story of the Internet bubble is investors with too much money chasing too few investment opportunities. Today inflation resides in financial assets rather than in consumer products, wages, or real property, reflecting the demographic profile of the nation. This relationship conjures up memories of inflation from the 1970s, a point not lost on Federal Reserve Chairman Alan Greenspan.

The fact is that if the Internet didn't exist, we'd have to invent it. It is no accident that the explosion in new economy companies comes at a time when money is pouring from the pockets of aging American baby boomers. Pioneers of the Internet did not cause the Internet bubble; they merely facilitated the gaming tendencies of a generation of newly empowered individual investors, armed with PCs and cell phones, who levitated stock prices beyond the dreams of the most avaricious investment banker.

Investors did not merely accept stock schemes at sky high valuations; they demanded them. Until recently, mysterious Internet companies were valued based on the number of people seeking to buy shares rather than the value of the business or even the future promise of the business. The market for dot.com stocks was crazy, whether evaluations were based on immediate- or longer-term considerations. The greater fool theory of public company valuation operated.

This does not diminish the value of the Internet as a new technology. But it does mean that given the abundance of ready cash and weak public market valuations, Internet entrepreneurs and investors must impose tough discipline on new technology vehicles to generate shareholder value. The latest example of this rationalization process is a company you probably don't know: Boo.com, an aptly named startup that collapsed last month and has given the broader technology market cold sweats. Funded by JP Morgan, Goldman Sachs, and Benetton, Boo.com was a retail startup that raised and spent $135 million to create a new ecommerce brand in Europe.

The failure of Boo.com and several other ecommerce startups brings into question valuations in this entire sector. Despite the sudden end of the gold rush on the Internet, the market was already moving toward a view that profits and earnings, the foundation of value, do matter after all. The fall in valuations for companies that populate the new economy is part of a natural selection process. Unfortunately, many new Internet companies focused on the consumer will suffer or even fail as a result of the collapse of the Great Internet Bubble. Many would have failed anyway.

One benefit of the meltdown in technology stocks: It forces investors and management alike to move back to basics. Internet companies can no longer rely on the day-trading crowd to justify momentum driven valuations, which by definition have no connection to the underlying business. Now that the link between earnings and value has been restored, Internet companies must address three basic issues: 1) What does it cost to acquire and/or retain customers; 2) what is the cost of providing the product or service to the customer; 3) and what is the lifetime value of a customer or member?

Technology companies that can answer these questions may have a chance to obtain funding in today's environment. Today it seems laughable, but over the past several years many companies in the Internet space never questioned the cost to acquire customers or compared this cost to the prospective value of the customer in terms of revenue potential. Having access to the audience was deemed to be enough. But with companies like AOL and Yahoo! spending hundreds of millions of dollars annually to attract new users or retain their existing community, consumer focused startups seeking to compete for mindshare on the Internet face enormous challenges.

AOL, for example, admitted to spending upwards of $300 per user in terms of overall acquisition cost versus $9.99 per month in subscription charges. Doing the math, how long would it take AOL to break even much less generate a profit? Or put another way, Steve Case is one smart fellow for buying cash-flow rich Time Warner when his own currency was a lot higher than it is today. Case's timing was perfect: It preceded the market crash and, more important, the slowing of growth in U.S. Internet users.

The collapse of Internet retailer Boo.com and other like situations confirms that when building a new retail brand on the Internet, the strength of a business model lies not only in a big operation and ad budget. The campaign to build online brand awareness must be accompanied by sound execution, value for the consumer, and more than a little luck. Names such as Amazon, eBay, and Sportsline come to mind, but each of these Internet giants is only marginally profitable if at all, and they are pursued by hundreds of smaller competitors.

Somehow both the managers of Boo.com and the company's blue-chip investors seemingly forgot (or maybe never knew) that retailing, on or offline, is one of the most risky areas of business. Look at the huge marketing expenditures required to establish mega brands like Yahoo! or AOL. Today, all of the top web sites have either a strong brand or a strong connection to the user via an Internet Service Provider (ISP) relationship that generates traffic or "eyeballs," as shown in the table (on the previous page).

Mar-2000               Avg. minutes per month for avg. user

AOL Network                          407.00
zJuno.com                            229.90
eBay                                 136.10
IWON.com                              87.80
Yahoo!                                76.60
MSN                                   74.60
Excite@Home                           34.90
TheUproarNetwork                      31.50
Go Network                            29.60
Alta Vista                            26.70
FREELOTTO.com                         23.70
iVillage.com                          22.60
Sportsline.com                        22.20
Lycos                                 21.50
Earthlink                             21.10
Snoball                               19.90
TimeWarnerOnline                      19.80
Priceline                             19.80
AT&T Web Sites                        19.10
ZDNet                                 18.60

Some of these sites are established Internet brands, others are new, but all generate a large community of users who have a reason to visit and, most important to advertisers, spend time on site. Marketing is important, but it is not sufficient to build a brand in a crowded market.

For example, my company, a U.K. ISP, forged a partnership with Excite in the U.K. to give our members access to Excite's content and personalization tools. This partnership allows us to enhance our brand awareness through association with Excite and also conserve financial resources for marketing and upgrading our access capacity, rather than reinventing the wheel by creating a content offering for our members.

On the Internet, the value of a brand or a Web site is measured best when you turn the advertising off. If a consumer oriented site has real brand power, consumers will find it without the type of big ad campaigns that have characterized the Internet in recent years -- the equivalent of shoveling money into the furnace. For this reason, the Internet appendages of existing brands like LL Bean in the U.S. or Tesco in the U.K. may ultimately have the strongest attraction for consumers, and thus the highest value for advertisers and investors. While there are many examples of new brands successfully appearing on the Internet, consumers are likely to deliver the highest response to brands they know and trust.

The Internet is a two-way communication medium, more like a telephone than the television, which offers sponsors vast opportunities. As larger, established players formulate and execute strategies to capture or retain the attention of potential customers on the Internet, new brands will find the cost of acquisition rising, both in terms of spending on marketing and by providing direct subsidies to consumers. This is precisely the same market situation found in retailing or consumer products, and signals a new phase in the evolution of competition on the Internet.

In the early part of the last century, monopoly Standard Oil used a beggar-thy-competitor strategy known as a "good soaking" to kill small upstarts. Today in the Internet market, major players like Yahoo!, Excite, Lycos and AOL likewise are vying for mindshare with large retailers, banks, and other consumer companies that want to control part of the mindshare of an audience, both in the U.S. and abroad. In Europe, for example, Germany's Bertelsmann has committed $1 billion to support the growth of Lycos, its partner in Europe. The other large players are planning similar campaigns to attract and retain audiences. Only the strongest new Internet companies and brands are likely to be successful competing in such an environment.

Christopher Whalen is Managing Director at The Free Internet Group Limited, a U.K. Internet Service Provider. He was previously a director at Prudential Volpe Technology Group in New York. [e-mail]