Journalistic Mishandling of AOL
April 20, 1999
by Kevin Prigel
---- =20 Yesterday the Wall Street Journal devoted over a third of a page of their=20 highly regarded editorial section to the publication of perhaps the most=20 flawed piece of literature the journal has ever run. The piece, written by=20 Jeremy J. Siegel, a professor of finance at the highly regarded Wharton=20 School, contained not only factual misstatements, and tired comparisons, but=20 also a blatant disregard for readily apparent industry fundamentals. I will=20 at this time ignore the fact that Mr. Siegel rushes forth comparing Internet=20 stocks to "Dutch tulip-bulb[s]," "Florida land," and "precious metals," all=20 together ignoring that these historical bubbles involved speculation in=20 hard-assets and not revolutionary business models. The primary focus of this=20 refute will be the professors unenlightened argument regarding the valuation=20 of "American [sic] Online."=20
In order to refute the professor=92s case against the Internet blue-chip's=20 valuation I must first correct his misstatements and questionable omissions.=20 America Online currently has a market cap of $108 billion, not $200 billion=20 as the professor says. In fact, at its all-time intra-day high AOL had a=20 market cap of only $164 billion, over 20% shy of the professor=92s mark.=20 America Online was ranked 415th in sales and 311th in profits on the latest=20 Forbes 500 lists, but the good professor failed to mention that AOL=20 experienced 62% sales growth and 414% earnings growth, numbers that will=20 quickly vault AOL to significantly higher rankings. America Online is sellin= g=20 at a 1999 price to earnings ratio of 203, rather than 450 as Mr. Siegel says= .=20 Finally, America Online=92s current valuation per subscriber is not $15,000 = as=20 the professor alleges, but a significantly lower $6,350 if we totally=20 disregard all of AOL=92s other lines of business.=20
With those facts clarified and corrected, I will now approach the professor= =92s=20 valuation argument. I will in fact approach the valuation issue with the=20 professor's exact methodology despite the existence of more widely accepted=20 valuation means. The professor targets a "maturity" PE of 30. This "high" of=20 a PE is supposedly supported only by "substantial" growth. This "mature" PE=20 altogether ignores the fact that slow-growing corporate giants such as GE=20 trade at price to earnings ratios well above 30. Nonetheless, I will accept=20 Mr. Siegel's pessimistic PE and work through the rest of his "new" math.
In order to justify a $200 billion market value (a healthy 85% premium to=20 today=92s closing price) Mr. Siegel correctly calculates that America Online=20 must generate $6.7 billion in earnings each year (given his PE of 30). Mr.=20 Siegel then goes on to predict that AOL will be able to generate a net margi= n=20 of only 10%, below what America Online has been able to achieve only in the=20 infancy of its business model, and substantially below the company=92s=20 guidance. It is not unthinkable that the online giant can generate unusually=20 high margins. Microsoft has achieved 25-30% net margins for over a decade by=20 employing the write one, sell thousands business model, a model very similar=20 to that of AOL. Using the middle range of America Online=92s guidance the=20 company would need to generate a little over $22 billion in sales,=20 significantly lower than the professor=92s calculation of $67 billion. That=20 works out to approximately $1300 in revenues per member each year, assuming=20 that AOL never adds another member (which is quite unlikely since the servic= e=20 added one million new members during the first 40 days of 1999).
The professor supports his low-ball margin estimate by citing the fact that=20 merchandising margins are quite small on the web. A fact that seems to have=20 escaped his careful analysis is that AOL has exited the merchandising=20 business over the past 3 years, such that today merchandise sales do not=20 significantly contribute to revenues or earnings. Finally, he claims that=20 Internet advertising should not continue to command a premium price due to=20 the likelihood that brand names will lose to deep discounters. This runs=20 counter to careful studies that indicate that loyalties online run high, and=20 new users (one of AOL's largest markets) are likely to stick with that which=20 they know first.
Finally, I must note that Mr. Siegel all together ignores any value in=20 America Online=92s 50 million unique visitors to its web sites each month, 2= 5=20 million ICQ users, server software acquired from Netscape, the Sun contract,=20 and investments in other popular Internet businesses.
Mr. Siegel has presented his valuation: a market PE, no future growth, low=20 ball revenue estimates, and outright wrong metrics. I have presented the tru= e=20 picture: parabolic growth, exploding margins, and a truly justifiable=20 valuation. The evidence demands a verdict. Mr. Siegel and his cohorts are th= e=20 real speculators, betting against the biggest change in the world since a=20 number of colonies revolted in 1776.=20