The Internet Implosion

January 12, 2000

Wynn Quon

Nothing conveys the electronic adrenaline high of the new economy better than the term "Internet time." It means light-speed innovation, brave new markets that spring up overnight, triple-digit revenue growth and mountains of money for the lucky winners. The bad news is that Internet time as we know it will end within 12 to 18 months.

Internet time is the offspring of three fundamental gale forces: the rapid growth in Internet use, the spread of the PC, and the financial mania of investors. But the first two of these forces are sputtering and the third is notoriously unreliable. Add to this the cyberglut of Web startups and the result is a Darwinian shakeout that will cut a swath through the industry. Two stunning Internet success stories, and Yahoo!, help explain why.

For the third quarter ending September 1999, reported sales of $356-million, up a whopping 130% from the same quarter in 1998. Yahoo! in its most recent quarter reported $201-million in sales, up an equally impressive 139%. Since going public less than five years ago, both companies have racked up triple-digit sales increases year after year. What's been driving this growth?

First and most important is the meteoric rise in Internet users. In 1996, 61 million people were on the Internet worldwide. By the end of 1998, according to the Computer Industry Almanac, there were 230 million. The number of users is doubling every year. But how long can this breakneck pace continue? Consider Table 1, which shows Internet users in the top 10 cyber-countries at the end of 1998. Analysts define saturation when more than 70% of the population is on the Net. As you can see, the top industrialized countries will all plateau in less than two years.

Take the U.S. for example. At the end of 1998, about one-third of its population was on the Net. That doesn't sound like too much. But at 100% annual growth, 68% were on the Internet by the end of 1999. By the end of 2000, growth will have hit a brick wall because everyone who will have wanted to be on the Net will be there already. The only reason analysts and investors haven't cottoned on is the age-old problem of underestimating the consequences of compounded growth.

The U.S. poses a special problem. With by far the largest number of Internet users, the flatlining of its Internet market will have a huge dampening effect. For the Internet to keep doubling, the rest of the world must add 184 million users this year to make up for the U.S. shortfall. That won't happen.Countries with the raw numbers, such as China, India and Brazil, aren't advanced enough in either infrastructure or economic wealth. China had only 3 million users in 1998. Neither India nor Brazil appear in the list of top 15 Internet countries. Their Internet future, though bright, is constrained by much slower GNP growth. These countries won't be on-line until far into the 21st century, too late to save today's Internet world from its looming crisis. The second powerful force behind the Internet boom is the rapid adoption of PCs. Unfortunately, this will also be slowing soon. Table 2 lists thepenetration rate of PCs. From historical figures, the PC market has been growing at 18% per year. Again the U.S., so far ahead of the others, is the critical market to watch. Its installed base of PCs is over four times higher than that of Japan's, the next largest. The number of U.S. PCs will hit 180 million in 2000, turning the PC growth market into a replacement market in which a new PC will be a discretionary purchase rather than a necessity. If you have a Pentium II, do you really need a Pentium III? The only way out for PC manufacturers is if new killer-apps (like digital video) appear that need higher horsepower.

Another ingredient for trouble -- in addition to waning demand -- is a supply glut. Lured by instant IPO riches, Internet companies have proliferated. There are now upwards of 2 million commercial web sites.The signs of jostling at the Internet banquet are already there, and it will get a lot nastier. As in any other maturing market, Internet companies are ramping up advertising and slashing their prices. According to Adweek, over 80 companies spent $3-billion on advertising in the first nine months of 1999. Remember the old business model where an Internet startup could provide free content and watch the money roll in from selling ad space? That idea has died a quick death. Except for half a dozen top Internet properties, the rest of the companies spend more on advertising in print, television and radio than they take in. Getting noticed was easy when only a dozen fish swam in the Internet pond. But now the Internet's an ocean and the fish are everywhere.

The landing won't be gentle as Internet growth shifts from high to low gear. The third force behind Internet time -- financial mania -- is also the most fickle. Investors have pumped up the prices of Internet and computer stocks to heights that ignore the impending drought of new customers. When investors see that the fundamentals underlying the Internet have changed once and for all, Internet stock prices will implode. Yahoo! traded at $428 on December 27,1999, giving it a trailing 12-month P/E of 2068. Some simple math shows the danger. Let's assume that we're being too pessimistic and that the Internet will saturate two years from now. Say this would allow Yahoo! to continue earnings growth at 100% until 2002. This would still leave its P/E at an exorbitant high of 517. A technology company in a steady market would typically sport a P/E of 30. A black hole will open up underneath the feet of Yahoo! shareholders because this suggests that Yahoo! stock has a fair price of $25, a drop of 94%. Such a drop is almost absurd to contemplate but only because lunatic euphoria is now considered normal.

The end result is an Internet recession. The casualties will be high. As stock prices plummet, cash-flow impaired businesses who rely on equity financing will be pushed over the edge. Internet infrastructure companies such as Lucent, Nortel and Cisco will also be affected. The need for new network capacity will suffer a slowdown along with everything else. The only consolation is that these companies' P/Es are considerably lower. The damage will be heavy but not catastrophic.

Most serious of all is the danger that the Internet recession could spread to the economy at large. One trigger point is the massive extent to which investors are leveraged. The U.S. margin debt stood at a record $192-billion as of October 1999. Disturbingly, the increase in margin debt has marched in step with the NASDAQ index's rise. Investors are borrowing money to invest in technology. Negative personal savings rates imply that exuberant investors have been spending their stock market winnings in advance. When the crunch comes, the tightened spending could put a severe chill on the economy.

All of this is not to say that the Internet will turn into a technological has-been. Far from it, the Internet will take its rightful place in the pantheon of human innovation. It will join its historical cousins the railroad, the radio, the telephone and television as inventions that changed the face of the world. The strongest of the Internet companies will survive, innovation will go on and the networking of the world will continue. But just as with its technological predecessors, the pace and the profits will run at a much more sober rate. The quickened pulse of Internet time was never meant to last forever.

Wynn Quon is chief technology analyst at Legado Associates. He can be reached at