Professional Documents
Culture Documents
United States
3 February 2000
Henry Blodget First Vice President (1) 212 449-0773 henry_blodget@ml.com Edward McCabe Vice President (1) 212 449-8862 edward_mccabe@ml.com
Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department
#5078
RC#60203410
Executive Summary
A new species of company is exploding onto the scene the B2B market maker. We believe that over the next five years, B2B market makers will cause profound change in the world economy and, possibly, create more than $1 trillion in stock market value. B2B market makers act as infomediaries and transaction engines within large, established, often stagnant industrial industries. Capturing just a small portion of the enormous value of goods and services transacted within these industries should translate into significant revenue and (hopefully) profit for the B2B market makers. An estimated $400-$500 billion gross revenue opportunity. We estimate worldwide B2B electronic commerce will grow from $158 billion in 1999 to $2.5 trillion by 2003. Importantly, in our view the overwhelming majority of this commerce will occur on seller sites, like those of Grainger, Intel, and FedEx. However, we estimate that 15-20% of B2B electronic commerce will likely be transacted through third-party marketplaces, generating revenue of $400-$500 billion by 2003. A revenue multiple of 2X-3X suggests that B2B market makers could generate market capitalization of $800 billion to $1.5 trillion by 2003, with a present value between $340 billion and $620 billion. Network effect should create high barriers to entry and ROIC for market leaders translating into 1) high valuations for the leader, 2) dismal valuations for No. 3-No.5. Even more than B2C, B2B e-commerce should evolve into a winner-take-most game (sellers will always gravitate to the marketplace with the most potential buyers; buyers to the marketplace with the greatest selection and price competition). The cost of ensuring market leadership will initially be high we dont look for profits anytime soon. Once leadership is won, however, the leader should find itself in the enviable position of being the operating system for the industry, the interactive platform around which the whole industry standardizes. Operating system businesses command high multiples. Not surprisingly, the B2B market maker opportunity has not gone unnoticed: investors are already paying through the nose for the promise of B2B. The current valuations of most public B2B companies, as well as the private valuations of many others, are dizzying (the 10-12 public B2B market maker stocks are valued at $85 billion on run-rate revenue of $3-$4 billion or 20-30X). We expect to see a plethora of B2B market makers go public this year some great, some okay, some poor. As supply and demand move closer to equilibrium, we recommend that investors take care to own only the stocks of the best companies. In fact, there could be as much as 100% downside for low-quality B2B stocks of which, in our opinion, there will be many.
We recommend that investors develop a B2B investment strategy, whether direct or indirect, offensive or defensive. For diversified growth investors, this would include allocating a small percentage of the portfolio to a basket of high quality B2B stocks. The leading B2C internet stocks have outperformed the major indexes for 5 straight years. Assuming B2B follows a similar trajectory, the risk associated with the sectors extreme valuations, volatility, and fundamental uncertainty will, for some investors, be offset by the potentially greater risk of not being involved. Put another way, we continue to believe that for investors the greatest risk in hyper-growth equity investing (which this is) is not losing money, but missing big upside.
Key Points
Huge market opportunity should create major market capitalization. We believe worldwide B2B electronic commerce could approach $2.5 trillion by 2003. Of this, we estimate that $400-$500 billion will be generated by B2B market makers. At 2X-3X these estimates, we believe B2B market makers could generate total market capitalization between $800 billion and $1.5 trillion by 2003 (with a present value between approximately $340 billion and $620 billion). Powerful business models (network effect, customer lockin, low capital intensity (at maturity), and operating system qualities) should create high barriers to entry and high ROIC. As a result of the network effect, leading market makers should enjoy exponential revenue growth once a critical mass of market participants and liquidity is achieved. Expenses, meanwhile, should grow linearly, creating high operating leverage. Once established as the leader in an industry, a market maker should enjoy declining participant acquisition costs, high barriers to entry, high switching costs, and recurring revenue. Start-up costs and near-term losses will likely concern some investors, but, in our opinion, for the best market makers, these investments can be viewed as analogous to CAPEX spending for physical networks (which is capitalized and therefore doesnt negatively affect the P&L). In our view, the good stocks are dizzyingly expensive, but we would rather pay up for them than look for cheap stocks of poorer companies. It is hard to generate firstrate returns by owning second-rate companies, and in this industry, you usually get what you pay for. Although the current crop of market makers will likely generate significant fundamental value over time, the current valuations are driven largely by an imbalance of supply and demand. Assuming markets remain robust, we expect to see a plethora of market makers go public in the next few years. As the supply of stocks moves closer to equilibrium with demand, quality will likely become more important (we believe there is close to 100% downside for low-quality stocks). Long-term, there are likely be many more losers than winners.
Each industry sector is different, so each market maker must be carefully analyzed (ie, a large industry does not necessarily translate into a valuable market maker). There are, however, some common characteristics for success: Plenty of buyers and sellers. If you want to make a market, you need both. Ideally, you will have more than your competitors do (or a plan to get them). Liquidity. The value of a market maker is a multiple of the value of transactions that flow through it. In the early going, the market maker should have, or be focused on generating, industry-leading liquidity. Fragmentation. Middlemen add the most value in markets that are highly fragmented on both the supply and demand sides. Inefficiency. Market makers must add value to both sides of the trade. They can often do so by making the buying and selling process more efficient.
Management with domain expertise. Senior level industry relationships and credibility ease concern and facilitate industry buy in. Early mover advantage. EBay only had a year head start in the C2C auctions business, but this was enough. Partnerships for distribution and logistics. UPS doesnt transport lumber, resin, or hydrochloric acid. Neutrality (but not at the expense of liquidity). Few companies opt to do business with their competitors or with subsidiaries of competitors. Public currency. With a billion dollar market cap, if you dont yet have a real business, you can buy one.
Ticker ARBA CMDX CMRC FMKT ICGE NEOF PCOR PPRO ROWE SQST VERT
02-Feb-00 97.50 172.25 229.00 119.00 50.31 46.38 82.88 35.38 56.63 238.25
52 Week Range High Low 143.00 331.00 212.00 60.94 94.00 175.00 53.56 91.63 289.56 15.13 8.83 7.00 39.88 26.75 14.66 13.13 25.94 17.38
Market Cap ($ millions) $12,203 3,208 12,402 8,107 32,868 3,270 723 2,325 357 1,556 8,386 $85,405 $49,267
2000E Rev. Market Cap ($ millions) To 2000E Sales $145 132 130 43 NA NA 68 18 598 68 77 $1,278 84x 24x 95x 190x NA NA 11x 126x 1x 23x 110x 39x
2001E Rev. Market Cap ($ millions) To 2001E Sales $278 271 260 86 NA NA 104 42 1,028 275 149 $2,491 44x 12x 48x 94x NA NA 7x 55x 0x 6x 56x 20x
370.00 163.88
(1) Revenue predominantly licenses, services, and maintenance fees (2) Revenue predominantly gross product sales (3) Revenue predominantly fixed monthly fees (4) Revenue predominantly subscription, content, and services fees (5) Revenue predominantly subscription fees (6) Revenue predominantly advertising fees
Note: At this early point, due to differences of what and how they sell, market makers are recognizing revenue differently. However, almost without exception, the long-term goal for all market makers is to generate more transaction-based revenue.
CONTENTS
n Section Executive Summary Introduction: Asking The Right 1. B2B Questions Overview: An Industry Snapshot 2. A Brief History of B2B 3. Electronic Commerce B2B Market Overview 4. Market Maker Models 5. Horizontal & Vertical Markets 6. Why We Like B2B 7. Market Makers Market Maker Beneficiaries 8. and Liquidity Market Maker Success 9. Key Industry Criteria Market Maker Success 10. Key Company Criteria B2B Market Maker 11. Valuation Framework B2B Market Maker 12. Investment Philosophy Company Profiles 13. B2B Market Maker Master List Page 2 5
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How large is the industry (gross sales, US and worldwide)? How much of it do you think will be transacted through a B2B market maker? Why? Many market makers just assume that 10%-40% of gross sales will go through market makers. In many cases, though especially in industries with low fragmentation there is little reason to use a market maker. Market makers must 1) solve specific, identifiable problems and 2) add value to both the buy and sell sides of the supply chain or industries will just ignore them. 2. How fragmented are the buy and supply sides of the industry? Industries with a high level of fragmentation on both the buy and sell sides are the best for market maker adoption, because the MM can add value simply as an aggregator. 3. How inefficient are procurement, sales, and distribution in the industry? The promise of the market place is, in part, to cut fat. So it helps if the industry is chubby to begin with. 4. What specific industry problem(s) can a third-party marketplace solve for both the buy and sell sides. The best MMs can identify specific buy and sell-side problems that they solve, as well as future problems that they expect to be able to solve. Remember: using a market maker requires a change in corporate behavior and changing corporate behavior is difficult, no matter how sensible the change seems. As a result, market makers that can ease painimmediately (provide obvious, identifiable, and quantifiable advantages) will likely see faster adoption than those that dont. 5. How much of a change in behavior does using your marketplace require on the part of suppliers and buyers? The less, the better unless you can convince the company to pay millions of dollars for software licenses and installation, in which case it will have to force change in behavior or risk losing its investment. 6. What are your transaction volumes today? How have they ramped? What is the strategy for generating industry-leading liquidity (transaction volume through the marketplace). The slickest, most highly functional marketplace in the world is worthless if buyers and sellers congregate to do business somewhere else. 7. What portion of your management team is from the industry you address? Do senior people have strong relationships at the most senior management levels of industry players? Even in the internet industry, people like to do business with people they know and like. This is especially true in the case of market makers, which initially might seem to be less friend than foe. 8. How do you intend to induce the participation of suppliers, particularly large ones? What has been the reaction, particularly among large suppliers, to your entrance into the industry? Have they agreed or at least indicated an intention to work with you? Are they considering it? Are they dead-set against it? Big suppliers are usually critical to gaining liquidity (who wants to shop at a market that doesnt carry most of the products?). They are also the least likely industry participants to need a third-party market maker, especially early on. Having clear strategies for signing them up, therefore, are critical to success. 9. Are there other B2B market makers addressing the industry? Are you ahead or behind them in terms of transactions and revenue as well as buyer and supplier relationships? Why? This will likely be a winner-takemost game. The aim is to identify the market leader as quickly as possible and put your eggs in its basket. 10. Do middlemen in the industry add significant value? If so, how do you plan to work with them? Have you partnered with the key distribution and logistics providers? You can buy and sell all day long, but when youre done transacting, you still have to ship the stuff. Depending on the industry, some middlemen will continue to add value in a market maker world, others wont. The best market makers will partner with middlemen that add value and, slowly but surely, take market share away from the ones that dont.
We dont quibble with Forrester Researchs U.S. forecast of $1.5 trillion ($1.3 trillion for goods and $200 billion for services) for B2B online trade. We also believe there are significant opportunities for market makers in international markets, particularly because many of the large industrial markets these companies typically address, like steel, automotive, telecommunications, and electronics, are global today. In 2003, we assume 38% of B2B electronic commerce revenue will be generated internationally. As a result, we believe worldwide electronic commerce revenue could total approximately $2.5 trillion by 2003. However, more important than this total sales figure is the likely mix between seller sites, like those of Cisco, Dell, Intel, Boeing, Grainger, Federal Express, etc., and the sites of online market makers the B2B investment opportunities upon which this report is focused. We believe that seller web sites will dominate the overall mix of B2B revenue (ie, to play this growth, investors must buy manufacturers such as Cisco directly or companies that sell ecommerce products and services to the manufacturers, such as Verisign, Scient, or iXL). However, we believe it is a reasonable assumption that third-party market makers could represent 15-20%, or $372-$496 billion of overall online B2B sales by 2003. In addition, we also assume advertisers spend $7-$10 billion with market makers at this point in time. Combined, we believe the total revenue attributable to online market makers by 2003 could range between $400 and $500 billion. (In our conservative case, which we consider less likely, we estimate that only 10% of B2B electronic commerce revenue, or approximately $250 billion, is transacted through market markers.)
Internet-based market makers, the latest incarnation of B2B e-commerce, come in different variations. The current market makers usually employ one or more of four basic models catalog, auction, exchange, and community which are outlined below. The critical component for success with all of these models is a clearly identifiable benefit for both buyers and sellers. Those that dont have this will have difficulty attracting the critical mass of buyers and sellers necessary to drive liquidity. Online Catalogs. Online catalogs are optimally suited for markets where the supply and demand sides of a market are highly fragmented. SciQuest and Chemdex in life sciences are examples of vertically focused players in this category. Ariba, CommerceOne, and PurchasePro in MRO (maintenance, repair, and operating supplies) are horizontally focused market makers. Essentially, these market makers take the paper-based catalogs of multiple vendors, digitize the product information and provide buyers with one-stop shopping over the Internet. However, the fact that, in most cases, these market makers embed themselves in
the business processes and IT systems of buyers and suppliers, reduce process and inventory costs, extend supplier reach, and improve customer access to suppliers makes their value much greater than just digitizing catalogs. Online market makers allow buyers to search for products more efficiently. Instead of flipping through a mountain of separate, often out-dated, supplier catalogs, buyers can utilize the powerful search capabilities of the Internet to compare products on many dimensions including price, availability, delivery dates, warranty, service information, etc. The prices of products on these sites are typically fixed. Online catalogs usually derive revenue from the combination of a percentage of gross transaction values, typically in the low single digits to the mid-teens, as well as product listing and advertising fees from suppliers. Auctions. Auctions provide a venue for the purchase and sale of unique items such as surplus inventory, used capital equipment, discontinued goods, perishable items, or refurbished products. Examples, among many, include FreeMarkets, a reverse auction for manufactured inputs, and TradeOut or AsseTrade, auctions for asset procurement and disposition and excess inventory. In addition, vertically focused companies like PaperExchange, which is predominantly (as its name suggests) a market maker in pulp and paper, also generate ancillary revenues from the auction of paper-related capital equipment. Auction pricing is dynamic. In a traditional auction, the competitive bidding process results in upward price movement. The reverse auction, a format in which sellers compete for a buyers offer to purchase, results in downward price movement. Revenue for online auctioneers is usually derived from the combination of transaction fees typically ranging from the high single digits to the low twenties as a percentage of gross merchandise value as well as product listing and supplier advertising fees. Exchanges. Exchanges provide a spot market for commodities often with high price volatility. They provide a venue for the purchase and sale of commodities like natural gas, electricity, and telecommunications bandwidth. Altra and Enermetrix in natural gas and electricity and Arbinet in telecommunications are all prominent examples. These markets are bid/ask and provide real-time pricing. Exchanges allow buyers and sellers to trade anonymously, which is key because identifying buyers and sellers can damage their competitive position and skew pricing. Although market share is important in every market maker category, we believe it is of paramount importance for exchanges. This is because market share means liquidity. Exchanges without significant liquidity are likely to fail due to the relatively small transaction fees they extract. However, exchanges that do attain leading market share should have extremely defensible competitive positions because offering the most liquidity will make trading on a competitive exchange less compelling. Exchange revenue typically comes from the combination of transaction fees as well as membership fees. Transaction fees usually range from a spread of a few basis points to percentage spreads in the low/mid single digits. Community Market Makers. Community market makers bring together potential buyers and sellers, in the form of professionals with common interests, through web sites that feature industry-specific content and community aspects. The content and community aspects these sites typically provide include industryspecific news, editorials, market information, job listings, chat, message boards, etc. As a result, these community market makers attract a targeted audience of potential buyers for suppliers. For the most part, community market makers generate revenue from advertising, sponsorship and membership fees as well as from fees paid by suppliers for lead generation. Although in most cases minimal transaction revenue is actually generated on these sites today, we believe this will change over time as these community market makers either add transaction-oriented market mechanisms onto their sites or generate revenue by driving traffic to the commerce sites of others. With over fifty sites ranging from pollutiononline.com to adhesivesandsealants.com, VerticalNet is the poster boy for community market makers.
In summary, today, many of the aforementioned market models are separate entities even within specific vertical industries. However, over time we would expect to see some convergence where, for instance, the catalog, auction and exchange pricing mechanisms for, say, the chemicals industry, take place on one site. Furthermore, as we are already seeing with VerticalNet, we would expect to see community-based market makers monetize eyeballs through revenue streams beyond advertising, sponsorship and lead generation fees. In other words, transaction-based revenue.
Fundamentally, we believe there are two business-to-business markets vertical markets and horizontal markets. Vertical markets are industry-specific. The inefficiencies addressed and the requirements required for success in each of these industries differ significantly. Horizontal market makers facilitate the purchase and sale of goods and services used by a plethora of industries. In the short history of Internet-based B2B e-commerce, hundreds of vertical market makers have already emerged in industries ranging from metals and livestock to printing and chemicals. Similarly, horizontal market makers have emerged that support the purchase and sale of goods and services such as those for maintenance, repair and operations (MRO), benefits administration, media buying and logistics. As business adoption of these new models matures, we expect a B2B quilt to be woven where horizontal market makers become interwoven with vertical ones. We expect market makers to capture a meaningful piece of overall B2B ecommerce. In our view, the overwhelming majority of the estimated $2.5 trillion in B2B e-commerce in 2003 will occur on seller sites, like those of Grainger, Intel, and FedEx. However, we believe that 15-20% of B2B electronic commerce will be transacted through third-party marketplaces, implying a revenue opportunity of approximately $400-$500 billion by 2003. User lock-in, operating system qualities, low capital intensity, and the network effect should lead to high barriers to entry and ROIC for the market leaders. Once leading B2B market makers achieve a critical mass of buyers and suppliers no easy accomplishment and one that few have achieved to date they should benefit from the network effect over time. In other words, leading B2B sites (or networks) should scale significantly as they attract buyers looking for a broad selection of products and suppliers seeking a large audience of potential buyers. This dynamic should allow market makers to enjoy exponential revenue growth once a critical mass of market participants and liquidity is achieved. At the same time, expenses should grow linearly, creating significant operating leverage. Although start-up costs are likely to be high, the pay-off for companies that gain control of their markets should be huge. In fact, we believe the initial start-up and customer acquisition costs can be viewed in the same way that CAPEX spending is viewed for companies building physical communications networks (ie, as an investment rather than operating cost). Because CAPEX spending is capitalized, the early P&L for the owner of a physical network will look better than one for a market maker, where the costs are expensed. Over the long-term, however, the market makers ongoing costs will be relatively fixed, whereas the physical networks costs will grow variably with each additional user, which will lead to much higher returns on invested capital for the successful market maker. Participant acquisition costs, which will start out extremely high, should decline over time and allow for margin expansion. For B2B market markers, the cost of attracting buyers and suppliers, in particular, will be extremely high in the early going. However, as the network effect takes hold and more participants migrate to a market maker, it should take less money and prodding to get suppliers to contribute their products to a growing source of demand and buyers to shop at a growing source of supply. Exponential revenue growth due to the network effect, coupled with declining participant acquisition costs should lead to margin expansion for leading market makers.
Critical mass will create high barriers to entry. Once a market maker gathers a critical mass of buyers and suppliers, embeds itself in the business processes and IT infrastructure of both, achieves market liquidity, and secures relationships with key distribution and logistics partners we believe it will be tough for another market maker to overtake the leader. Furthermore, leading vertical (industryspecific) market makers will align themselves with specialized distribution and logistics players to fulfill the orders taken on their site. We believe the B2B market makers that forge these important relationships will have a significant leg up toward securing highly defensible market positions. High switching costs for participants. Aligning with a particular market maker typically includes systems integration between the intermediary and buyers and suppliers as well as the market maker embedding itself in the business processes of both. In all likelihood, these factors will make switching to another network prohibitively expensive and disruptive. Recurring revenue. Once market makers embed themselves in the procurement processes of buyers, the sales and distribution processes of suppliers, and the systems of both they should become venues for highly recurring transactions and revenue.
We believe the benefits of online intermediaries are more evident for certain participants than for others. As we further explain below, we believe small suppliers benefit the most from online market makers, followed by small buyers and large buyers. We believe gaining the participation of large suppliers will prove the most challenging for market makers. Since, in our view, large suppliers are the single most important factor in providing liquidity, we consider their involvement the linchpin of a market makers success. Below we explain our thought process and rank marketplace participants according to what we believe is the relative value proposition offered to each by market makers. 1. Small Suppliers. We believe small supplier participation in online markets is pretty much a no-brainer. Small usually means limited resources which includes sales and distribution. Small suppliers usually have neither the brand name nor the scale to provide a sizable enough discount to induce large distributors or value-added resellers to push their goods and services. Online markets provide a low-cost distribution channel through which small suppliers can reach small customers formerly too far and expensive to reach and large buyers with whom they could never get an entre. Small Buyers. This is another online market maker participant we throw in the no-brainer category. Online market makers allow small buyers to automate and reduce the expenses related to the manual procurement process as well as reduce inventory and related carrying costs. Also, small buyers now get greatly expanded supplier access. Large Buyers. Large buyers buy in volume and, as a result, are highly sought after by suppliers of all sizes. A great deal of what large buyers purchase comes from large suppliers that can handle the service, quality, and pricing requirements to which big customers are entitled due to their buying power. In addition, commerce between large buyers and large suppliers is often already automated through EDI. Therefore, we dont believe the benefits of online market makers are as compelling for large buyers as they are for their smaller brethren. For the less progressive large buyers, market makers will add value through automation and reduce procurement processing and inventory carrying costs. For large buyers that have automated their procurement processes to a large degree, we believe that there are incremental process and inventory cost savings to be realized. Large Suppliers. We believe supplier affinity for online intermediaries will run inversely to their market share. In other words, the more market share a supplier controls, the more work it will take to get it to distribute through an online market maker for several reasons. For one, large suppliers are large, in part, because they already have broad customer reach and efficient sales
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and distribution channels. Secondly, as leaders in their industries, customers are already required to consider these suppliers when making a purchase. Third, due to their strong competitive position these suppliers will be reticent to serve as one of the big draws for a market maker that carries competitive offerings. As a result, large suppliers like Cisco and Intel are likely to continue to sell directly through their own sites. However, we believe large suppliers will end up participating in third-party hosted Internet markets for several reasons. First and foremost, customers will demand it. With global competition increasing, suppliers differentiate themselves now, more than ever, through customer service. As such, we believe that, long-term, suppliers will respond to buyer demands that they make their products and services available via online market makers. Also, once the most progressive large suppliers in an industry have come on board, laggard suppliers are likely to fall like dominos just to maintain market share. Furthermore, market makers present a channel through which smaller suppliers can nibble away at the market shares of larger players; we dont expect large suppliers to sit idle and watch this happen. Finally, we expect large suppliers will use online market makers to gain access to new customers and revenue streams altogether.
We believe there are key characteristics that will make certain industries more fertile ground for online market maker success. We paint some pretty broad strokes here and advise investors to assess specific industry characteristics thoroughly for each market maker opportunity. However, we believe developing some broad framework to assess the likelihood of market maker success, one that will be tweaked as we learn more about B2B, is required to even begin considering the merits of particular B2B investment opportunities. The key characteristics we would assess or be looking for follow. A large market. To oversimplify things, we would be looking for market makers that address very large vertical or horizontal markets. Online market makers are about reducing inefficiency. Even if a large market is relatively efficient, it is likely that, due to its size, inefficiencies within it can support a very significant internet business. The optimal market maker will be one that addresses a very large, inefficient market like paper, steel and plastics. However, be careful. While large, inefficient markets might have the most fat to take out and, therefore, the most profit potential for a market maker long-term, the fact that they have remained inefficient for so long likely indicates that they are extremely resistant to change. As a result, some of the best market maker opportunities might take longest to come to fruition. Buyer and seller fragmentation. Theoretically, the more fragmentation, the better. As we mentioned earlier, we believe small suppliers and small buyers benefit the most from online market makers. Therefore, in our view, an industry full of little guys would be ideally suited for a market maker. However, we also believe gaining liquidity in such a market, the key to a market makers success, may take some time because it will require bringing a large number of entities online. We think industries where most of the commerce is conducted between large buyers and large suppliers might be slowest to adopt market makers. However, we also believe that once a couple of large industry leaders contribute supply that others will have to follow suit. Therefore, once the ball starts rolling, we expect liquidity to follow. Fat. We view fat as the non-value-added links in the value chain. Investors need to be careful here. We would be wary of the prospects of market makers that lead with purely a disintermediation strategy. While there are middlemen in many value chains that add minimal value beyond matching buyers and sellers (brokers in the paper and plastics industries come to mind), many middlemen, such as value-added resellers and many distributors, are important and irreplaceable links in the value chain. Market makers that focus on automating processes that are currently manual so employees can focus more on the value added functions they
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perform will probably find themselves in a solid industry position. Those that trumpet a goal of taking food off somebodys table are likely to feel powerful industry forces come to bear on them. High IT adoption. Generally speaking, we believe industries that have widely adopted information technology will be more receptive to online market makers than those that have not. First of all, we believe the fact that the technology infrastructure is already in place for companies within these industries makes utilization of online market makers an easy transition technology-wise. Second, and probably more importantly, we believe IT adoption serves as a rough proxy for an industrys attitude toward change particularly change that increases efficiency, which is exactly what market makers are about.
Management with domain expertise. Successful B2B market makers must have management with the industry knowledge, senior level industry relationships, and credibility to address industry concerns, particularly among suppliers, and articulate the benefits of migrating to this new market maker paradigm in order to gain industry buy in. (Near flawless) early mover advantage. Market makers that move first without major mistakes are likely to build the critical mass of buyers and suppliers that will make them the default online location for conducting trade in their particular industry. However, more important than moving early, is executing well once youre moving. One high-profile incident of a market maker site going down or a major steel or chemical customers production line grinding to a halt because a market maker facilitated a delivery that was late or off-spec is likely to prompt a chorus of I told you sos from industry. Strong partnerships for distribution and logistics. Unlike books, CDs, and stereos, UPS doesnt transport lumber, resin, or hydrochloric acid. This takes specialized distribution and logistics players. In many industries, leading market makers will need to forge relationships with the key distribution and logistics providers in their industry. Neutrality and liquidity. Market makers need to ensure that all market participants are playing by the same set of rules and being treated equitably in the marketplace. However, we do believe there are ways (ie, performance-based warrants or small equity stakes for large suppliers) for market makers to jump start liquidity while remaining neutral enough to enlist broad participation. To participate in the huge potential upside of a B2B investment, investors cant wait for liquidity to be achieved in order to invest the horse will be way out of the barn by then. So investors need to look for the characteristics that are likely to lead to liquidity management with industry knowledge and expertise, earlymover advantage, a critical mass of potential buyers to attract suppliers, a handful of supplier relationships, key distribution and logistics relationships, and relative neutrality. Public currency. This is not to fan the flames of what may be characterized as a scorching B2B IPO market, but assuming that a market maker is confident that it can execute against the key metrics investors are looking for, we contend that going public is a major competitive advantage. Aside from the fact that the cost of capital may never be cheaper, the IPO significantly increases the visibility of these companies vs. their private competition and also provides them with highly valued currency to quickly grow their businesses through acquisition.
At this early stage, sizing the B2B market and the shareholder value it might create is tough. Frankly, over the next couple of years, valuations are likely to be driven as much by the grandiose promises of B2B, a scarcity of investment choices, strong sequential revenue growth (on diminutive numbers), press, hype, sentiment etc. as by the potential long-term fundamentals of market makers. If history has taught us one thing, it is that many investors are insensitive to valuation when the fundamentals for Internet companies are improving. Given that the sector is so nascent, we expect to see improving fundamentals and increasing
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market caps for B2B companies for the foreseeable future. Nonetheless, we believe it is necessary to set up a framework to at least put valuation in some fundamental perspective. Based on our methodology, we believe it is likely that B2B market makers could generate total market capitalization between $800 billion and $1.5 trillion by 2003. We estimate the present value of this total market capitalization to be between approximately $340 billion and $620 billion. (Note: Currently, there are only a handful of publicly traded market markers. Therefore, most of the potential market capitalization to be created resides in private companies. As a result, we believe that the extraordinary valuations of some public market makers reflect more than their long-term fundamentals namely, the general excitement surrounding this seemingly huge opportunity and the scarcity of public ways to play it.) Our methodology is fairly straightforward. We estimate 1) the total market for B2B electronic commerce, 2) the percentage of revenue to be captured by market makers, 3) market maker profit margins, 4) a multiple to apply to the implied market maker earnings, and 5) an acceptable discount rate (35%). As mentioned, we believe worldwide electronic commerce revenue could total approximately $2.5 trillion by 2003. Clearly, in order for third-party market makers to create meaningful market capitalization they will have to pick up a greater share of this growing market. The fact that the Ciscos, Intels and FedExs of the world are dominant suppliers in their respective industries has made gaining relatively quick revenue traction over the web easier for them than it has been for market makers. This makes sense to us because market makers need to enlist supplier and buyer participation, which takes time, before generating a meaningful volume of transactions. Furthermore, established companies with seller-centric sites have a number of characteristics that make generating web-based business relatively easy almost immediately their own supply or relationships with major suppliers and existing customers as well as a brand name and marketing resources to attract new customers. In addition, these companies already have relationships with the key distribution and logistics players necessary for fulfilling orders. In other words, these businesses are quick out of the box in regard to generating online sales, while market makers take longer to ramp. Over the coming years, we expect that many market makers will add meaningful numbers of buyers and suppliers and establish the key distribution and logistics relationships. We believe that seller web sites will dominate the overall mix. However, we believe it is a reasonable assumption that third-party market makers could represent 10-20%, or $248-$496 billion of overall online B2B sales by 2003. In addition, we also assume advertisers spend $5-$10 billion with market makers at this point in time. Combined we believe the total commerce passing through online market makers by 2003 could range between approximately $250$500 billion. We believe something in the $400-$500 billion range is likely. Based on the higher end of our 2003 revenue range, we believe market makers could create approximately $800 billion-$1.5 trillion in market capitalization by 2003. Below, we lay out three scenarios.
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$2,481
$2,481
$2,481
90% 10%
$248 $5 $253 237% 63% 38% 3% $8 50x 1.5x $380 $154
85% 15%
$372 $7 $380 259% 63% 38% 4% $15 55x 2.2x $835 $339
80% 20%
$496 $10 $506 275% 63% 38% 5% $25 60x 3.0x $1,518 $617
Source: Merrill Lynch Internet Research; Forrester Research; Veronis Suhler & Associates
The valuation methodology outlined above is a framework to bring some perspective to where valuations might normalize several years out. Obviously, tweaking any of the inputs overall B2B market size, the percentage of this market captured by third-party market makers, margins or multiples causes the potential market cap created by the B2B opportunity to swing wildly. In addition, over the near-term (probably the next couple of years, rather than months), the revenue multiples applied to leading B2B companies are likely to remain in substantial excess of what we use for our valuation framework. Despite strong near-term growth, for the foreseeable future almost all B2B market makers are likely to continue to appear small relative to the huge market opportunities they typically address. We expect investors to ascribe extremely high price-to-sales multiples to companies for which potential market opportunities look far from saturation, upside to revenue estimates remain likely, the waning of hyper-growth any time soon seems remote, and execution is strong.
Investment Philosophy
As evidenced by the spectacular public market debuts of B2B companies like Internet Capital Group, FreeMarkets, Ariba, CommerceOne, Purchase Pro, Chemdex, SciQuest, RoweCom, and VerticalNet, among others, there is significant investor demand for public B2B investments. Given the size of the opportunity, this is not surprising. However, despite the multi-billion dollar market caps most public B2B companies enjoy, they are all at early stages of development. In many ways, public investors are taking on roles once reserved for venture capitalists. Whether this role should ever be left to public market investors is open to debate, but, in our minds, that debate is academic. We believe B2B will create tremendous value for public market investors. We believe potential investors should be cognizant of some key points when considering B2B investing. B2B market makers will likely have a profound effect on many economic sectors, particularly industrial ones. The steel, paper and plastics industries have been doing business in essentially the same, often inefficient, manner for many years. B2B market makers, with no legacy business or relationships to protect, seek to make businesses out of capturing profit that many large companies for many different reasons, including potential channel conflict, fixed asset investment, delicate partner relationships, vertical integration, a general failure to embrace electronic commerce, or complacency, have foregone. The established,
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often stagnant industrial ecosystems into which these new B2B market maker organisms look to insert themselves are typically huge often hundreds of billions of dollars. Capturing just a small portion of the value transacted within these industries is likely to create what could be valuable B2B Internet investments. Investors are paying up for the promise of B2B. Currently, the public valuations of most B2B companies, as well as the private valuations of many others, look very expensive. Almost every public B2B company sports a market cap of over $1 billion. Most have multi-billion dollar market caps. In addition, it is not uncommon to see premiere private companies with hundreds of millions of dollars of private valuation. Undoubtedly, valuations are driven, in large part, by the fact that many B2B companies address huge opportunities and will become valuable long-term based on fundamentals. However, we believe that the valuations of public B2B stocks and ones likely to come public over the next year are also driven, to varying degrees, by what seems to be indiscriminate investor demand for anything B2B. This can be attributed to numerous factors, including the B2B hype created by Wall Street, venture capitalists, and the media and the fact that many investors are determined to catch, in B2B, the Internet run they may have missed in B2C. Assuming markets remain robust, we expect to see a plethora of B2B market makers come to the public market some great, some okay, some poor. As supply and demand move closer to equilibrium, it is important for investors to understand the quality of what they might own and realize that, over time, there could be as much as 100% downside for lowquality B2B equities. The net result of so many B2B companies coming public is likely to be that there will be many more losers than winners. Generally speaking, successful market makers will create liquidity in the markets they address by enlisting participation from a critical mass of buyers and suppliers. For vertical market makers particularly, it is likely that the No. 1 player in medical equipment, chemicals, or livestock, etc. will dwarf No. 2 in terms of value. Why? Market leaders will enjoy the benefits of the network effect. In other words, suppliers will align themselves with market makers that provide them access to the most buyers and buyers are likely to make purchases through market markers that present them with the largest choice of products and suppliers. As a result, within a specific market, a dominant share of electronic commerce is likely to be transacted through the leading site and allow the No. 1 player to enjoy the leverage associated with significant scale as well as strong returns on invested capital. However, in these winner take most (if not all) markets, it is questionable whether the next tier of players will scale to a size that provides them the leverage to reach profitability. Obviously, we believe investing in No. 1 is optimal, investing in No. 2 could result in good returns but is more risky, and investing in No. 3, No. 4, and No. 5 is likely to be a bad use of capital. Winners are likely to create significant value. The downside for losers could be close to 100%. Therefore, if you have a loser, we would recommend that you cut bait immediately. If you have a winner, dont let valuation scare you into selling. Historically, good internet stocks have looked expensive from the beginning and looked more expensive over time. Bad internet investments have done one of two things they have either started expensive and gotten cheaper or started cheap and gotten cheaper. In our experience, the only time investors focus on the valuation of an internet stock is when fundamentals are deteriorating. Given that B2B is in its infancy, we would not expect to see sector-wide fundamental deterioration for quite some time. However, if fundamentals should truly deteriorating for a particular B2B company, we believe the stock should be sold. However, if fundamentals are improving and upside to estimates is expected to continue, the stock is likely to continue to rise over the long-term.
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We dont expect investors to sell their best internet stocks because they suddenly look expensive (they always look expensive). On the flip side, we would not advise investors to rush to buy what seem to be cheap B2B internet stocks. They are almost always cheap for fundamental reasons. Investor suitability. So market opportunities are large, the companies addressing these opportunities are early-stage, winners are likely to create extraordinary returns, losers could prove to be close to worthless, and picking winners and losers is tough. Isnt this type of investing suitable only for venture capitalists? No, diversified growth investors, sector investors, and speculative investors all need a strategy for B2B whether offensive or defensive, direct or indirect. In a vacuum, almost every B2B market maker is a speculative, high-risk and early-stage investment. B2B investing is arguably the closest thing to venture capital in todays public markets, so, obviously, these investments are not suitable for the risk averse. However, many other investor types of varying risk profiles need to develop a strategy for the sector. Investors that choose to have exposure to the space need to take different approaches. Diversified growth investors. We have always maintained that diversified growth investors allocate a small percentage of capital (ie, 10%) to pure play internet investments. We would suggest that these same investors earmark a percentage of this overall internet allocation to a basket of B2B market maker stocks. Most B2B market makers address huge markets and have great promise, but they also still have much to prove. A basket approach gives investors the best chance to realize excellent returns by having a couple of success stories in a portfolio of investments in which the majority are losers. In addition, we believe diversified growth investors have limited chances of outperforming applicable investment benchmarks, which are likely to have an increasing B2B component embedded in them over time, without B2B exposure. Sector investors. It is hard to tell if market makers will actually create new value or take it from established industry players. They will probably do a bit of both. In the best case, market makers would create value for themselves and others by providing leading industry veterans with new customers and incremental revenue streams, lower cost distribution channels, expanded customer reach, and improved productivity. Either as a way to capture newly created value or as a hedge against value lost by established businesses, we believe portfolio managers with assets in many industries need exposure to these new market maker investments. Speculative investors. As mentioned, B2B market makers investments are high risk/high reward. Under the assumptions that they have more risk capital at their disposal and are emotionally conditioned to endure more risk than most, we believe speculative investors can seek outsized returns by allocating more capital to B2B investments over the near-term. For maximum near-term appreciation, we would seek out companies likely to deliver extraordinary sequential revenue unit growth over the next several quarters.
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Supplier A
Supplier D
Supplier B
Buyer
Supplier E
Supplier C
Source: Merrill Lynch Internet Research
Supplier F
Many companies have employed B2B electronic commerce for years. Federal Express
Beyond EDI, many companies have been utilizing the Internet to increase revenue, reduce and avoid expenses, and improve customer service for several years. We highlight some examples of the successful use of the Internet in B2B electronic commerce. Not surprisingly, the companies we highlight are at or near the top of their industries. Federal Express evolution onto the Internet dates back to 1982 when FedEx put terminals on the shipping docks of its major customers. From these terminals, shipping clerks could place pick-up orders directly into FedExs systems, automating paperwork and allowing for the electronic tracking of shipment status. The evolution continued in 1995 when FedEx extended this functionality to personal computers that accessed FedExs systems over modems. This moved customer access beyond the shipping dock and into individual departments. Customers could now track the status of orders, helping them better manage production schedules and, as a result, customer expectations. In 1996, Federal Express moved onto the Internet. Using fedex.com customers can request pickup, find drop-off points, and track deliveries, among other things. FedEx estimates it would have to hire over 20,000 additional couriers, customer service reps and data-entry clerks to handle the tasks that customers now handle themselves. Clearly, forgoing these hires allowed FedEx to avoid significant personnel costs. Furthermore, FedEx estimates that customers track millions of packages per month on its web site. FedEx estimates that over half of these Internet-tracked packages would have generated customer service handled calls. Its really a double-dip for FedEx. Customers are doing work that allows FedEx to avoid and reduce costs and focus on more strategic and revenue-generating activities. Meanwhile, customers are more satisfied performing these tasks themselves anyway.
Cisco
As the leader in networking gear and the major provider of the Internets plumbing, Cisco is certainly eating its own cooking. Beyond serving as an incredibly lucrative sales channel, the Internet also enhances Ciscos ability to optimize customer service and reduce expenses. In 1991, Cisco began offering software downloads, defect tracking and technical assistance over the Internet. With the deployment of Ciscos web site, which commenced in mid-1995, Cisco brought greater efficiency to and improved customer satisfaction with the ordering process. Ordering networking gear is complicated. It is typically configured-toorder by engineers of Ciscos customers. Pre-Internet, these engineers used to
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communicate these complex orders via fax, phone or mail. If mistakes were made in placing or receiving an order, the procurement process would begin again from scratch with the frustrated customer re-configuring the order. Before Cisco deployed its web site, approximately one out of four orders needed to be re-initiated. Obviously, in such cases, the time and money of both Cisco and its customer were wasted and customer satisfaction was presumably damaged. Via online ordering, engineers now configure products online, get immediate feedback as to errors, fix those errors and route the order to procurement. Customer pricing is maintained on Ciscos web site. Therefore, a customers authorized purchaser can easily complete the order. Similar to FedEx, Cisco allows customers to check the status of their orders on its web site. Cisco receives hundreds of thousands of inquires per month. Ciscos primary freight forwarders update Ciscos database, typically via EDI, so Ciscos customers can get current updates on the status of an order. Cisco sells approximately $30 million+ in products over the Internet every day. Thats approximately $12 billion annually. Over 70% of Ciscos customer service requests are handled on the companys web site. Cisco estimates it is saving at least $500 million in operating costs through its Internet-based initiatives. Cisco is a great example of the benefits that B2B e-commerce can bring to a company increased revenue, improved productivity, reduced expenses and improved customer satisfaction.
Dell
Dell is the #1 personal computer company in the world. Dells build-to-order, direct sales model has allowed the company to reduce inventory carrying costs and avoid the mark-ups of value-added resellers, distributors and resellers. As a result, Dell estimates it has a 10-15% price advantage over its major competitors. In short, Dells model has made it the fastest growing major PC provider in the world and revolutionized the industry. Consistent with its leading edge strategy, Dell was quick to embrace the virtues of the Internet and electronic commerce. While the vast majority of Dells sales are to large corporations, its Internet sales are much more weighted toward small businesses and consumers. Therefore, Dells Internet strategy goes beyond B2B and has allowed the company to expand its presence in the consumer market. However, since small businesses are buying over the Internet and large businesses are accessing the website for product information, technical assistance and order status updates as well as increasingly to buy product, we still consider Dells Internet strategy largely B2B. Similar to Cisco, Dell currently generates $35 million in Internet sales per day thats over $12 billion annually, and growing. In the most recent quarter, Internet sales accounted for over 43% of Dells overall revenue. Dell expects over half of its sales to occur online in the next year or so. The Internet allows Dell to reach brand new customers. Beyond increased sales, Dells web site is extremely valuable in terms of reducing service and support costs. Calls for order status updates and software downloads cost Dell $3-$5 each. Phone inquiries for troubleshooting tips run approximately $15. In aggregate, all of these calls run in the hundreds of thousands of dollars. Moving even a small percentage to the Web enhances Dells bottom line. Given the amount of business running through its website, B2B electronic commerce isnt new to Dell.
GE
GE implemented numerous strategies, including use of the Internet, to improve the purchasing process. GE lighting piloted an online procurement solution developed by GE Information Systems in 1996. Using the system, employees from GE Lighting send requisitions to sourcing electronically. The system pulls down the appropriate diagrams and attaches them to the electronic requisition forms. Suppliers are alerted to an incoming RFQ (Request for Quote) within two hours of when the process is initiated. Bids can be awarded within the same day. Putting together a requisition, which used to require retrieving diagrams from a vault, photocopying them and attaching them to a paper requisition form, took at least seven days. As mentioned, the process can now be completed within one day. As a result, sixty percent of the procurement staff has been redeployed and the sourcing department has at least 6-8 additional days per month to focus on
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strategic activities instead of manual processes. Labor costs in procurement have been cut 30%. Due to the fact that sourcing can reach a much larger group of suppliers, material costs have been reduced 5%-20%. The process of identifying suppliers, preparing a request for bid, negotiating price and awarding a contract has been cut from 18-23 days to 9-11. Over the course of 2000, GE expects all of its business units will be purchasing MRO products via the Internet totaling $5 billion. GE thinks it will be able to save $500-$700 million at this time. Clearly, the Internet is playing an important role in improving margins. These are just a handful of examples of companies utilizing the Internet to improve business. Intel in microprocessors, Grainger in MRO and Boeing in aerospace and defense are other industry stalwarts considered leading edge in the adoption of Internet-based business-to-business electronic commerce. This small sample and a continually growing list of companies using the Internet to significantly enhance their businesses indicate that B2B is neither new nor a tough concept to sell.
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$1,600
$1,400
$1,200
$1,000 Billions
$800
$600
$400
$200
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$2,500
$2,000
However, what we view as more important than this total sales figure, is its likely mix between seller sites, like those of Cisco, Dell, Intel, Boeing, Grainger, Federal Express, etc., and the sites of online market makers the B2B investment opportunities upon which this report is focused. We believe that seller web sites will dominate the overall mix. However, we believe it is a reasonable assumption that third-party market makers could represent 15-20%, or $372-$496 billion of overall online B2B sales by 2003. In addition, we also assume advertisers spend $7-$10 billion with market makers at this point in time. Combined we believe the total revenue attributable to online market makers by 2003 could range between approximately $400-$500 billion. (In our conservative case, which we consider less likely, we estimate that only 10% of B2B electronic commerce revenue, or approximately $250 billion, is transacted through market markers.)
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Chart 5: B2B Electronic Commerce Seller Site Sales vs. Market Maker Sales
Conservative Case Middle Case Bullish Case
$2,481
$2,481
$2,481
90% 10%
$248 $5 $253 237% 63% 38%
85% 15%
$372 $7 $380 259% 63% 38%
80% 20%
$496 $10 $506 275% 63% 38%
Source: Merrill Lynch Internet Research; Forrester Research; Veronis Suhler & Associates
Essentially, two constituencies will drive the adoption of B2B e-commerce buyers and suppliers. For the buyers, B2B e-commerce will drive savings through lower process costs, reduced inventory carrying costs, improved purchasing policy compliance, and better prices. Furthermore, it will allow buyers to source based on important parameters beyond price including availability, delivery, quality, and service, among others. For suppliers, B2B e-commerce will provide a cheaper channel through which suppliers can sell to existing customers or reach new customers altogether. It will also enable suppliers to reduce their process costs. Adoption on both the supply side and the demand side, which we believe is critical to e-commerce fulfilling its potential, will allow for much more efficient supply and demand chains. Middlemen that add value will use the Internet to automate processes that are currently manual, middlemen that add no value beyond hooking up buyers and sellers better watch out. Below we explain further what we believe to be some of the major values of B2B e-commerce for both buyers and sellers. n Buyer Benefits Reduced procurement process costs. The National Association of Purchasing Managers estimates that the average manual purchase order costs a company $79 to process, $38 of which is related to internal processing. Searching for products through the separate paper-based, outdated catalogs of suppliers, corresponding with these suppliers to clarify product and service specifications, availability, delivery, price, etc. and routing requisitions through the approval process manually is all terribly inefficient. The efficiencies of B2B e-commerce not only reduce costs related to the procurement process but also allow personnel to spend more time on value-added, strategic work. Reduced inventory costs. A slow procurement process coupled with an inefficient supply chain leads to long lead times and bloated inventory. e-commerce helps buyers reduce inventory costs by improving the order process and increasing the speed at which suppliers can fulfill orders. Reduced rogue purchases. Aberdeen Group estimates that 40-45% of corporate purchases of manufactured goods are made from suppliers other than those on a companys preferred vendor list. As a result, businesses are paying much more for goods and services than needs be the case. B2B e-commerce automates the procurement process and helps keep employees within corporate purchasing guidelines. More choices and better pricing. Oftentimes, there are many suppliers from which a customer could be buying goods. However, whether due to a suppliers or its distributors limited geographic coverage or the time and expense related to investigating all possible options, a customer is limited to certain suppliers and distributors. These suppliers and distributors are not always optimal as it regards numerous key sourcing parameters, including quality, service, availability, delivery and price.
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The B2B Market Maker Book 3 February 2000 n Supplier Benefits Suppliers reduce the costs associated with sales. The Internet is a cheap, efficient and ubiquitous sales channel, not to mention that it works 24 X 7 without breaks, sick days, vacations or complaints. The nature of some customers and products will always require sales and distribution through traditional channels. However, there are many products sold and customers reached through existing channels because no better alternatives exist. The inefficiencies of these less-than-optimal channels typically reveal themselves in inflated costs and margin pressure. The Internet provides suppliers with a new alternative for selling products and services that dont necessarily require the high touch and related expenses of traditional channels. Suppliers reach new customers thereby generating new revenue streams altogether. In many markets, demand is extremely fragmented. Traditional sales and distribution channels are not limitless, so there are potential buyers that suppliers never reach. B2B market makers provide a venue in which vendors can peddle their wares to a brand new audience of potential customers. Suppliers reduce the process costs of order management. Due to the fact that suppliers and buyers often communicate by phone, fax and mail, the exchange of information is not only slower than if executed electronically but also more prone to error, which results in costly rework. By automating the exchange of information, B2B e-commerce helps suppliers reduce errors, speed up the orderto-cash cycle, focus employees on value-added functions, and improve customer satisfaction to boot. Obviously, buyers and suppliers dont operate in a vacuum. In other words, to a large degree, a buyers efficiency is limited by the efficiency of its suppliers and vice versa. Clearly, B2B e-commerce allows businesses to utilize the Internet to automate the workflow of many different processes including manufacturing, finance, sales, and purchasing. The Internet can also be used to increase information flow within an enterprise and outside of it creating a virtual enterprise that spans the entire value chain, which includes customers, suppliers, distributors, etc. All in all, the Internet provides businesses with the ability to increase operational efficiency by reducing the time, costs and resources required to transact business, lowering inventory levels and procurement costs, and improving responsiveness to customers and suppliers.
We believe the adoption of B2B e-commerce is still in its very early stages. In our view, a major shift to Internet-based commerce among businesses is inevitable and not too far off. However, not all industries will move to this new paradigm as quickly as others will. With technology blue chips such as Cisco, Intel and Dell, among others, already doing a tremendous amount of business on the Web, the hitech industry has quickly embraced commerce over the Internet. This is not surprising given that change and innovation is so deeply ingrained in the hi-tech culture, not to mention that these companies provided the Internets plumbing. In addition, industries like hi-tech, where product lifecycles are short and the risks of carrying inventory are high, are likely to migrate to B2B e-commerce fairly quickly. In addition to industries with short product cycles, we expect companies with high waste from inventory (suitable for auction markets), high distribution costs (online catalogs provide a low-cost distribution channel) and commoditypriced products (suited for exchange-oriented market makers) will embrace B2B e-commerce over the next several years. Aerospace and defense, automotive and electricity are among industries likely to come on board sooner than later. Like in any other paradigm shift, the best companies will move quickly and boldly to make an opportunity out of an inevitable change. Less progressive companies will move more slowly and with dire consequences.
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Telecom $1,600 $1,400 $1,200 $1,000 Billions $800 $600 $400 $200 $0 1999E Business Travel Admin & Support Professional Financial Industrial equipment Heavy industries Construction Aerospace & defense Pharmaceutical & medical Consumer goods Food & agriculture Shipping & warehousing Paper & office products Utilities Petrochemicals Motor vehicles Computing & electronics 2000E 2001E 2002E 2003E
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Pricing
Buyer Benefits
Seller Benefits
Revenue Sources
Percentage of gross
Ad revenue from suppliers transaction value (typically a Revenue sharing with few basis points to low single suppliers and other market digit percentages) makers for commerce and lead generation Membership fees Sponsorship Membership fees
Online Catalogs Online catalogs are ideal for fixed-price products and services and fragmented markets
Since their principal function is to aggregate supply from a mass of suppliers and demand from a mass of buyers, online catalogs, for lack of a better word, are optimally suited for markets where the supply and demand sides of a market are highly fragmented. SciQuest and Chemdex in life sciences are examples of vertically focused players in this category. Ariba, CommerceOne, and PurchasePro in MRO are horizontally focused market makers. Essentially, these market makers take the paper-based catalogs of multiple vendors, digitize the product information and provide buyers with one-stop shopping over the Internet. However, the fact that, in most cases, these market makers embed themselves in the business processes and IT systems of buyers and suppliers, lower process and inventory costs, extend supplier reach, and improve customer access to suppliers makes their value much greater than just digitizing catalogs. Online market makers allow buyers to search for products more efficiently. Instead of flipping through a mountain of separate, often out-dated, supplier catalogs, buyers can utilize the powerful search capabilities of the Internet to compare products on many dimensions including price, availability, delivery dates, warranty, service information, etc.
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The prices of products on these sites are typically fixed. However, these market makers need to be capable of customizing the buyers view of the site so that it is consistent with specific buyer-supplier contracted pricing arrangements where necessary. Inability to support different pricing arrangements will make the participation of many large buyers and suppliers highly unlikely. Online catalogs usually derive revenue from the combination of a percentage of gross transaction values, typically in the low single digits to the mid-teens, as well as product listing and advertising fees from suppliers. n Buyer Benefits
Lower process and inventory costs and strategic sourcing are major benefits for buyers
Lower procurement process costs and better allocation of human resources are the principal benefits to buyers. While the potential for buyers to source from lowercost suppliers is important, we do not believe it is chief among the benefits online catalogs provide for buyers. We consider improving the procurement process, reducing inventory costs, and providing buyers with the ability to strategically source based on many parameters aside from price much more important. For many organizations, procurement is extremely inefficient. Time is money and this means that corporations are paying employees a great deal of money to flip through catalogs in order to get information about suppliers and their products. Since the information in these catalogs is not real-time, buyers typically need to phone suppliers to get current information about pricing, availability, delivery and service, among other important information. Furthermore, the data entry and manual paperwork inherent in the procurement process often results in human error and subsequent rework. Improving the process helps buyers speed up the time it takes to order and receive goods, allowing them to reduce the amount of inventory they must carry. In general, online catalogs enable purchasing professionals to spend more time on value-added, strategic work than current manual processes allow. Finally, the Internet shrinks the world providing buyers with access to suppliers that otherwise never would have been possible. n Seller Benefits
New revenue streams, lower costs, and improved customer satisfaction are major benefits for sellers
Brand new revenue streams, lower-cost sales, marketing and distribution, better order management, and improved customer satisfaction are key benefits for sellers. Due to the costs associated with selling, marketing, and distributing a product there is often demand too expensive for a supplier to fulfill. Furthermore, there is often demand that suppliers dont even know about. Online catalogs allow suppliers to utilize the ubiquity of the Internet to reach these customers at a lower cost than traditional channels allow. Furthermore, automating manual processes such as order management also improves efficiency and reduces process costs. The fact that automation allows suppliers to receive and fulfill orders more accurately and quickly also improves customer satisfaction and inventory turns. The self-service nature of online catalogs enables customers to get answers to inquiries that would usually require human intervention, enabling suppliers to reallocate human resources to more strategic, value-added functions. For example, with the time of sales people freed from providing product information easily accessed by customers over the Internet, they can spend less time managing accounts and more time chasing new business.
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prices are typically fixed, auction pricing is dynamic. Auctions usually last for a pre-determined period of time. In a traditional auction, sellers post an offer to sell and buyers bid. The competitive bidding process results in upward price movement and, for this reason, we believe the lions share of the benefits of traditional auctions accrue to sellers. However, the reverse auction, a format in which sellers compete for a buyers offer to purchase, results in downward price movement. In these auctions, we consider buyers the major beneficiaries. Revenue for online auctioneers is usually derived from the combination of transaction fees ranging from the high single digits to the low twenties as a percentage of gross merchandise value as well as product listing and supplier advertising fees. n Buyer Benefits
Buyers get access to many more products and services than in physical auctions
Buyers get easier access to much more product at somewhat bigger discounts than through physical auctions. The sale of surplus inventory, used capital equipment and the like is extremely inefficient today. Currently, it is typical for a business to unload these types of goods to liquidation brokers at steep discounts who then sell them at auction or resell them to sources of demand only they know about. The number of items for auction is limited to what the broker tracks down and purchases. Conceivably, virtual auctions are able to offer much more for sale. With the middlemans mark-up removed, buyers can purchase goods at steeper discounts than in real-world physical auctions. However, due the Internets reach we would expect virtual auctions to attract more potential buyers. As a result, it is likely that buyer savings related to the removal of middlemen will be offset to some degree by the upward price movement caused by larger bidding populations. Obviously, reverse auctions via the Internet allow buyers to benefit from more competitive pricing because they receive offers to sell from a wider range of suppliers. n Seller Benefits
As mentioned, we believe sellers benefit more than buyers when it comes to traditional auctions conducted over the Internet. There are primarily two reasons: 1) the reach of the Internet allows the auction to aggregate a critical mass of buyers and, as such, drive more competitive bidding and higher winning bids and 2) online auctions allow sellers (suppliers) to take liquidation brokers, who typically demand fire-sale prices to buy product, out of the process. Not only does the nature of traditional auction pricing favor sellers but the auction market has many other characteristics beneficial to suppliers. Suppliers can use auctions to test pricing on new products, manage inventory levels, promote products, take old products out of the market to make way for new product releases and, of course, liquidate excess inventory, capital equipment, and other items. While we believe buyers are the primary beneficiaries of reverse auctions, suppliers do benefit because they get the opportunity to sell to buyers they may never have reached without the Internet.
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defensible competitive positions because offering the most liquidity will make trading on a competitive exchange less than compelling. In addition to providing a venue for immediate buying and selling of commodities, exchanges provide a pricing reference for industry players. The primary inefficiency addressed by exchanges is the use of brokers. Almost by definition, commodities are clearly defined and well understood by all market participants. Brokers add little value beyond matching buyers and sellers a service for which they extract a transaction fee. Online exchanges at least minimize and, arguably, eliminate the need for brokers in many industries. Exchange revenue typically comes from the combination of transaction fees as well as membership fees. Transaction fees usually range from a spread of a few basis points to percentage spreads in the low/mid single digits. n Buyer/Seller Benefits
Assuming the market is liquid, buyers and sellers benefit equally in exchanges. Initially, we expect exchanges to attract industry players producers, end-users and members of the extended value chain of a particular industry. These players are likely to purchase in spot markets based on near-term needs and sell to unload excess capacity at market prices. In addition, we would expect futures and derivatives markets to emerge so industry players can hedge risks. Finally, we would expect financial traders and speculators to emerge that are likely to drive trading volumes factors larger than the volumes produced by industry participants.
Community Market Makers Community market makers will migrate toward transactions
Community market makers bring together potential buyers and sellers, in the form of professionals with common interests, through web sites that feature industryspecific content and community aspects. The content and community aspects these sites typically provide include industry-specific news, editorials, market information, job listings, chat, message boards, etc. As a result, these community market makers attract a targeted audience of potential buyers for suppliers. For the most part, community market makers generate revenue from advertising, sponsorship and membership fees as well as from fees paid by suppliers for lead generation. Although in most cases minimal transaction revenue is actually generated on these sites today, we believe this will change over time as these community market makers either tack transaction-oriented market mechanisms onto their sites or generate revenue by driving traffic to the commerce sites of others. With over fifty sites ranging from pollutiononline.com to adhesivesandsealants.com, VerticalNet is the poster boy for community market makers. With its recent acquisition of NECX, a market maker in the multi-billion dollar electronics industry, VerticalNet has accelerated its migration to more commerce-oriented revenue. n Buyer Benefits
The industry focus of these community web sites gives professionals, who, hopefully for their employers sake, dont have time to aimlessly surf the web all day, a destination with content and community aspects of high relevancy to their professions. Within these communities, professionals, a great number of whom are potential buyers, can access editorial content, chat with colleagues and reach suppliers, among other things.
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n Seller Benefits
Suppliers benefit from community market makers by gaining access to a highly targeted audience of potential buyers. Many of the professionals these sites attract are looking to make a purchase making the sites valuable real estate for suppliers to advertise their offerings. Other site visitors may be on the site simply to take advantage of the content and community it offers with no initial intention to buy. However, we believe advertising on these sites is more likely to convert these visitors into customers than more broad, less targeted web advertising strategies. In summary, today, many of the aforementioned market models are separate entities even within specific vertical industries. However, over time we would expect to see some convergence where, for instance the catalog, auction and exchange pricing mechanisms and all the variations thereof, for, lets say the chemicals industry, take place on one site. Furthermore, as we are already seeing with VerticalNet, we would expect to see community-based market makers monetize eyeballs through revenue streams beyond advertising, sponsorship and lead generation fees. In other words, transaction-based revenue.
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MRO
ENERGY MANAGEMENT
PLASTICS
CHEMICALS
PAPER
STEEL
MEDIA BUYING
EXCESS INVENTORY
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To attract buyers to their sites, vertical market makers feature industry-specific content and community aspects in order to attract buyers. Content often includes industry news, editorials, job listings and the like. This content, coupled with interactive features like message boards and chat, engenders a sense of community among users and keeps them coming back. Without attracting a critical mass of buyers, it is unlikely that suppliers will participate (and, vice versa). Attracting suppliers may require more than just a well-visited site. It will likely require the convincing, understanding and, at times, prodding of market maker executives and senior sales people with strong industry relationships. Selling through an intermediary is typically not a no-brainer for suppliers. In fact, in most cases it is a major strategic decision made at the most senior levels of an organization. In the minds of suppliers, particularly large ones, it often raises concerns about channel conflict, price degradation, partner alienation, reduced customer control, employee morale etc. Gaining the participation of suppliers will require that the market makers know the industry and the players within it. In fact, we consider these relationships supremely important to the success of a market maker.
Obviously, failure to generate meaningful numbers of both buyers and suppliers will result in meager transaction volumes. Assuming a market maker does attract a critical mass of buyers and sellers, which is much easier said than done, it will need to accommodate the specific needs of these participants in terms of pricing, distribution and logistics, quality, service, etc. Were not talking about books here. The goods and services traded between businesses, especially where vertical market makers are involved, are often mission-critical. Send the wrong tires to an auto manufacturer or send them late and production could grind to a halt. Needless to say, the cost of failure could be enormous. As it is, market makers are being adopted cautiously in many industries. We expect the value of market makers to win out in the end, but widespread adoption may take longer in many industries than some expect. Industries, especially those least receptive to the market maker concept at the outset, are not likely to tolerate mistakes from interlopers trying to improve processes viewed by many industry veterans as plenty efficient. It wont take many mistakes (maybe one) for a market maker to lose the participation of significant numbers of buyers and sellers. So, while early movement is extremely important. Near flawless early movement is more important. The only thing worse than moving late is moving early and disappointing participants. Once disappointed they are unlikely to return. For the reasons mentioned above, and many more, domain knowledge is of paramount importance to a vertical market makers success.
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Many horizontal market makers do utilize content and community to attract buyers. However, we believe this could prove challenging over the long haul. This is due to the fact that although some of the buyers who utilize horizontal market makers focus solely on a specific function and identify themselves with it lets say media buying others buy these goods and services in conjunction with industry-specific functions. These employees may associate themselves with the industry rather than the function. Targeting this mixed bag of users with meaningful content and building a sense of community might be tough. The heterogeneity of horizontal market maker users also may make attracting premium-priced advertising revenue equally difficult.
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Manufacturing
Distribution
Retail
Consumer
User Relationships and the Network Effect. With seller-hosted sites like those of FedEx, Cisco or Amazon.com, relationships are one-to-one in nature. Business is transacted between the seller and each individual buyer separately and revenues grow linearly. However, B2B market makers are different. They facilitate many-tomany relationships. Each buyer can buy from one or many suppliers and each supplier can sell to one or many buyers with the B2B market maker getting a cut of each transaction. Once B2B market makers achieve a critical mass of buyers and suppliers no easy accomplishment and one that few have achieved to date they should benefit from the network effect over time. In other words, leading B2B sites (or networks) should scale significantly as they attract buyers looking for a broad selection of products and suppliers seeking a large audience of potential buyers. This dynamic should allow market makers to enjoy exponential revenue growth once a critical mass of market participants and liquidity is achieved. EBay is probably the best example of the network effect weve seen to date in electronic commerce. EBay is the clear leader in person-to-person auctions in the C2C (consumer-to-consumer) market. In our view, only through the power of the network effect could a company just over four years old and staffed with approximately 130 employees serve as the transaction platform for gross merchandise estimated at just under $3 billion for 1999 and enjoy profitability.
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Seller-Hosted Site
Buyer A Supplier A
Market Maker
Buyer A
Buyer B
Supplier B
Buyer B
Participant Acquisition Costs, Which Will Start Out Extremely High, Should Decline Over Time and Allow for Margin Expansion. For B2B market markers, the cost of attracting buyers and suppliers, in particular, will be extremely expensive relative to the transactions and revenue they will generate in the early going. Sales cycles are typically long because, in most cases, the decision to participate is one made at the highest levels of an organization. B2B market makers need to attract a critical mass of buyers and suppliers before revenue traction will occur. However, as the network effect takes hold and more participants migrate to a market maker, it should take less money and prodding to get suppliers to contribute their products to a growing source of demand and buyers to shop at a growing source of supply. Exponential revenue growth due to the network effect, coupled with declining participant acquisition costs should lead to margin expansion for leading market makers. Barriers to Entry. For market leaders, we believe the barriers to entry for competition will be extremely high. Once a market maker gathers a critical mass of buyers and suppliers, embeds itself in the business processes and IT infrastructure of both, and achieves market liquidity, we believe it will be tough for another market maker to overtake the leader. Furthermore, we believe that leading vertical (industry-specific) market makers will align themselves with specialized distribution and logistics players to fulfill the orders taken on their site. We believe the B2B market makers that forge these important relationships will have a significant leg up toward securing a highly defensible market position. High Switching Costs for Participants. Aligning with a particular market maker typically includes systems integration between the participants and the intermediary. Furthermore, market makers, once aligned with, embed themselves in the business processes of both buyers and suppliers. In all likelihood, both of these factors will make switching to another network prohibitively expensive and disruptive. Recurring Revenue. Once market makers embed themselves in the procurement processes of buyers, the sales and distribution processes of suppliers, and the systems of both they should become venues for highly recurring transactions and revenue.
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1.
Small Suppliers. We believe small supplier participation in online markets is pretty much a no brainer. To us, small usually means limited resources this includes sales and distribution. Capacity is not unlimited for distributors and resellers. They usually limit the products they move to those with the widest customer appeal and the best profit margins for them. Even if a small suppliers quality and service is top notch they usually have neither the brand name nor the scale to provide a sizable enough discount to induce large distributors or value-added resellers to push their goods and services. Online markets provide a low-cost distribution channel through which small suppliers can reach small customers formerly too far and expensive to reach and large buyers with whom they could never get an entre. Small Buyers. This is another online market maker participant we throw in the no brainer category. Online market makers allow small buyers to automate and reduce the expenses related to the manual procurement process. In addition, more efficient procurement allows small buyers to reduce inventory and related carrying costs. Finally, small buyers now get greatly expanded supplier access from the remotely located high-quality supplier they never would have connected with without the Internet to the large supplier for whom selling to smaller customers by traditional means was too expensive. Large Buyers. Large buyers buy in volume and, as a result, they are highly sought after by suppliers of all sizes. A great deal of what large buyers purchase comes from large suppliers that can handle the service, quality and pricing requirements to which big customers are entitled due to their buying power. In addition, commerce between large buyers and large suppliers is often already automated through EDI. Therefore, we dont believe the benefits of online market makers are as compelling for large buyers as they are for their smaller brethren. However, market makers can be beneficial to large buyers by introducing them to smaller suppliers to whom they never would have had access otherwise. These smaller suppliers often sell highquality products and offer high-touch service. In addition, they offer large buyers alternatives on occasions when their large suppliers are constrained in terms of product availability or delivery requirements. For large buyers, market makers mean more choices in terms of products, services, and suppliers. Finally, large organizations have automated procurement to varying degrees. For the less progressive large buyers, market makers will add value through automation and reduce procurement processing and inventory carrying costs. For large buyers that have automated their procurement processes to a large degree, we believe there are incremental process and inventory cost savings to be realized. Large Suppliers. We believe supplier affinity for online intermediaries will run inversely to their market share. In other words, the more market share a supplier controls the more work it will take to get it to distribute through an online market maker, and vice versa. We make a few assumptions here: 1) large suppliers are large, in part, because they have relatively broad
2.
3.
4.
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customer reach and efficient sales and distribution channels, 2) as leaders in their industries, we think customers are essentially required to consider these suppliers when making a purchase, and 3) due to their strong competitive position these suppliers will be reticent to serve as one of the big draws for a market maker that carriers competitive offerings. As a result, large suppliers like Cisco and Intel are likely to continue to sell directly through their own sites. However, although at times begrudgingly, we believe large suppliers will end up participating in third-party hosted Internet markets for several reasons. First and foremost, customers will demand it. With global competition increasing constantly, suppliers differentiate themselves now, more than ever, through customer service. As such, we believe that, long-term, suppliers will respond to buyer demands that they make their products and services available via online market makers. Also, once the most progressive large suppliers in an industry have come on board, laggard suppliers are likely to fall like dominos just to maintain market share. Furthermore, market makers present a channel through which smaller suppliers can nibble away at the market shares of larger players we dont expect large suppliers to sit idle and watch this happen. Finally, large suppliers will use online market makers to gain access to new customers and revenue streams altogether.
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A Large Market. By and large, we believe most market makers, if they are successful long-term, will drive revenues by taking a cut of the transactions they facilitate. So, to oversimplify things, in general, we would be looking for market makers that address very large vertical or horizontal markets. Online market makers are about reducing inefficiency. Even if a large market is relatively efficient, it is likely that, due to its size, inefficiencies within it can support a very significant Internet business. The optimal market maker will be one that addresses a very large, inefficient market like paper, steel and plastics. However, be careful. While large, inefficient markets might have the most fat to take out and, therefore, the most profit potential for a market maker long-term, the fact that they have remained inefficient for so long likely indicates that they are markets extremely resistant to change. As a result, some of the best market maker opportunities might take longest to come to fruition. Below, using data from the US Census Bureau, we have ranked what we consider major business-to-business industries in terms of commerce. We have excluded data on industries we deem to be almost exclusively retail in nature. The generic category, wholesalers, tops the list. This is not surprising given that these intermediaries are entrenched parts of the supply and distribution chains in so many industries. As one might expect, the list is populated primarily by old, established industries many with complex supply and demand chains.
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Business-to-Business Wholesale trade, durable goods Wholesale trade, nondurable goods Merchant wholesalers, durable goods Merchant wholesalers, nondurable goods Professional, scientific, and technical services Transportation equipment manufacturing Computer and electronic product manufacturing Food manufacturing Chemical manufacturing Building, developing, general contracting Special trade contractors Machinery manufacturing Administrative and support services Fabricated metal product manufacturing Agriculture Petroleum and coal products manufacturing Primary Metal Manufacturing Publishing industries Plastics and rubber products manufacturing Paper manufacturing Truck transportation Heavy construction Electrical equipment, appliance, and component manufacturing Repair and maintenance Miscellaneous manufacturing Printing and related support activities Beverage and tobacco manufacturing Wood product manufacturing Nonmetallic mineral product manufacturing Oil and gas extraction Apparel manufacturing Furniture and related product manufacturing Textile mills Information services and data processing services Mining (except oil and gas) Textile product mills Water transportation
Business-to-Business (contd) Monetary authorities-central bank Pipeline transportation Support activities for mining Leather and allied product manufacturing Warehousing and storage Lessors of intangible assets, except copyrighted works Business-to-Business/Business-to-Consumer (Mix) Insurance carriers and related activities Credit intermediation and related activities Hospitals Utilities Broadcasting and telecommunications Ambulatory health care services Securities intermediation and related activities Real estate Religious, grantmaking, civic, professional and similar org Nursing and residential care facilities Rental and leasing services Personal and laundry services Motion picture and sound recording industries Waste management and remediation services Support activities for transportation Couriers and messengers Air transportation Educational services Transit and ground passenger transportation Funds, trusts, and other financial vehicles
172,010 166,835 6,892 15,558 44,007 454,853 58,020 222,540 99,125 57,359 65,099 186,028 22,100 16,336 30,358 10,923 3,611 40,996 16,006 1,262
1,062,365,641 886,819,003 391,786,805 391,243,209 367,841,279 347,752,717 269,342,485 162,824,225 102,965,794 92,833,001 79,156,509 58,813,352 49,214,165 40,294,167 40,267,182 39,676,674 21,437,669 20,934,202 13,919,480 11,383,601
Buyer and Seller Fragmentation. Theoretically, the more fragmentation, the better. In the ideal scenario, an industry would not only be large but feature many small buyers purchasing from many small suppliers. As we mentioned earlier, we believe small suppliers and small buyers benefit the most from online market makers. Therefore, in our view, an industry full of little guys would be ideally suited for a market maker. However, we also believe gaining liquidity, the key to a market makers success, in such a market may take some time because it will require bringing a large number of entities online. We think industries where most of the commerce is conducted between large buyers and large suppliers might be slowest to adopt market makers. However, we also believe that once a couple of large industry leaders contribute supply that others will have to follow suit. Therefore, once the ball starts rolling, we expect liquidity to follow. In order to measure industry fragmentation, we have again used US Census data. This time we have sorted the same set of industries used in ranking industry commerce by the number of establishments in each industry. The census counts individual establishments as separate locations. Therefore, multiple establishments may be part of a single company. This may overstate fragmentation of buyers and sellers to some degree. That stated, we believe the number of establishments in an industry probably serves as decent proxy for the fragmentation within it. It is also important to note that, oftentimes, enterprises with a large number of geographically dispersed locations often cant or dont centralize purchasing, in the case of buyers, or sales and distribution, in the case of suppliers.
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Business-to-Business/Business-to-Consumer (Mix) Ambulatory health care services Real estate Personal and laundry services Insurance carriers and related activities Credit intermediation and related activities Religious, grantmaking, civic, professional and similar org Rental and leasing services Securities intermediation and related activities Nursing and residential care facilities Broadcasting and telecommunications Educational services Support activities for transportation Motion picture and sound recording industries Waste management and remediation services Transit and ground passenger transportation Utilities Couriers and messengers Hospitals Air transportation Funds, trusts, and other financial vehicles
454,853 222,540 186,028 172,010 166,835 99,125 65,099 58,020 57,359 44,007 40,996 30,358 22,100 16,336 16,006 15,558 10,923 6,892 3,611 1,262
347,752,717 162,824,225 58,813,352 1,062,365,641 886,819,003 102,965,794 79,156,509 269,342,485 92,833,001 367,841,279 20,934,202 40,267,182 49,214,165 40,294,167 13,919,480 391,243,209 39,676,674 391,786,805 21,437,669 11,383,601
Market Maker Receptivity. In the table below, we rank industries based on a combination of the two aforementioned key characteristics market size and fragmentation. Nothing scientific here. We multiplied the number rank of an industry in terms of commerce by its number rank in terms of fragmentation. We then ranked these industries by the product of those two numbers. We acknowledge that the methodology here is extremely conceptual. In addition, many industry characteristics beyond market size and fragmentation will play a part in how quickly an online market maker is adopted (if at all) in a particular industry. However, in terms of setting a framework for assessing possible industry receptivity of market makers, this methodology might be a decent starting point.
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Business-to-Business/Business-to-Consumer (Mix) Insurance carriers and related activities Ambulatory health care services Credit intermediation and related activities Real estate Personal and laundry services Broadcasting and telecommunications Hospitals Religious, grantmaking, civic, professional and similar org Securities intermediation and related activities Utilities Rental and leasing services Nursing and residential care facilities Motion picture and sound recording industries Support activities for transportation Waste management and remediation services Educational services Couriers and messengers Transit and ground passenger transportation Air transportation Funds, trusts, and other financial vehicles
Source: US Census Bureau; Merrill Lynch Internet Research (Market Maker Receptivity is calculated by multiplying an industrys commerce rank by its fragmentation rank. For example, an industry ranked #1 in commerce and #1 in fragmentation would produce a Market Maker Receptivity score of 1, and, theoretically, be most receptive to a market maker.)
Fat. We view fat as the non-value-added links in the value chain. In our view, investors, should be wary of the prospects of market makers that lead with purely a disintermediation strategy. While there are middlemen in many value chains that add minimal value beyond matching buyers and sellers (brokers in the paper and plastics industries come to mind), many middlemen, such as value-added resellers and many distributors, are important and irreplaceable links in the value chain. Market makers that focus on automating processes that are currently manual so employees can focus more on the value added functions they perform will probably find themselves in a solid industry position. Those that trumpet a goal of taking food off somebodys table are likely to feel extremely powerful industry forces come to bear on them. IT Adoption. Generally speaking, we believe industries that have widely adopted information technology will be more receptive to online market makers than those that have not. First of all, we believe the fact that the technology infrastructure is already in place for companies within these industries makes utilization of online market makers an easy transition technology-wise. Second, and probably more importantly, we believe IT adoption serves as a rough proxy for an industrys attitude toward change particularly change that increases efficiency, which is exactly what market makers are about.
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Strong Partnerships For Distribution & Logistics. Unlike books, CDs, and stereos, UPS doesnt transport lumber, resin, or hydrochloric acid. This takes specialized distribution and logistics players. In many industries, leading market makers will need to forge relationships with the key distribution and logistics providers in their industry. Due to the generic nature of what they transport, UPS or FedEx can typically carry many different types of deliveries for numerous suppliers/senders in a single truck or plane. Conceivably, this allows UPS or FedEx to more easily maximize the utilization of their fleets. However, due to the expense of their vehicles (ie, tankers) and the people that man them, and the specialized nature of what they deliver, scaling up for the incremental supplier that may or may not create enough demand to maximize utilization is a risky economic proposition for specialized logistics players. Winning market makers will have locked in agreements with specialized logistics providers and distributors that can support delivery of the products they sell. Neutrality. Neutrality has quickly become the First Commandment of B2B markets. However, neutrality means different things to different people. To us, it means ensuring that business is transacted in an equitable manner and that all market maker participants are playing by the same clearly defined set of rules. However, market makers must balance neutrality with their #1 goal achieving liquidity. In our view, liquidity is the biggest challenge facing every market maker and achieving it is typically contingent upon gaining the participation of large suppliers. Clearly, a market maker featuring content that favors one or several suppliers to the detriment of their competitors is unlikely to gain mass supplier participation. In addition, a market maker that gives a disproportionately large ownership stake to one or several large suppliers is likely to alienate other potential participants. However, on a case by case basis, we do believe there are ways for market makers to induce supplier participation without becoming or appearing biased. For instance, giving major players in a particular industry moderate, but equally sized ownership stakes in a market maker may help jump start liquidity. Performance-based warrants that reward suppliers for putting a certain amount of volume through a market maker may also work. Neutrality is important, and investors should probably avoid market makers that blatantly violate it as this is likely to limit the participation of other industry heavyweights and, as a result, hamper long-term growth. However, investors also must beware of market makers so wedded to such a narrow definition of neutrality that they never gain liquidity. Liquidity. Before market makers achieve liquidity, the holy grail for every market maker, they must build a critical mass of buyers and suppliers. Once a market maker has acquired a critical mass of buyers and suppliers, it will still take some time to achieve liquidity as these participants, particularly suppliers, are likely to move cautiously to the paradigm until they have confidence in it, which wont happen overnight. At the point most makers go public, in general, they have attracted a significant number of potential buyers (typically through industryspecific content), are working on supplier participation (their biggest challenge), and are quite far from achieving transaction liquidity. In our view, to participate in the significant potential upside of a B2B investment, investors cant wait for liquidity to be achieved in order to invest, as the horse will be way out of the barn by then. So, investors need to look for the characteristics that are likely to lead to liquidity management with industry knowledge and expertise that moves early (and close to flawlessly), a critical mass of potential buyers to attract suppliers, at least a handful of supplier relationships and a bunch more in the pipeline, key distribution and logistics relationships, and relative neutrality.
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Going Public First (if ready). This is not to fan the flames of what may be characterized as a scorching B2B IPO market, but assuming that a market maker is confident that it can execute against the key metrics investors are looking for, we contend that going public is a major advantage. Market makers that have limited or essentially no competition, like PaperExchange in paper, enjoy the luxury of going public when it is optimal and they can get the most value for their companies. However, in markets like steel (e-STEEL and MetalSite), chemicals (CheMatch, ChemConnect, and e-Chemicals) and life sciences (Chemdex and SciQuest both are now public; Chemdex came first), where competition is likely to become intense very quickly, moving into the public markets first is an advantage. Aside from the fact that the cost of capital may never be cheaper, the IPO significantly increases the visibility of these companies vs. their private competition and also provides them with highly valued currency to quickly grow their businesses through acquisition. Weve seen it in B2C. Clearly, it was the highly valued stock currencies of Yahoo! and AOL that allowed them to grow and broaden their respective businesses through acquisitions of companies like Broadcast.com and Time Warner, respectively, and put insurmountable distances between themselves and potential competitors. In B2B, weve already seen Chemdex, which solely addressed the $36 billion worldwide life sciences market at the time of its IPO, move into the healthcare supplies market through its acquisition of Promedix. VerticalNet, a company whose business to date has been predominantly based on advertising revenue, intends to generate much more commerce revenue long-term. By recently acquiring NECX, a market maker in the multi-billion dollar electronics industry VerticalNet was able to accelerate its transition toward commerce revenue because of its public currency.
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In terms of value created, the mix of revenue between sellerhosted sites and third-party market makers is probably more important than the accuracy of the overall forecast Seller sites will always dominate the mix
As mentioned, we believe worldwide electronic commerce revenue could total approximately $2.5 trillion by 2003. However, what we view as more important than this total sales figure, is its likely mix between seller sites, like those of Cisco, Dell, Intel, Boeing, Grainger, Federal Express, etc., and the sites of online market makers the B2B investment opportunities upon which this report is focused. Clearly, in order for third-party market makers to create meaningful market capitalization, they will have to pick up a greater share of this growing market. The Ciscos, Intels and FedExs of the world should be commended for recognizing relatively early (read mid 1990s) the value Internet sales could bring to their businesses. However, the fact that they themselves are dominant suppliers in their respective industries has made gaining relatively quick revenue traction over the web easier for them than it has been for market makers. This makes sense to us because market makers need to enlist supplier and buyer participation, which takes time, before generating a meaningful volume of transactions. Furthermore, established companies with seller-centric sites have a number of characteristics that make generating web-based business relatively easy almost immediately their own supply or relationships with major suppliers and existing customers as well as a brand name and marketing resources to attract new customers. In addition, these companies already have relationships with the key distribution and logistics players necessary for fulfilling orders. In other words, these businesses are quick out of the box in regard to generating online sales, while market makers take longer to ramp.
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but market makers will gain enough share to create tremendous value
Over the coming years, we expect that many market makers will add meaningful numbers of buyers and suppliers and establish the key distribution and logistics relationships. As a result, we expect them to hit their stride and gain ground in terms of the percentage of overall B2B sales they facilitate. We believe that seller web sites will dominate the overall mix. However, we believe it is a reasonable assumption that third-party market makers could represent 10-20%, or $248-$496 billion of overall online B2B sales by 2003. In addition, we also assume advertisers spend $5-$10 billion with market makers at this point in time. Combined we believe the total revenue attributable to online market makers by 2003 could range between approximately $400-$500 billion. (In our conservative case, which we consider less likely, we estimate that only 10% of B2B electronic commerce revenue, or approximately $250 billion, is transacted through market markers.) In our conservative case, which we deem least likely, we assume only 10% of online B2B trading, or $248 billion, is captured by third-party market makers. Throwing in $5 billion for advertising, the total revenue attributable to market makers would be $253 billion. In this conservative case, we assume an overall net margin of 3%, generating net income of $8 billion. We use a 50X multiple on this net income to reflect the fact that, even in 2003, these are likely to remain high-growth and high return on invested capital businesses for years to come and they will be assigned premium PE multiples to reflect it. Our conservative case yields an aggregate B2B market cap of approximately $380 billion, or 1.5X sales. Discounted at 35%, this market capitalization is presently valued at over $150 billion. In our middle case, we assume market makers garner 15%, or $372 billion, of the online B2B market. Including $7 billion for advertising, we attribute $380 billion in aggregate revenue to market makers. We also assume economies of scale resulting from this stronger top-line produce a net margin of 4% and net income of $15 billion. We apply a 55X multiple to these earnings to reflect strong performance and what is likely to be a great outlook. Market cap generated from this case exceeds $830 billion or 2.2X sales. The present value of this market cap, discounted at 35%, is approximately $340 billion. Following the same methodology, in our bullish scenario, we assume that market makers grab 20% of the online B2B market and generate $506 billion in revenue, including $10 billion for advertising revenue. We assume that net margin expands to 5%. The result is $25 billion in net income. We raise our multiple assumption to 60X, which generates market cap of approximately $1.5 trillion and a revenue multiple of 3.0X. Again we discount this market value at 35%. As a result, we arrive at a present value of approximately $620 billion.
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$2,481
$2,481
$2,481
90% 10%
$248 $5 $253 237% 63% 38% 3% $8 50x 1.5x $380 $154
85% 15%
$372 $7 $380 259% 63% 38% 4% $15 55x 2.2x $835 $339
80% 20%
$496 $10 $506 275% 63% 38% 5% $25 60x 3.0x $1,518 $617
The valuation methodology outlined above is a framework to bring some perspective to where valuations might normalize several years out. Obviously, tweaking any of the inputs overall B2B market size, the percentage of this market captured by third-party market makers, margins or multiples causes the potential market cap created by the B2B opportunity to swing wildly. In addition, over the near-term (probably the next couple of years, rather than months), the revenue multiples applied to leading B2B companies are likely to remain in substantial excess of what we use for our valuation framework. Despite strong near-term growth, for the foreseeable future almost all B2B market makers are likely to continue to appear small relative to the huge market opportunities they typically address. We expect investors to ascribe extremely high price-to-sales multiples to companies for which potential market opportunities look far from saturation, upside to revenue estimates remain likely, the waning of hyper-growth any time soon seems remote, and execution is strong.
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suppliers. As a result, within a specific market, a dominant share of electronic commerce is likely to be transacted through the leading site and allow the #1 player to enjoy the leverage associated with significant scale as well as strong returns on invested capital. However, in these winner take most (if not all) markets, it is questionable whether the next tier of players will scale to a size that provides them the leverage to reach profitability. Obviously, we believe investing in #1 is optimal, investing in #2 could result in good returns, but is more risky, and investing in #3, #4, and #5 is likely to be a bad use of capital. (There is likely to be more than a handful of winners among horizontal market makers because they sell products and services across many industries a huge market. It is unlikely that one player can make a sizable enough early land grab to lock up the market. That said, there will be many more entrants chasing this market, so while there will be many more winners than in individual vertical markets, there will also be many more losers. Beware.) Investment in successful companies should be extremely rewarding. However, the risk in stocks of companies that fail could be significant. Historically, good internet stocks have looked expensive from the beginning and looked more expensive over time. Although past performance is no guarantee of future results, we recommend that investors stick with the good quality companies and not let what appear to be expensive valuations scare them away. Bad Internet investments have done one of two things they have either started expensive and gotten cheaper or started cheap and gotten cheaper. From our experience, the only time investors focus on the valuation of an Internet stock is when fundamentals are deteriorating. Given that B2B is in its infancy, we would not expect to see sector-wide fundamental deterioration for quite some time. If fundamentals are truly deteriorating for a particular B2B company, the stock should probably be sold immediately. However, if fundamentals are improving and upside to estimates is expected to continue, the stock is likely to continue to rise regardless of valuation. We dont expect investors to wake up some day soon, come to work, and sell their best Internet stocks because they suddenly look expensive. They always look expensive. On the flip side, we would not advise investors to go bargain hunting for B2B Internet stocks. They are almost always cheap for fundamental reasons. So market opportunities are large, the companies addressing these opportunities are early-stage, winners are likely to create extraordinary returns, losers could end up close to worthless, and picking winners and losers is tough. Isnt this type of investing suitable only for venture capitalists? No, diversified growth investors, sector investors, and speculative investors all need a strategy for B2B. In a vacuum, almost every B2B market maker is a speculative, high-risk and early-stage investment. B2B investing is arguably the closest thing to venture capital in todays public markets. So, obviously these investments are not suitable for the risk averse. However, many other investor types of varying risk profiles need to develop a strategy for the sector. Investors that choose to have exposure to the space need to take different approaches. Diversified Growth Investors. We have always maintained that diversified growth investors allocate a small percentage of capital (ie, 10%) to pure play Internet investments. We would suggest that these same investors earmark a percentage of this overall Internet allocation to a basket of B2B market maker stocks. Most B2B market makers address huge markets and have great promise. They also still have much to prove. On a macro level, we are confident that B2B will create significant market cap. However, at this early stage, picking the individual winners is tough. A basket approach gives investors the best chance to realize excellent returns with a couple of success stories in a portfolio of investments in which the majority are major disappointments.
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Yes, investors could realistically lose 80% of their money (with a theoretical maximum loss of 100%) in B2B investments gone sour. However, winners are likely to return investors many multiples of their initial investment. In addition, we believe diversified growth investors have limited chances of outperforming applicable investment benchmarks, which are likely to have an increasing B2B component embedded in them over time, without B2B exposure. Sector investors. It is hard to tell if market makers will actually create new value or take it from established industry players. They will probably do a bit of both. Regardless, sector investors need to formulate an investment strategy to account for the potential impact of successful market makers. We believe investors with exposure to steel, chemicals, and paper, etc. also need to consider portfolio exposure to an e-STEEL and a MetalSite, an e-Chemicals, ChemMatch and ChemConnect, and a PaperExchange. In addition, investors with exposure to certain distribution, wholesale, or broker businesses need to consider investment in market makers, many of which will play the role of improving the lives of middlemen that add value and ending the lives of those that do not. Furthermore, investors in companies that publish trade magazines need to consider exposure to market makers that provide industryspecific content that may compete with existing publications for advertising dollars. In the worst case, some market makers will render existing businesses or important components of them devalued or obsolete and, as such, steal market share, margin points, and market capitalization from established players. In the best case, market makers will create value for themselves and others by providing leading industry veterans with new customers and incremental revenue streams, lower cost distribution channels, expanded customer reach, and improved productivity. In all likelihood, different market makers in different industries will produce results on various points of this continuum. Either as a way to capture newly created value or as a hedge against value lost by established businesses, we believe portfolio managers with assets in many industries need to consider exposure to these new market maker investments. Speculative Investors. As mentioned, B2B market makers investments are high risk/high reward. Our strategy for diversified growth investors, due to the lack of clarity with regard to who the winners will be in B2B, is to allocate a small portion of capital to a diverse basket of investments. This diversification strategy, while limiting downside, obviously limits upside. Therefore, we tweak this strategy for speculative investors. Under the assumptions that they have more risk capital at their disposal and can endure more risk than most, we believe speculative investors can seek outsized returns by allocating more capital to B2B investments over the near-term. For maximum near-term appreciation, we would seek out companies likely to deliver extraordinary sequential revenue unit growth over the next several quarters.
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Henry Blodget First Vice President (1) 212 449-0773 henry_blodget@ml.com Edward McCabe Vice President (1) 212 449-8862 edward_mccabe@ml.com
ACCUMULATE
Long Term BUY
Price:
Estimates (Dec)
EPS: P/E: EPS Change (YoY): Q3 EPS (Sep): Cash Flow/Share: Price/Cash Flow: Dividend Rate: Dividend Yield:
$112
1998A
NM NM NM NA NM Nil Nil
Investment Highlights:
1999E
NM NM NM NM NA NM Nil Nil
2000E
NM NM NM NA NM Nil Nil
Stock Data
***3 Week Range: Symbol / Exchange: Options: Institutional Ownership-Spectrum: $14-$64 1/16 ICGE / OTC None NA
**The views expressed are those of the macro department and do not necessarily coincide with those of the Fundamental analyst. ***Since IPO, 4 August 1999. For full investment opinion definitions, see footnotes.
ICG is a holding company with ownership positions in 50 partner companies, most of which are focused on Business-to-Business (B2B) e-commerce. In the land grab that is B2B, ICG is quickly establishing itself as the leading land baron. ICG allocates capital to promising B2B opportunities, then provides partner companies with strategic and operational guidance with the aim of building market leaders. ICG facilitates strategic relationships and shares best practices, advantages not enjoyed by stand-alone B2B start-ups. For three reasons, we believe ICG represents an exceptional long-term investment opportunity: 1) it is focused on B2B, which we believe will be the next big Internet wave, 2) it offers a built-in basket approach, allowing investors to diversify risk, and 3) it effectively allows public-market investors to invest at private-market prices. In the last five years, the total market capitalization of pure play B2C companies has risen from about $1 billion to $1 trillion. We think B2B could ultimately generate even greater market value. We believe ICGE is positioned to capture a meaningful percentage of this value.
Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department
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Summary
As a holding company with ownership positions in 50 business-to-business partner companies, we believe Internet Capital Group presents investors with a great opportunity to play what we believe is the next big Internet wave B2B ecommerce. According to Forrester Research, domestic B2B e-commerce is projected to grow from $43 billion in 1998 to $1.5 trillion in 2003, approximately 14X the 2003 B2C e-commerce estimate of $108 billion. Generally speaking, ICG has interests in two types of companies market makers and infrastructure service providers. Market makers bring together corporate buyers and sellers of goods, services, and information in a virtual marketplace. Infrastructure service providers sell the software, hardware, and services required for businesses to participate in e-commerce. ICG is a fairly complex company with many moving parts. However, from 50,000 feet the company and its strategy look fairly simple. ICG: identifies or creates companies it believes have the potential to become market leaders; acquires significant ownership interests (ideally, 40%-80%) in these companies and integrates them into its collaborative network; provides strategic guidance and operational support to its partner companies; and promotes collaboration.
ICGs intention is to own its partner companies long-term and actively provide these companies with strategic guidance and operational support. This long-term operating focus clearly differentiates ICG from venture capital firms, which typically fund and advise a diverse portfolio of businesses with eyes keenly focused on a relatively near-term exit strategy. We advocate that aggressive investors allocate a small percentage of capital (ie, 10%) to a basket of high-quality Internet stocks. We would add Internet Capital Group to this group of premiere Internet names, and we believe it has several characteristics that make it an especially compelling investment. ICG is focused on B2B a much more nascent (read strong growth ahead) and larger Internet market long-term, in our view, than B2C, access, content or services. ICG, in and of itself, is a basket of investments. All but four of ICGs 50 B2B partner companies are private. Obviously, there is a large amount of risk in private-market investing. However, that risk is offset by diversity and by what we believe is the potential for a great deal of upside. Not all of ICGs companies will be outstanding success stories. In fact, it is likely that some wont grow at all and thats okay. A few homeruns would likely offset dozens of strikeouts. ICGs most significant stake in a publicly held partner company is its interest in VerticalNet, in which it has invested a total of $14 million. A year after the initial investment, ICGs stake is currently valued at close to $3 billion. By no means should this type of return be considered typical, but it represents the potential value residing in some of ICGs partner companies. ICGs management and Advisory Board are strong. We believe strong management is a prerequisite for investing in early-stage companies. The members of ICGs management team and Advisory Board run the gamut from former entrepreneurs venture executives, and former and current senior executives at blue chip companies. All in all, it is an impressive group.
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Market Opportunity
The business-to-business opportunity is large and in its infancy. The value of U.S. online intercompany trade in 1998 was estimated at $43 billion. In 2003, the total is estimated to grow to $1.5 trillion. That is a compounded annual growth rate exceeding 100%. We think measuring the B2B market vs. the B2C market helps put things in some perspective. In 1998, the B2C market was estimated at $8 billion. It is expected to grow at a compounded annual growth rate of close to 70% to $108 billion by 2003. Thats nothing to sneeze atexcept when you compare it to B2B. As mentioned, in 1998 the B2B e-commerce market was estimated at $43 billion over 5X the $8 billion B2C market. If forecasts are accurate (forecasting markets this big is not an exact science; they could be larger or smaller but it is safe to say they will be big), at $1.5 trillion, the U.S. B2B market will be over 14X the size of B2C. We believe there are several fundamental drivers that will drive B2B e-commerce growth over the coming years. Expanded Access to New and Existing Customers and Suppliers. The sales forces of suppliers and the purchasing departments of customers have traditionally developed and maintained their relationships with each other. We think B2B ecommerce brings important benefits to these relationships for both customers and suppliers: B2B reduces the time and cost required to exchange current information regarding requirements, prices and product availability. Customers get realtime, accurate information whenever they want it and their personnel spend more time on more value-added functions than phoning, faxing and mailing suppliers. Also, in addition to suppliers receiving better marks for customer satisfaction, their sales forces spend more time chasing new business as opposed to dealing with account maintenance issues. Suppliers get access to new customers altogether. In many markets, demand is fragmented. As such, there is often a base of potential customers too expensive to reach by traditional means. The Internet represents a new channel through which to reach new customers. In many cases, suppliers can limit the involvement of middlemen in the selling and distribution process and reduce their costs. Buyers get more choices and better pricing. Oftentimes, there are many suppliers from which a customer could be buying products. However, whether due to a suppliers or its distributors limited geographic coverage or the time and expense constraints that limit a customers ability to investigate all possible options, a customer is limited to certain suppliers and distributors not always the best ones in terms of quality, service and price. Increased Efficiency and Reduced Cost. Traditional businesses can utilize the Internet to automate internal business processes including manufacturing, finance, sales, and purchasing functions. The Internet can also be used to increase information flow within an enterprise and outside of it creating a virtual enterprise that spans the entire value chain, which includes customers, suppliers, distributors, etc. All in all, the Internet provides businesses with the ability to increase operational efficiency by reducing the time, costs, and resources required to transact business, lowering inventory levels and procurement costs, and improving responsiveness to customers and suppliers.
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Risks
Internet stocks in general, VerticalNet in particular, and the health of the Internet IPO market. If any of these were to break down, ICG would likely lose significant value. If all three deteriorated simultaneously, which is more likely than not, the downside could be significant. Competition. ICG competes with venture capital firms as well as some emerging and existing holding companies focusing more on B2B to acquire ownership in partner companies. We believe ICGs ability to offer potential partner companies operational support, strategic guidance and a collaborative network should serve as a significant competitive advantage vs. existing and emerging competition. Potentially, some of ICGs partner companies could compete with each other. However, we believe that as both steward and significant owner of its partner companies ICG is well positioned to cultivate mutually beneficial partnerships where, in other cases, competition might have been the only resolution.
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(a)
1 2 3 4 5 6 7 8 9 10
IPO C andidates C om m erX (PlasticsNet.com ) C om puterJobs.com D eja.com eMerge Interactive MetalSite O NVIA.com PaperExchange U niversal Access Benchm arking Partners C om m erceQuest
C om pany Type Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Infr. Svc. Provider Infr. Svc. Provider
ICG % O w nership 37.0% 34.0% 27.0% 28.0% 35.0% 16.0% 27.0% 25.0% 9.0% 23.0% Total IPO Candidate H oldings
$828
(b)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Em erging Com pany H oldings AgProducer Network Anim ated Im ages Arbinet AsseTrade AutoVia BidCom BuyMedia.com C ollabria C ourtlink e-Chem icals eMarket W orld Em ployeeLife.com Internet Com m erce System s iParts.com JusticeLink logistics.com N etVendor System s PlanSponsor Exchange Purchasing Solutions R esidential Delivery Services Starcite! Solutions U sgift.com Blackboard C learC om m erce C ontext Integration Entegrity Solutions LinkShare PrivaSeek SageMaker ServiceSoft Technologies Sky Alland Marketing Syncra Software traffic.com U nited Messaging Vitaltone Vivant!
C om pany Type Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Market Maker Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider Infr. Svc. Provider
ICG % O w nership 61.0% 35.0% 7.0% 26.0% 14.0% 20.0% 32.0% 10.0% 33.0% 34.0% 35.0% 40.0% 38.0% 84.0% 37.0% 0.0% 26.0% 40.0% 60.0% 34.0% 36.0% 35.0% 25.0% 13.0% 14.0% 11.0% 29.0% 13.0% 25.0% 5.0% 26.0% 29.0% 20.0% 33.0% 21.0% 18.0% Total Value of Other H oldings Cash (est.) Subordinated Convertible Note Total Valuation Shares O utstanding Asset Value Price-to-NAV
(d) (d)
5.8x
(a) Public holdings marked to market; (b) IPO candidate value assumes a 35% discount rate and 20% post-IPO dilution; All IPO candidates expected to go public within one year; (c) Emerging Company holdings valued at cost or last round of financing; (d) Pro-forma for equity and convertible subordinated notes; Ownership stakes presented on a fully diluted basis Source: Company Reports and Merrill Lynch Internet Research estimates.
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Christopher C. Shilakes First Vice President 415-676-3520 Peter Goldmacher Assistant Vice President 415-676-3522
Ariba Incorporated
Foundation Technologies for Net Exchanges
ACCUMULATE
Long Term BUY
Price:
Estimates (Sep)
EPS: P/E: EPS Change (YoY): Consensus EPS: (First Call: 01-Dec-1999) Q1 EPS (Dec): Cash Flow/Share: Price/Cash Flow: Dividend Rate: Dividend Yield:
$172 5/16
1999A
d$0.84 NM
Fundamental Highlights:
2001E
d$0.54 NM NM d$0.50
2000E
d$0.93 NM NM d$0.88 d$0.23 d$0.24 NM Nil Nil
Stock Data
52-Week Range: Symbol / Exchange: Options: Institutional Ownership-Spectrum: Brokers Covering (First Call): $240 5/8-$61 ARBA / OTC None 2.4% 12
Aribas ORMS, ORMX and IBX product lines and the Ariba Network position Ariba to take full advantage of the explosive growth in both the automated procurement and net market maker vertical exchange markets. The acquisition of Trading Dynamics for $400 million in stock enhances Aribas net market maker offerings by including auction, reverse auction and bid/ask functionality. We expect Ariba to grow revenues from $45.4 million in FY99 to $91.8 million in FY00 (102% YoY): operating margins should drop from -37% in FY99 to -42% in FY00 as the company invests heavily in infrastructure. Key drivers for the next six months include the development of industry leading partnerships and the buildup of the Network Effect as more and more customers and suppliers sign on to the Ariba Network.
Stock Performance
220 200 180 160 140 120 100 80 60 1996 0.15 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.05 1997 Ariba Incorporated Rel to S&P Composite Index (500) (Right Scale) 1998 1999
*Intermediate term opinion last changed on 19-Jul-1999. **The views expressed are those of the macro department and do not necessarily coincide with those of the Fundamental analyst. For full investment opinion definitions, see footnotes.
Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department
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Investment Thesis
Ariba has developed one of the first true B2B e-commerce applications to fully leverage the Internet. Aribas first application, Operating Resource Management System (ORMS), automates procurement of operating resources. Operating resources consume 33% of a typical corporations revenue base, and are the last bastion of inefficiency in the enterprise, untouched by the huge ERP tide which swept industry for the last five years. We estimate Aribas current customer base, which includes Chevron, Cisco, Fed Ex, HP, Merck, Nestle, Philips, US West, Motorola, Charles Schwab and Visa, has well over $180 billion in purchasing power for operating resources. This attracts suppliers that want to join the Ariba Supplier Link to provide electronic catalogs and conduct commerce via the Internet using Ariba technology. Already the company has signed over 40 suppliers since December 1998 to join ASL, including Office Depot, MicroAge, HP, Boise Cascade Office Products, Beyond.com, and Cort Furniture Rental. Investment highlights include: 1. 2. Ariba is positioned to become the platform of choice for optimizing operating resource demand and supply chains. Aribas leadership in leveraging core e-commerce technologies (cutting-edge Java deployment, cXML champion, The Ariba Network commerce portal) presents unparalleled competitive advantage. Aribas business model combines a proven, profitable enterprise software sale to blue-chip customer base and an expanded revenue opportunity via the ecommerce network effect. The Ariba Network leverages the network effect to lock-in supplier relationships and lockout competitors. Financial history speaks to solid execution and powerful top line growth trends. Ariba employees are smart, aggressive, and loyal team players and senior management had worked together prior to founding Ariba.
3.
4. 5.
We believe that over the intermediate term, investors should expect a highly volatile trading pattern in ARBA, given the premium valuation. As with most ecommerce investments, significant new customer wins, partnerships and revenue upside surprises will be the primary catalysts behind further gains in ARBA.
Ariba ORMS
Aribas Operating Resource Management System (ORMS) attacks the last bastion of inefficiency in corporations worldwide: ERP deployments ignored the operating resource burden pressuring corporate margins. Paper clogged and process-heavy procurement of goods and services supported armies of administrators. ORMS combines a powerful optimization engine and ubiquitous linkages between corporate consumers and suppliers with a zero learning curve interface. Result: Hard dollar savings for efficiently purchased resources and reduced soft dollar costs involving vendor benchmarking and management as well as processing, fulfillment and delivery for both consumer and supplier.
New Products
Ariba ORMX is Aribas Application Service Provider (ASP) version of its market leading ORMS product. This plays exceptionally well in the middle markets where companies typically dont have the money to fund a full IT staff and
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ongoing product implementation. Ariba ORMX contains all the functionality of the ORMS product thereby bestowing all of the same benefits associated with centralized purchasing to the middle markets. The Ariba Internet Business Exchange (IBX) service is geared towards those smaller companies that want to leverage the Ariba Network platform without utilizing the automated workflow associated with the front-end ORMS application. This new adaptation of the Ariba Network is ideally suited for vertically oriented purchasing communities where Ariba can broker the purchasing of resources from an exchange where a multitude of users can add industry specific content. These vertical hubs allow users to create an exchange around a specific industry.
New Technologies
Aribas punch-out technology is a critical part of its added value in the purchasing world. Rather than simply displaying a static version of a supplier catalog, Aribas punch out technology lets buyers link to a suppliers web site via cXML to take full advantage of all the functionality the supplier offers while still remaining on the Ariba Network. For example, if a company wants to buy a laptop from Dell, using punch-out technology it can go directly to Dells web site to configure a PC exactly as desired. When the configuration is completed, because the purchaser is still on the Ariba web site, it merely submits the order for approval.
Acquisitions
In November of 1999, Ariba announced its intent to acquire TradingDynamics, Inc. for $400 million in stock in a deal expected to close in January of 2000. With this acquisition, Ariba will enhance its product offerings to include value-added services like auctions, reverse auctions and a bid/ask exchange for Net Market Makers. This acquisition enables Ariba to begin to follow through on its strategy of building out its product offerings to become the dominant vendor in the business to business on line purchasing market. In December, Ariba announced the signing of a definitive agreement to acquire net market maker platform vendor TRADEX technologies for $1.86 billion in stock. Aribas acquisition of TRADEX complements the Ariba Network strategy by adding similar services and functionality to the emerging net market maker segment of the market. Whereas Aribas initial network focus was on the Fortune 500 buy side B2B market, TRADEX specializes in platform software for net markets including both horizontal and vertically oriented digital marketplaces. TRADEX customers in the horizontal space include American Express, NTT and EDS. Vertically oriented marketplaces include MetalSite and Chemdex. Aribas acquisition of TRADEX and the subsequent creation of the net markets business unit is in line with Aribas stated intent of creating a best of breed global B2B e-commerce platform. By buying TRADEX, Ariba is getting a jump-start in the net market maker space which is expected to grow to over 7,500 Net Market Makers (NMM) by the year 2003. Also, by getting a foothold in the space early through acquisition, Ariba will be able to keep its focus and continue to capitalize on its first to market lead.
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Partnerships
In December of 1999, Ariba announced a partnership with American Management Systems (AMS) that will serve as a solid introduction for Ariba to the newly coined G2B (government to business) marketplace. AMS is a $1.3 billion systems integrator that generates over 90% of their business through government contracts. By controlling roughly 50 of the top 80 government agencies, AMS will introduce Ariba to approximately half of the $200 billion the federal government is expected to spend on goods and services next year. In January of 2000, Ariba announced a definitive agreement with EDS subsidiary CoNext to provide the software to run managed consortia based B2B net markets. CoNext, a newly formed EDS subsidiary, was created to provide its customers with actively managed joint purchasing, strategic sourcing, auctions and e-procurement. Calling its new service Leveraged Sourcing Networks (LSN), CoNext has targeted 12 net markets, approximately $160 billion in managed spending and has already signed customers including Bethlehem Steel, Clorox, Kellogg and Prudential. More simply, CoNext is creating 12 net markets and has created a partnership with Ariba to resell its e-procurement software and the Ariba Network.
1Q 2000 Highlights
Aribas 1Q 2000 (December) results accelerated further from the strong fiscal year-end close in September. License revenues were well above our projections, at $15.8 million (+227%) and total revenues grew 243% to $23.5 million. License and transaction related revenues grew 61% sequentially off of the strong September quarter close. These numbers were well above our projected $10.4 million in license revenue and $18.7 million in total revenue. It appears that transaction related revenue is ramping much faster than we anticipated, and was 60% of license revenue in the quarter. The aggregation of buying power on the Ariba Network continued to increase dramatically, up 227% to over $200 billion in operating resource spending alone. Subscription revenues from the Ariba Network increased by 450% to $3.3 million. Six to eight customer went live in the quarter, bringing the total number to better than 35. Margins benefited from the revenue upside. Gross margins were 700 basis points better than our model, at 85%. Operating loss narrowed to $7.6 million, versus our forecast $9.2 million operating loss. Ariba has continued to move towards profitability ahead of our model. The balance sheet showed signs of strength as well. The company reported its second consecutive quarter of positive operating cash flow, cash balances grew $8 million sequentially to $107 million; deferred revenues grew 52% sequentially to $ 46.7 million; and A/R days sales outstanding were 34 days, well below our expectations of a move into a 50 to 70 DSO range. Over time, we still expect A/R DSOs to increase to a more traditional level, especially as Aribaa non-US business increases.
Outlook
Despite a stair-step increase in our model assumptions from a revenue and expense standpoint (as TRADEX and Trading Dynamics come on line), we still believe our forecasts for Ariba to be conservative. We believe the potential catalysts from Net Market Makers and new system integrator partnerships with EDS and AMS and hosting providers like USinternetworking have not yet registered in the model. Channel partner contribution is still uncertain and Ariba is treating it as such, with the current model largely driven by direct sales. The companys confidence in turning the corner towards profitability by the end of FY 01 has increased further, and it appears that investors may see black ink before 4Q FY 2001.
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Licenses % of Revenues Network Revenue % of Revenues M aintenance & Services % of Revenues Total Revenue Cost of Revenues % of Revenues Gross Profit Gross Margin Sales & Marketing % of Revenues R&D % of Revenues General & Administrative % of Revenues Am ort. of Stock Bsd Comp Total Operating Exp Operating Income (Loss) Operating M argin Other Incom e (Expense) Pretax Income Pretax Margin Income Taxes Tax Rate Net Income Net Margin Operating EPS (Basic) Basic Shares Outstanding YoY Licenses Network Revenue M aintenance & Services Total Revenue Cost of Revenues Gross Profit Sales & Marketing R&D General & Administrative Total Operating Expense Operating Income (Loss) Pretax Income Net Income Sequential Licenses Network Revenue M aintenance & Services Total Revenue Cost of Revenues Gross Profit Sales & Marketing R&D General & Administrative Total Operating Expense Operating Income (Loss) Pretax Income Net Income
Source: Merrill Lynch
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NetVendor (Privately held) Automotive, Industrial Products, and Electronics (AIE) Inventory Management
Through SurplusBIN.com for surplus inventory and E.MBACE, which allows suppliers to establish private-labeled trading networks with their distribution partners, NetVendor provides solutions for customers in the automotive parts, industrial products, and electronics industries. It is typical for suppliers in the AIE market to have numerous surplus inventory items (often in excess of 10,000). There is a lack of infrastructure in these industries to facilitate efficient distribution of surplus inventory. As a result, companies often negotiate the sale of excess inventory through brokers, who typically require deep discounts to take items. Inefficiencies of this system include the geographic limitations of brokers as well as the limits of their buyer contacts. SurplusBIN.com allows participants to communicate, advertise, and post product offerings electronically, participate in online auctions, and arrange for private inventory purchase transactions. Currently, NetVendor offers surplus trading communities for specific vertical markets called PlasticsBIN.com, AutopartsBIN.com, and ElectronicsBIN.com. The industry-specific nature of this vertical market strategy allows suppliers to reach a highly relevant audience of potential buyers, which expands their reach beyond that currently provided by brokers. Currently, most transactions between companies and their trading partners are conducted via printed catalogs, telephone, and fax. The internet enables companies to automate these manual, paper-intensive, time-consuming, and expensive processes. The fragmentation of buyers and sellers, importance of information exchange, numerous product offerings, large transaction volumes, among other characteristics, makes the AIE market well suited for E.MBRACE.com. E.MBRACE.com is NetVendors software-service platform that allows suppliers to establish their own private-labeled trading marketplace to sell and distribute inventory to their established trading partners. NetVendor intends to cross-market SurplusBIN.com and E.MBRACE by leveraging the traffic of SurplusBIN.com to promote E.MBRACE. E.MBRACE facilitates the transfer of product data from a suppliers private trading partner community to the vertical surplus inventory marketplace of SurplusBIN.com. NetVendor generates revenue from transaction fees related to surplus inventory sold through SurplusBIN.com, service and subscription fees from E.MBRACE, and consulting, integration, and customization services.
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TradeOut estimates that there are over 10,000 liquidation brokers. However, these liquidators focus on many different industries. It is neither easy nor a corporate sellers core competency to find a large audience of liquidation brokers in order to stimulate maximum price competition for the surplus assets they are disposing. Assuming a seller does find a reasonably sized audience of potential liquidators, the inefficient exchange of information, predominantly phone and fax, used to negotiate the optimal deal is slow, expensive, and time-consuming. Finally, once a deal is done with a particular liquidation broker, there is always the risk that disposition is not executed the way the seller wants. For instance, a broker might not adhere to a sellers instructions that certain excess inventory be resold internationally to avoid domestic channel conflict. TradeOut.com brings much needed efficiency to the process. TradeOut.com allows sellers to not only achieve better prices, but also speed up and reduce the expense of the overall process of surplus asset disposition. Buyers get access to more supply. In addition, TradeOut speeds up and reduces the cost of the buying process. Obviously, TradeOut significantly improves the exchange of information between buyers and sellers.
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BidCom provides a suite of business-to-business services that help companies manage risk and complete projects on time and at reduced costs. BidComs services provide an environment for secure communication, collaboration, commerce, business process management as well as relevant industry content. BidComs solution automates the construction industrys standard business practices with Business Process Models (BPMs) that improve the management of the full lifecycle of a construction project from design to completion. BidComs services are sold through a direct sales force on a per-project, per-user basis.
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PetroChemNet, a leading online information resource and communications network for the chemical industry, which launched in March of 1997, acquired CheMatch (and kept the name) in June. The combination marries PetroChemNets 170+ information products from respected sources within the petroleum and petrochemical industries with CheMatchs trading platform. From one desktop, participants will be able monitor pricing real-time, execute trades, monitor breaking news news that could effect spot market prices and communicate with peers online.
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conveniences of using Automated Power Exchanges include better price discovery, verification of buyer and seller creditworthiness, delivery arrangement, and single party settlement. Using APX Markets, users can trade 24 hours a day, seven days a week. Trading can take place hours, days and weeks ahead of delivery. With APX Market Window, a graphical user interface, buyers and sellers can view price information, market depth, and submit market or limit orders. Transactions are anonymous, which prevents price manipulation. Through services such as off-peak savings, automatic scheduling, web-based settlements and reporting, and credit management, end-users can lower the process costs related to procuring electricity as well as the prices they actually pay. The guidance of forward prices coupled with a ready market in which to sell energy, provides generators with a more profitable way to sell output. APX Markets reduce the costs related to purchasing and reselling energy for aggregators and resellers. The anonymity and liquidity of APX markets allows energy traders to quickly liquidate positions at better prices.
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CommerceOne (CMRC, $169, Not Rated) MRO/Indirect Goods and Services Procurement/CrossIndustry
CommerceOne provides e-commerce solutions that link buyers and suppliers of indirect goods into internet-based trading communities. CommerceOnes Commerce Chain Solution is designed to automate procurement between multiple buyers and suppliers. The procurement processes of corporations for indirect goods like information technology and telecommunications equipment, office equipment and supplies, travel and entertainment, professional services, among other goods and services are typically very inefficient. Procurement of these non-strategic, yet essential items and services, is typically paper-based and time-consuming, and, therefore, expensive. Various software products designed to automate procurement of indirect goods and services have had limited success due to the fact that they have been too buyer-centric and generally neglected the supplier side of the transaction. The Commerce Chain Solution is comprised of BuySite, MarketSite Open Marketplace Platform, and MarketSite Commerce Services. BuySite is an intranet-based purchasing application that allows buyers to purchase from catalogs of many different suppliers, while eliminating paperwork, automating workflow and the approval process, and ensuring employees remain in compliance with corporate purchasing policies. The MarketSite Open Marketplace Platform is the nexus of the CommerceOne network. It serves as a single point of integration for buyers and suppliers. It allows suppliers to publish their catalog content once and update it easily. Buyers, using BuySite or other third-party procurement applications, connect to supplier content on the MarketSite Platfrom. Using the MarketSite Platform, commerce service providers can maintain marketplaces for specific geographies or industries. CommerceOne has established strategic relationships with British Telecom to host a MarketSite in the U.K., Nippon Telegraph and Telephone to host a MarketSite in Japan, and Singapore Telecommunications to host a MarketSite in Southeast Asia. Among other industry-specific relationships, CommerceOne recently announced a high-profile agreement with GM to create GM MarketSite, where GM, its suppliers, and dealers will be able to buy and sell products and services in fixed price catalog, bid-ask exchange, and auction formats.
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Once small businesses join SmartClicks, SmartAge offers them a multitude of services from which it generates revenue. Beyond the free banner ad placement users get for presenting the ads of other affiliated sites for free, users can use SmartAge to purchase advertising space not only on the SmartClicks network, but on other popular ad networks and sites. SmartAges MarketPlace and Resource Center allows small businesses to buy from and sell to SmartAges user base, which totals over one million. SmartAge Site and Store allows small businesses to get online and sell online quickly. SmartAges Corner Office, where SmartAge hosts user data, is a management tool that makes SmartAges offering sticky. In summary, SmartAge helps small businesses start a web site, enable it for commerce, find customers, buy with economies of scale, sell on the web, run an affiliate network, and generally, manage their businesses.
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Merrill Lynch makes no representations or warranties whatsoever as to the data and information provided in any referenced website and shall have no liability or responsibility arising out of or in connection with any referenced website.
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[ICGE] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years. [ICGE] The securities of the company are not listed but trade over-the-counter in the United States. In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt from registration or have been qualified for sale. MLPF&S or its affiliates usually make a market in the securities of this company. Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 Reduce, 5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend. Copyright 2000 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). This report has been issued and approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by SFA, and has been considered and issued in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.
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