Network Effects

Earlier this year, Institutional Investor ranked SG Cowen's sales force as one of the best in the business. Reamer calls them his "bull horns to the Street." When he makes a move, his troops spread the word. And word travels fast. Reamer covers only 7 companies. So when he adds a new name to his portfolio, it's news in and of itself. "I don't cover 45 companies because it doesn't make sense," he explains. "You don't want to diversify on Internet investments; you want to pick the best companies and stay with them. The goal of my research list is to reflect those companies always."

America Online is a cornerstone of Reamer's list. And it too is generating big news this morning. On Friday, a federal judge in Portland, Oregon ruled that cable-TV operators cannot block AOL and other Internet-service providers from getting access to their infrastructure. This is bad news for AT&T, which has been buying up cable properties in the hope of locking up Internet access, but it's great news for AOL -- and for Reamer. Last October, when the young analyst launched his biweekly newsletter, "The Internet Capitalist," investors had been hammering AOL's stock, concerned that it would fail to be a player in the Internet's broadband future. Reamer took a hard line in the opposite direction. "AOL most certainly will not be left out of the broadband game," he wrote with characteristic directness. "Indeed, it is our firm belief that it will be driving it."

The game's far from over. But on Friday, after the Portland ruling, AOL jumped 12 points. When Reamer checks his monitor this morning, the stock has already dropped 5 points to 115. At that valuation, AOL is still a $125 billion company. But just two months ago, when the stock hit its 52-week high of 175, it was a $190 billion company. From a market-capitalization standpoint, AOL has lost $65 billion. Or put another way, in 8 weeks, AOL's value has decreased by the GNP of Ireland.

That kind of volatility is what makes Reamer's job one of the toughest in the entire Internet space. "Clients pay me to separate the wheat from the chaff," he says. "In a world that changes every day, I try to distill things to their essence: What are the enduring qualities of Yahoo!, Amazon.com, and AOL -- the two or three factors that really matter to investors? And what other companies have those things?"

AOL, with 19 million paying customers and 1998 revenues of $3.8 billion, is undeniably a real business in a virtual world. But even with a market cap of $125 billion, Wall Street is saying that AOL is worth more than General Motors, Sears Roebuck, and Boeing combined. Does the new math of the Internet economy really compute?

For Reamer, the way to answer that question is to ask a related one: How much is a customer really worth? "The ultimate value of network effects comes down to the lifetime value of a customer," he explains. "Obviously, it takes a certain amount of money to acquire a customer. Then you spend a certain amount of money to service the customer. And, of course, you derive a certain amount of revenue from that customer. You hope that the revenue you get from 'monetizing' customers -- whether it's from subscription fees, or e-commerce, or advertising -- exceeds the cost of acquiring and servicing them." It sounds pretty simple. But the miracle of network effects -- what separates a company like AOL from companies like gm and Boeing -- is that all three elements of this value equation can improve at the same time. Forget the law of diminishing returns. AOL and other fast-growing Internet companies can operate under the principles of increasing returns.

Take customer acquisition. In the first quarter of fiscal 1998, when AOL had 9.8 million subscribers, the company was spending $3.91 per customer on marketing costs -- to retain its current members and attract new ones. By the first quarter of fiscal 1999, with 13.5 million members, the cost had dropped to $3 per person. By the third quarter, when the service had grown to 16.9 million members, AOL's marketing costs per member had fallen to $2.51. In other words, as AOL got bigger, it became cheaper, rather than more expensive, to get bigger still. Old-economy companies just don't work that way.

So why does AOL work that way? Reamer tells a simple story: "I have an institutional salesperson here on the New York sales desk who got off AOL because he basically outgrew it. In effect, he became a more advanced and sophisticated Internet user, so a year ago he dropped his account. But this Christmas, he told me he was back on AOL. Why? Because his daughter came home and said, 'All of my friends at school are on AOL. I want to get an AOL account and chat with them.' AOL didn't spend one dime to market to this nine-year-old girl. All the other nine-year-old girls who were in her class spent their precious time and energy convincing his daughter that she should be on AOL. That's network effects."