The making and bursting of the Internet bubble

Citation

Lam, P.-L. (2002), "The making and bursting of the Internet bubble", info, Vol. 4 No. 2. https://doi.org/10.1108/info.2002.27204bab.001

The making and bursting of the Internet bubble

Pun-Lee LamPun-Lee Lam is based at the Department of Business Studies, The Hong Kong Polytechnic University, Hong Kong, China.

Keywords: Internet, Communications, Convergence, Mergers, Stock markets

Abstract: The Internet bubble that formed at the turn of the century stimulated the prices of IT stocks to stupefying levels. Yet this trend ceased at a time that was more or less coincident with the announced merger of the world's largest Internet company, America Online (AOL), with Times Warner. Two months later, the Nasdaq stock market crashed. In the making and bursting of the Internet bubble, wealth was transferred from the old media to the new media, but the income-generating process remained unchanged. Today many countries are still fixing up the economic problems caused by Internet mania.

1. Introduction

The Internet bubble that formed at the turn of the century stimulated the stock prices of Internet and dotcom companies, traditional telecommunications and media companies, and even energy trading companies like Enron, to stupefying levels. The additional demand for computer equipment that was caused by the Y2K problem, expanding broadband trading, "endless demand" for bandwidth, mergers and acquisitions, and the auctioning of 3G licenses, provided abundant stimuli to the information technology (IT) industry. When the financial market became overdrawn in early 2000, the bubble finally burst.

Following the bursting of the bubble, the stock prices of IT and energy companies that were built upon "concepts" plummeted. In the last two years, the stock prices of many Internet and dotcom companies have dropped by more than 90 per cent. Investors have woken up, and they must now face the reality of holding depreciating assets. Financial analysts should reassess the "actual" earnings of Internet companies, not what they "promise" to deliver. Stockholders can no longer rely on the capital appreciation or the paper money that they enjoyed in the past.

This article focuses on two Internet companies, America Online (AOL) in the United States and Pacific Century CyberWorks (PCCW) in Hong Kong. The rise and fall of these two companies provide anecdotal evidence of the formation and bursting of the Internet bubble.

2. The digital revolution and promises of broadband

Over the past decade, technological development has brought about a convergence and global integration of the telecommunications, broadcasting, and information industries. New broadband technology has rendered the distinction between telecommunications and broadcasting services useless, and the term "multimedia" is in vogue (Blackman, 1996; Schiller, 1999). In the emerging broadband market, one can identify four sub-markets:

1. 1.

   content provision;

2. 2.

   service provision;

3. 3.

   infrastructure or distribution networks (the "fat pipes"); and

4. 4.

   consumer equipment (OFTEL, 1995; Higham and Lee, 1996).

The first level in the vertical chain covers the production and sale of programmes or content. It not only includes the creation of content, but also the process of obtaining content and decisions on making it available through service providers. At the second level, service providers acquire programmes, and package and present them to the final users. To perform their activities properly, service providers may be required to conduct market research to evaluate the potential audience for a programme.

The third level involves the transmission and distribution of programmes through traditional and new networks using different technologies, while the last level involves the equipment that is used for receiving telecommunications services and broadcast signals. The four sub-markets involve diversified activities that are horizontally and vertically inter-related.

In the traditional mode, telecommunications services are delivered through narrowband fixed-line or mobile networks, while broadcast signals are mainly delivered by terrestrial transmitters using the radio spectrum. The initial investment in distribution networks is substantial, and the frequencies that are available for programme distribution are scarce. Cable systems provide alternatives to terrestrial transmission, but they are usually localized. Another alternative transmission technology is the use of satellites, which transmit radio signals that are received by individual users directly when they are equipped with dish antennas, or through satellite master antenna televisions.

The development of digital signals in recent years has enabled the compression of a large volume of broadcast signals, and the provision of telecommunications services through the installation of cable modems. The new technology, including 3G technology, has allowed service providers to develop a whole range of innovative services (Cave, 1997). This development has blurred the boundary between broadcasting, telecommunications, and information services. To enjoy these entertainment and information services, users must be equipped with a set-top box or a handset to decode the digital signals. New technology can now allow two-way transmission for the provision of interactive services.

The process of convergence, the emergence of the Internet, and the development of digital broadband networks have stimulated the business community to formulate a new model to face new challenges. With the introduction of new media like the Internet, video-on-demand (VOD), digital television and broadband technology, consumers can now enjoy a multifarious and unscheduled choice of programmes. Telecommunications and cable operators have hybridized, and now provide both telecommunications and television services.

Many emerging Internet companies have seized the opportunities that are provided by the new technology to offer a wide variety of financial, recreational, educational, legal, medical, and other utility services. The use of the Internet has not only changed many traditional ways of doing business, but has also removed the boundaries between market segments and countries. Elusive concepts and ideas such as the global village, a cyber world, multimedia, the digital revolution, the information marketplace, and the like have become commonplace (Dertouzos, 1997).

In the broadband market, successful players deliver a combination of value-added products and services through high-quality and reliable distribution networks. They make the promise that their customers can enjoy one-shop service. To enhance their competitive positions in the information age, Internet companies form alliances with content or network providers. Mergers and acquisitions between players in different markets are inevitable.

3. Content or infrastructure?

In the global IT market, the development of infrastructure facilities and consumer equipment has been reserved for major multinationals like Intel, IBM, AT&T and Global Crossing. The required technology, the huge investment needed, product brands, and network effects have served as effective entry barriers to the business. In the service provision market, however, the initial investment is small, entry is fast, and the switching costs of customers are more or less zero. These conditions make the market very competitive, and the absence of any effective entry barrier has attracted a large number of companies.

As capitalization depends more on the number of users than potential profits, Internet companies must distinguish themselves from other competitors. Many have tried to link with strong content providers, while others place a greater emphasis on the bandwidths that they can provide to the customers. The debate on whether "content is the king" or "infrastructure is the key" has continued since the arrival of information age.

Strong alliances with content or infrastructure providers through mergers and acquisitions, with the promise of delivering various broadband services through integrated networks, stimulated the market capitalization of Internet companies to a stupefying level by early 2000. It has been argued that much of the capitalization of Internet companies was effectively Monopoly money (Curwen, 2000), which means that it was worth no more than the paper that it was written on.

However, this trend of asset inflation ceased at a time that was more or less coincident with the announced merger of the world's largest Internet company, America Online (AOL), with Times Warner on 10 January 2000. The merger between AOL, which was only 10 years old, and Time Warner was anticipated to be the first amongst many mergers of new media companies with traditional media giants. Exactly one month later, PCCW, an emerging Internet company in Hong Kong with a history of less than one year, announced a merger with the one hundred year old telephone incumbent, Cable & Wireless HKT (HKT). These two mergers were symbolized as a perfect union of the old and new economies that would give substance to virtual reality and provide Internet companies with real assets and concrete performance. Market analysts argued that the content and infrastructure of the old media would allow the new media to reach the global information marketplace.

The value of Time Warner to AOL was its content and cable infrastructure; and for PCCW, HKT's broadband telephone infrastructure allowed it easy access to every home and office. Indeed, the merger between AOL and Time’Warner has since shown how the new technology can combine traditional film and television production to create a new environment for entertainment and information delivery. It has been argued that the deal was significant because it ended the pretence of a long-lasting difference between the Internet and traditional media such as television.

The theory behind the AOL-Time Warner merger was that the Internet and the entertainment media would make a perfect marriage. The merger certainly illustrated how traditional content providers and Internet service providers could be restructured in the new digital economy to offer value the customers (The Economist, 7 October 2000). To that stage, Internet users had been spending more of their time searching for information about consumer products than on traditional media-industry products. Internet companies needed entertainment companies to enrich their content. On the other side, the merger with branded Internet companies allowed entertainment companies to reach new, distant, and scattered customers across different regions of the world. Mergers would allow users better access to traditional entertainment services through the Internet. Alliances with existing media conglomerates would further enhance the competitive position of branded Internet companies, making it more difficult for small independent companies to compete.

PCCW provided a similar rationale for its acquisition of HKT, which was a traditional telephone company with a large customer base that owned an extensive transmission network. The company had tried, with little success, to transform itself into a modern multimedia company that provided interactive services. In 1993, HKT became the first telephone company in the world to fully digitalize its networks, with all of its main lines connected to digital exchanges. In 1998, the company again became the first in the world to launch a commercial video-on-demand (VOD) service through its broadband service network. The company's broadband network had already reached 80 per cent of the households in Hong Kong. However, this pay-for-view service was not well received by the market, and service penetration was slow.

From the PCCW point of view, the merger with HKT promised to help expand the customer base for its Internet services, and accelerate the creation of platform independent bundled services that could be distributed across China, Asia, and the rest of the world. PCCW envisioned that as the bundling of services evolved, online entertainment and applications and broadband mobile communications would emerge as high-end proprietary products. Pure transmission companies would have to lower their costs or align with content suppliers to compete, and the strongest content brands would also need to gain access to multiple platforms. It was important for Internet companies to merge with those media companies that had leading and emerging information delivery platforms. The combination of platforms that were owned by HKT and the Internet business partners of PCCW, which included many content providers, would help the combined entity to achieve synergies and effectively pursue new business opportunities. The merger was considered to be Asia's answer to the challenge of broadband Internet (The Economist, 7 October 2000)

4. Old wine in a new bottle

In early 2000, many acquisitions in the IT industry received market responses which were similar to those that were evoked by AOL and PCCW. The stock prices of Internet companies that had yet to make any profit surged to unbelievable levels. However, unlike the wave of previous mergers between Internet companies (such as between AOL and Netscape) that stimulated stock prices to rise incessantly, this round of merger movement between the old and the new media precipitated stock price collapses. The financial market was overdrawn. Two months later, the Nasdaq index began a plunge from its historical high of above 5,000 to less than 2,000 within one year (see Figure 1). More than 70 per cent of the market capitalization of Internet and dotcom companies was written off. Some companies had even lost 99 per cent of their stock values from the peak levels. Today many countries are still fixing up the economic problems caused by Internet mania. Accounting malpractice and fraud have been found in the accounts of many fast-growing companies built upon Internet bubble.

Figure 1 ---Nasdaq Index, from January 1999 to January 2002

The fall in the prices of IT stocks was thought to reflect the bursting of the Internet bubble. The market became skeptical about what the Internet could deliver to shareholders in the long run. Soon after the PCCW-HKT merger concluded, many financial analysts re-evaluated the business value of the new company. They argued that its income would be derived from traditional telecommunications services, and its Internet business value was reduced to zero.

Similarly, when the AOL-Time Warner deal was close to being finalized, financial consultants warned that the Internet was a zero-revenue business for traditional media companies. The prospects of deriving income from subscription and advertising on the Internet were remote. The new company had to work out solutions to tackle the technical problem of distributing video through a broadband network, and also the problem of privacy in distributing music over the Web. Internet companies usually acquired media companies by new shares whose prices had been falling continuously since early 2000. With all the bad news, some consultants began to urge the shareholders of media companies to block the sale of their companies, and not to exchange their shares with worthless Internet shares. By the end of 2001, the market capitalization of the two mergers dropped by 80-90 per cent.

What is the future direction of these emerging and once rapidly growing Internet companies? Some market analysts have argued that Internet companies should avoid trespassing on the terrain of traditional media to ensure that it maintains its uniqueness and market capitalization. At the same time, we have heard the counter-argument that the merger of the new media with the old is a necessary step towards the realization of a global information marketplace. In that sense, the bid for Time Warner by AOL, and HKT by PCCW, can be regarded as a major step on the road to the delivery of multimedia services. If this is the case, then the decision to merge with the income-generating old media can be interpreted as a wise move to enhance the wealth of both traditional and new media businesses.

The AOL-Time Warner and PCCW-HKT mergers bear much resemblance. The acquirers in both cases were emergent Internet companies that had yet to generate real profits. The market capitalization of both AOL and PCCW was effectively Monopoly money, in the sense that it was worth little more than the paper that it was written on. Merging with traditional media allowed the acquirers to turn their Monopoly money into real money. The two mergers were intended to achieve synergies and "vertical value-chain convergence", but the reality is that share prices and market values of both companies dropped precipitously thereafter (see Figures 2 and 3). The share prices of the two new companies have since returned to the pre-merger levels of several years ago. Because of the huge increases in "goodwill" in the mergers and the subsequent write-offs as share prices fell, both companies have experienced record losses. PCCW-HKT had to write off US$20 billion and AOL-Warner had to write off US$60 billion for the 2000 and 2001 financial years (see Annual report of PCCW-HKT, 2000 and South China Morning Post, 9 January 2002).

Figure 2 Stock prices of AOL before merger and AOL-Warner after merger

Figure 3 Stock prices of PCCW before merger and PCCW-HKT after merger

However, there is one major difference between the two. AOL launched an all-paper bid for a debt-ridden old media company, Time Warner, by issuing new shares. In contrast, PCCW borrowed a huge amount of cash to acquire HKT, because the majority shareholder, Cable & Wireless, was desperately looking for cash. Consequently, the new company was, and remains, debt-ridden. The huge interest expenses imply that the company will not pay dividends to its shareholders for many years to come.

Ironically, both AOL and PCCW, which were once fast-growing Internet companies, are now relying on the sale of traditional entertainment and telephone services to maintain viability. In the making and bursting of the Internet bubble, wealth transferred from the old media to the new media, but the income-generating process remained unchanged. In retrospect, the Internet bubble was a New Economy nostrum. Internet technology has added little value, and has only changed the way that businesses conduct their activities.

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