The Rise and Fall of the Dotcom Bubble - Case Study Example

appears here] appears here] appears here] appears here] The Rise and Fall of the Dot.com Bubble What was to ultimately turned out to be known as ‘The Internet’ was developed in the 1960s through funding by the US military so as to discover a means of making possible communication in the event of nuclear conflict 1. Until the beginning of 1990s, though, the Internet was the sphere of influence of academics as well as researchers as commercial use was proscribed. 2A process of commercialization began in the late 1980s and the wider use this encouraged was to be given an additional heightening with the emergence of the World Wide Web in the beginning of 1990s. The progress of browsers in the early 1990s which facilitated web pages to be viewed in a graphical format in color after that brought the benefits of the Internet to a wider community. 3The World Wide Web was to develop at an exponential rate together in terms of the number of websites as well as users as shown in Figures 1. This changed some in the business community to its potential as a means of communication also as a sales and marketing channel. 4 Thus the notion of the “New Economy” has been hit hard since the “dot.com” bubble burst in early 2000. NASDAQ, the high-tech stock index, shortly after soaring to slightly over 5,000 in the first quarter of 2000, dropped precipitously in the second and the third quarters of 2000, continuing its downward trend through 2002 to roughly one-fifth its peak value. 5But the problem ran deeper than the failure of most dot.coms to make a profit. The hype around the Internet during the late 1990s included a widely accepted statistic that Internet traffic was doubling every three months. Analysts estimate that Internet traffic actually grew at a rate closer to 100 percent a year. (Marc J. Epstein, 2004) This is still hefty by most standards, but nowhere near the volume that led more than a dozen companies to build expensive fiber-optic networks, most of which remain unused. 6Millions of miles of fiber-optic lines were buried beneath streets and oceans, but only an estimated 2.7 percent of this capacity is actually being used. Much of the remaining fiber could lie dormant forever. Meanwhile, the resulting fiber glut caused bandwidth prices to plummet by an average of 65 percent, forcing most of the long-haul data-transmission companies to file for bankruptcy protection Hence two major areas of technological innovation, the Internet and advanced telecommunications hailed as ushering in a new Industrial Revolution, and indeed did help fuel the remarkable economic boom of the late 1990s in the end seemed to be instrumental in triggering a recession and one of the worst stock market crashes in Wall Street history. 7This clearly is a case of technological advance getting ahead of the marketplace; earlier examples include computer microprocessors outpacing the demand for computing power and agricultural advances driving down farmers’ pricing power. 8But it also illustrates how even the most conservative and savvy investors can confuse hype with reality in the face of seemingly ground-breaking technological innovations with huge economic potential. (Robert Hargrove, 2001) Not everyone has bought into the notion of a “New Economy,” and many critics undoubtedly feel vindicated by the collapse of the dot.com-telecom speculative bubble. Some academics, such as Northwestern University economist Robert J. Gordon (2000, 2002), challenge the contention that the Internet/information technology revolution is as historically significant as the nineteenth-century Industrial Revolution, which profoundly altered the material basis of our economy and society. 9Gordon further argues that the economic growth ostensibly generated by the advent of the Internet, underlying what became known as the “New Economy,” does not measure up to the so-called Second Industrial Revolution associated with the “great inventions” of the late nineteenth and early twentieth centuries. (Joseph A. Divanna, 2002) During the late 1990s, continuously rising prices of high-tech stocks created euphoric conditions, as more and more investors rushed into these stocks in anticipation of large capital gains. 10Once shareholders became drawn to stocks because everyone else was buying, realistic valuations of stocks based on their earnings potential got crowded out by what Greenspan characterized in 1996 as ‘irrational exuberance’11. This kind of bull market is typically fuelled by cheap money and lots of debt. 12The low interest policy pursued by the Fed in the wake of the Asian crisis in 1997–99 induced many investors to take out broker loans 13 for additional stock purchases. With shares serving as collateral for those loans, rising stock prices enhanced the borrowing capacity of investors and so became a funding machine for the bull market. In addition, many firms took out a lot of debt to buy back their shares and so counter the dilution of stock ownership brought about by the extensive use of stock options as a new form of employee compensation. It is this interaction between debt and asset inflation which turns a reasonably bullish stock market into a speculative bubble. Such a bubble is, however, unsustainable. It will burst when the rosy expectations about future profits underlying those sky-high stock-market valuations turn out to have been unrealistic. 14As market sentiments shift and disappointed investors try to cash in their capital gains, selling waves ensue to push stock prices rapidly lower. Pressured by high levels of indebtedness in the face of declining asset values and mounting capital losses, investors rush to liquidate their assets. 15Greed turns into fear, even panic. Precisely such a panic began to unfold in March 2000, causing internet stocks to tumble and pulling the NASDAQ over 60 percent lower16. As we know there were always strong business ground rules that would show the way to the ultimate downfall of many of the dot coms. 17From a crest of 5000 reached in the beginning of 2000 the NASDAQ, where the majority of the dot coms were listed, drop down as pointed up in Figure 2. (Journal of Accountancy, 1998) The most evident cause for that turn of fortune was a slowing US economy, cooled off by six consecutive interest-rate hikes from the Fed. 18Why did Greenspan squeeze us so hard? What prompted the Chairman of the Fed to hit the brakes was the prospect of an overheating economy triggering a bout of renewed inflation. He was particularly concerned with increases in spending brought about by large capital gains in the stock market. As this source of income grew amidst one of historys greatest bull markets, consumers began to feel richer and spend correspondingly more while saving less. 19The steady decline of Americas savings rate, becoming negative in 1998 among the richest 20 percent of Americans typically holding a lot of equity shares in their portfolios, illustrated the force of this wealth effect. 20As this boost to aggregate demand accelerated in 1999 and early 2000, Greenspan came to view the booming stock market with rising apprehension. He worried that the spectacular capital gains in the wake of NASDAQs meteoric rise would prompt further spending increases before supply capacity had a chance to catch up. So he decided to tighten monetary policy as a preemptive strike against such a scenario of an overheating economy. His interest hikes did pierce the stock-market bubble by impairing the future earnings potential of firms in the face of higher debt servicing costs, reducing the present value of future earnings and making it more expensive to borrow for stock purchases. As the Feds tightening moves began to bite, the New Economy suddenly revealed itself as vulnerable. With every passing day it became clearer that the expected profit explosion among dot-com firms was far from being realized. On the contrary, most internet-based firms continued to operate in the red, even those showing rapid growth in sales revenues. Somehow, investors began to realize, the internet might not be such an easy place to make a profit. If that suspicion proved true, then the sky-high valuations of dot-com firms or their suppliers could no longer be justified. 21As the doubts intensified in the spring of 2000, the flight of capital out of internet stocks gained force. Within a year those stocks had lost over 90 percent of their peak value, and thousands of dot-com firms faced annihilation. (Shelley C. Rhoades-Catanach, 2003) The crash of 2000–01 was inevitable. Every speculative bubble, driving itself in a self-feeding frenzy to the point of unsustainable overextension, bursts with a bang. But this particular bubble had its own unique engine, an unprecedented marriage between finance and industry bringing together high-risk investors and high-tech entrepreneurs. 22For the first time in the history of capitalism we had created a fast-speed industry, the internet sector, which matched the preferences of financial investors for rapid change and short payoff periods. The amount of capital mobilized in the direction of the internet allowed this new growth sector to expand with breathtaking speed, far beyond the level of sustainability based on effective demand. 23What Greenspan perhaps underestimated was a different kind of wealth effect, the one driving up business spending to the point where supply outpaces demand. Such a deflationary situation is actually more dangerous than the much-feared inflationary wealth effect of overheating demand. Japans lost decade serves in this regard as a serious warning. It should be clear by now that the explosive birth of the internet ended in a classic overproduction crisis. The initial burst created simply too many dot-com firms, all experimenting with unproven business models and chasing the relatively few customers ready to conduct transactions online. 24Demand for paid internet services has grown much less rapidly than anticipated even just three years ago, causing the excess supply imbalance underlying the collapse of NASDAQ. The brutal shake-out now under way in the high-tech sector puts into question the future viability of the New Economy. Unfortunately, this problem may not be just cyclical in nature, but reveal itself as a structural problem of longer duration. To begin with, the internet was from the very beginning designed as an open network with practically free access, as a public good offering such enormous social benefits that you would a priori not want to exclude anyone from having access to it. Its essential benefits, as a medium of information and means of communication, were available for free and thus difficult to fit into the confines of commercial exploitation for profit. Yes, the multi-layered infrastructure of the internet proved flexible enough to direct e-commerce traffic through an encrypted high-security layer specially designed for online transactions, but that addition did not make the task of charging for services on the internet any easier. In the absence of profitable cost-plus pricing, internet-based firms tried to generate other revenue streams from advertising, sales of information about customer profiles and membership fees. But none of these alternatives generated sufficient revenues fast enough to warrant sky-high stock-market valuations. Even under the best of circumstances it will prove intrinsically difficult for dot-com firms to earn a profit online in a sustainable fashion. The internet, as currently constituted, deprives businesses of many of the usual advantages which had previously allowed them to earn a bigger profit: ▪For one, businesses lose a large degree of monopoly power when going online. In the old world of brick-and-mortar stores, barriers to entry for newcomers were quite high compared to the low start-up costs on the internet which encourage a lot more competition. 25Whereas in the Old Economy consumers typically chose among a handful of local suppliers for most of their goods or services, no such geographic limitation exists on the internet where consumers can easily shop anywhere. The internet turns neighborhood oligopolies into globally integrated markets where every supplier is forced to compete with the worlds best. (Jana Matthews, Jeff Dennis, Peter Economy, 2003) To the extent that the internet yields globally integrated markets, it makes it much more difficult for businesses to charge different prices in various regional market segments, depending on what the local market will bear. 26There will instead be a price-leveling effect of enhanced competition, forcing price uniformity towards the lowest possible level. In addition, businesses lose the benefit of asymmetric information when operating on the internet. Whereas before potential buyers had only limited knowledge about products and prices, specialized web sites allow any customer nowadays to compare both in an instant for the best possible deal. No longer can customer ignorance be used as a source of easy profits. Another change in power relations to the detriment of profit stems from the flexibility which the internet affords buyers wishing to control how they compose desired services. 27The net enables consumers to unbundled service packages into separate components and then pick the best combination of those among a variety of online suppliers. This ability deprives businesses of tie-ins through which they forced consumers in the real world to acquire less-desired products whenever buying most-desired goods or services, in many instances a significant source of their profits. (Anne Colamosca, Brent Cunningham, 2002) The internet makes it easy for individual agents to group together, whether as buyers or suppliers, and so change the dynamic of the marketplace to their advantage. 28Depending on the precise constellation emerging from the centralization of bargaining power, one group of actors might squeeze the other side of the exchange transaction. This issue may arise especially in the B2B commodity exchanges where large corporations, working together, use their collective market power to impose price discounts on more fragmented and smaller suppliers forced to bid against each other for business. In light of these online constraints on profits, investors saw their hopes for a profit explosion from e-commerce dashed and the bears chasing the bulls out of the stock market. 29The first phase in the life cycle of the New Economy has now ended with a bang, forcing a painful reassessment of what works and what does not work in e-commerce. The crisis of 2000–01 has cooled investor and consumer enthusiasm for the commercial viability of the internet, and this profound change in sentiment has created a much more difficult environment for all but a handful of dot-com firms. 30There have already been spectacular failures of once promising e-commerce firms, such as pets.com, toys.com, Webvan, and kozmo.com. Even dotcom giants, such as Amazon.com or Yahoo!, are reeling from heavy losses and failed revenue models. 31All internet-based firms focusing on e-commerce have seen a massive reduction of their capitalization base thanks to collapsing stock prices, making it much more difficult to sustain ongoing operating losses for longer periods of time as is still the case with many dot-com firms. 32The crisis has spread to the computer industry which is suffering from a slowdown in sales amidst sharp cuts in IT investments by the business sector. 33Even worse hit have been the telecommunication firms, many of which took on billions in debt to build very expensive, but barely utilized fiber-optics networks or wireless data-transmission capacity for cell phones. 34As fast as it arose in the 1990s, the internet seems to have imploded with even greater speed in the early 2000s. (Sam Nataraj, Jim Lee, 2002) Conclusion The bursting of the dot.com bubble does not mean the internet revolution is over. This bubble is just one in a long series of similar bubbles that accompany waves of technological innovation. In every case, the bubble collapsed, but the innovation continued. In the 1800s, successive stock market bubbles arose with the building of canals, railways, telegraph systems and electricity companies. 35In the 1920s, the new car industry temporarily drove share prices to irrational heights the share price of General Motors climbed to an all-time peak in 1928 and then fell by 80pc within a few months. A few years later, the share price of the Radio Corporation of America followed a rising and falling trajectory remarkably similar to that of, say, Amazon or Yahoo over the last year or so. In the 1960s, investors focused on electronics and computer shares. 36By 1968, technology price-to earnings ratios were over three times higher than the long-run average. A severe downward correction in share price followed soon after. Although all these bubbles collapsed, the underlying technologies generated successful new industries. Logic also suggests the internet revolution will continue. The technology underlying the internet 37 was invented in the mid-1960s, but couldnt take off until the economics were favorable. 38In the 1960s, the processing power and bandwidth needed were too expensive. Moores Law has hit this problem, cutting the cost of processing power in half every 18 months. Bandwidth and memory costs have fallen even faster. Subsequent internet use has grown exponentially and, because the underlying processing, memory and bandwidth technologies continue to advance, we can expect high rates of growth to continue. The implications for most businesses are enormous because quite soon most businesses will use the internet as another sales and marketing channel. 39Employees will access HR services online, more staff will work part-time and from home and buying and co-ordination of suppliers will all happen online. Of course, believers in the "new economy" of the internet thought it would change the world. The result was a rush to market with untested business models. Valuations were based not on the old-fashioned principles of discounted cash flows and rational price-earnings ratios but on loose parameters, such as the number of customers attracted to a website. With valuations being driven by the number of customers rather than profitability, the outcome was predictable: large amounts of investor money thrown at marketing and low prices. When sanity returned, many internet start-ups had spent their capital but, lacking any evidence of profits, they were unable to raise further funds. Early internet evangelists believed that new players would sweep away the old. In fact, the old players turn out to have huge advantages in the internet world. The grocery sector is a prime example of the advantages of incumbent players. Perhaps the highest profile Internet grocery retailer is the US start-up Webvan. The company promised to revolutionize the grocery business, and it built a large and expensive infrastructure to bring this about. However, groceries are low margin products, and profits depend on the rapid achievement of high volumes. Unfortunately, customers have been slow to change their buying habits and have placed relatively small orders. Before the dot.com boom, venture capitalists expected to take three to five years to build a start-up. But in the heat of the internet bubble, the mantra was "first to market". 40The early gains achieved by VCs were huge, attracting yet more venture capital. The predictable result has been a large number of poor investments, negative VC returns in the last quarter of 2000 and imminent returns now expected to be the worst in more than 30 years. 41Yet VCs and business angels are still investing in internet start-ups. They are, however, very selective and no longer expect to achieve a profitable exit quickly. Factors that make for a successful start-up THE key factors in the success of an internet start-up are no different from those of any other start-up: 42The market size of the venture must be large enough to justify the risk of investment; It must be possible to develop the business without having to reinvent it over and over; It must be easy to understand why customers would welcome the product or service; In general, revenue from online advertising or subscriptions is not credible - revenue based on transactions is to be preferred; 43The cost of acquiring a customer must be recovered reasonably quickly; A good idea is unlikely to generate profits if it can be easily and quickly imitated; And the number-one factor is the management, which must have relevant domain expertise, a balanced mix of skills and, ideally, a track record in startups. Reference: Reference: Anne Colamosca, Brent Cunningham, 2002. Dot-Com Dreams, Dot-Com Doubts; Columbia Journalism Review, Vol. 39, July Jana Matthews, Jeff Dennis, Peter Economy, 2003. Lessons from the Edge: Survival Skills for Starting and Growing a Company; Oxford University Press Joseph A. Divanna, 2002. Redefining Financial Services: The New Renaissance in Value Propositions; Palgrave Journal of Accountancy, 1998. “Dot Com” Monopoly to End; Vol. 185 Marc J. Epstein, 2004. Implementing E-Commerce Strategies: A Guide to Corporate Success after the Dot.Com Bust; Praeger Robert Hargrove, 2001. E-Leader: Reinventing Leadership in a Connected Economy; Perseus Pub. Sam Nataraj, Jim Lee, 2002. Dot-Com Companies: Are They All Hype? SAM Advanced Management Journal, Vol. 67 Shelley C. Rhoades-Catanach, 2003. Dot.com or Dot.bomb? The Unpleasant Tax Surprise of Stock Options in a Volatile Market; Issues in Accounting Education, Vol. 18 http://www.dejavu.org Read More