The Internet: It's classic economics

Yahoo! deal reveals a consolidating market -- but merger window may be closing.

The consolidation sweeping the Internet sector offers a textbook example of business-school theory.

As any new industry establishes itself, this theory goes, it will move through several stages. First, many industry players will emerge. Second, a group of leaders will start to stand out from the pack. Third, these leaders will then move to cement their positions through acquisitions and consolidation, resulting in a divergence between the stronger and the weaker players. And eventually, a new group of more specialized, niche-oriented companies will emerge to coexist with the leaders.

Right now, analysts said, the Internet industry is clearly in the third stage -- consolidation -- as the leading companies in the sector solidify their positions by buying other leading companies.

"This is classic business school," said William Blair analyst Abhishek Gami. "It's a tried-and-true blueprint for any emerging industry."

Shares as currency
Yahoo! Inc.'s (Nasdaq:YHOO) planned purchase of Inc. (Nasdaq:BCST), which was announced Thursday, is simply the latest in a series of merger agreements to sweep the Internet sector in recent months.

Other deals include America Online Inc.'s (NYSE:AOL) recent purchase of Netscape Communications Corp., At Home Corp.'s (Nasdaq:ATHM) pending acquisition of Excite Inc., (Nasdaq:XCIT) and Yahoo!'s existing agreement to buy Geocities (Nasdaq:GCTY).

The leading Internet companies -- which have been richly rewarded by Wall Street -- are using their highly valued shares as currency to make acquisitions through stock swaps. That has led to speculation about which companies will be the next to make purchases and which will be the next to be bought.

For the time being, the portal companies appear to be doing most of the buying, said Jefferies & Co. analyst Bruce Smith. Although AOL and Yahoo! have been in the lead so far, Smith believes the company that will be formed through the merger of @Home and Excite could also be very active in making acquisitions. "The portals will become the superbrands," he said.

As for which companies will be bought, Gami believes that just about "anyone in the Internet space" other than AOL itself is a potential target.

The deal between Yahoo! and has focused attention on companies that provide technology or services to deliver streaming audio and video over the Internet -- is a leader in this market -- and pushed shares of those companies higher.

Gami said he believes many of the acquisitions taking place in the Internet sector right now are notable since they involve purchases of companies with "significant brands and assets that cannot be duplicated easily," such as, Excite and Netscape.

With the acquisitions of all of these companies, he said, "a significant asset just got taken off the table." Gami added that this was not true of many of the deals that took place in the sector several years ago.

The clock is ticking
But according to BancBoston Robertson Stephens & Co. analyst Keith Benjamin, Internet companies that want to make acquisitions need to move quickly to do stock swaps.

"They want to take advantage of their inflated currencies to do deals," Benjamin said, "before people wake up to the fact that there is no way to justify some of these valuations."

Benjamin said, however, that some Internet companies with inflated stock prices could ultimately grow into their valuations if they can generate "real revenue and real earnings" -- something that the mergers currently being negotiated could make possible.

But the same voracious appetite for Web stocks that has given many leading players the currency to do deals is also fueling a glut of initial public offerings in the Internet sector as private companies try to capitalize on the exuberant sentiment.

It is some of the companies behind these IPOs, Gami said, that will emerge as the more specialized, niche-oriented companies expected as the Internet industry matures.

But in the end, some warned, the wave of IPOs could help deflate the broader market for Internet stocks if enough new supply hits the sector.

And once the market for Internet stocks cools off, Benjamin said, the next wave of acquisitions could be cash purchases of private companies that never made it out to the public market.


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