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Gorillas or kings?
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July 23, 1998: 11:24 a.m. ET
Why Internet service companies' valuations may not be justified
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SAN FRANCISCO (The Red Herring) - In high technology there are two kinds of market leaders. I call them "gorillas" and "kings." Service companies, for the most part, are only kings--particularly Internet service companies like America Online and Yahoo, despite their current (and perhaps ephemeral) strangleholds on their markets.
Both companies' stock values make them look as powerful as gorillas. They're not. To be sure, both AOL's (AOL) and (YHOO) Yahoo's revenues are so modest that their valuations are exceptional. But the question remains, How sustainable are these companies' competitive advantages, and how much future profit can investors project for the companies' current business?
When market capitalizations rise, it is a sure sign that companies are expanding their market power. But it behooves the tech investor to look carefully at the underpinnings of this growth. Market share may ultimately be the most helpful clue, but it's not everything. Consider the differences between gorillas and kings: Gorillas are product-based companies in hypergrowth markets that impose proprietary architectures on their customers and partners and, therefore, exact high switching costs. If the market forms its standards around their architectures, gorillas gain enormous power, which translates into the extraordinary market caps enjoyed by the likes of Microsoft (MSFT) and Cisco Systems (CSCO), whose valuations have recently been as high as 18 times their revenues.
Kings also enjoy market-share leadership in hypergrowth markets, but, unlike gorillas, they lack the leverage of proprietary architectural control. Examples of kings include 3Com (COMS), with network interface cards; Seagate Technology (SEG), with disk drives; and Compaq Computer (CPQ), with PCs. While kings typically offer the best products in their categories, their market caps eventually settle at just two or three times revenues.
Although Yahoo and AOL have no proprietary architectural advantage, they do enjoy wonderful brands. But does that justify their valuations? Probably not. At the peak of a brand's power, brand-based switching costs are every bit as high as architecture-based ones. But a brand can deteriorate. The advantage of a blocked exit route, which gives gorillas longevity, is not shared by kings.
Wall Street has yet to factor the possibility of rapid brand deterioration into Yahoo's and AOL's valuations. Though near-term valuations seem to be rooted in a sky's-the-limit ideology -- and, at the moment, the companies do deserve a big run-up -- they signify added responsibility for investors to monitor brand health and be prepared to exit quickly should it falter. 
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