Investment Overview, 11 June 1999

The week began with the news that Dixons is to float a minority interest in Freeserve and has appointed a syndicate to handle the offering, although full details have yet to be announced.

The syndicate is believed to include Dresdner Klienwort Benson, ING Barings, Merrill Lynch, Schroders, CSFB and Cazenove. The predictable news follows the appointment in April of Credit Suisse First Boston and Cazenove & Co. to "explore the strategic alternatives available to enable Freeserve to realise its full potential and to optimise value for Dixons Group shareholders". As soon as the announcement was made in April, the market knew that the logical result would be a flotation. At the very least, the type of investors in Dixons and Freeserve are likely to be very different. The questions that remain to be answered are how much of the company will be floated, and where the listing will take place.

It is clear that the service cannot be floated on the London Stock Exchange, as a company must have three years of trading history to qualify for the market. While it is possible that these rules might be relaxed in the future, that certainly won't happen in time for Freeserve. It is also highly unlikely that Dixon's would dream of listing the Freeserve shares on AIM, as that market still does not have the visibility that such as listing would require. There is a chance that the listing could take place in Europe, in order to raise the visibility of the service in that marketplace. However, the most likely target for the listing seems to be Nasdaq. Some have expressed regret that the first major retail brand created by the UK internet industry should need to list in the US but it is more positive to view such a move as proof that UK creations can compete in a international market as a global brand.

There is still a major issue to be resolved as to how the company should be valued. It is clear, having plumped for the flotation option, that Dixons is confident of a good valuation. Yet valuations of the service have ranged from around 500m to 2bn. At high points of the market earlier this year, figures of around 4bn were being bandied about. The differences in valuation highlight the enormous difficulties of valuing such a young company in such a rapidly evolving market. While it has a large user base, there is still little, if any, information on what its e-commerce revenues are. The service is part ISP, part e-commerce site, part content provider. The models used in the US for such types of company are different, and the pace of change in the UK market may well make some part of the existing model obsolete.

No one could dispute that Freeserve, although not the first of the free ISPs, was responsible for a major change in the marketplace. Non subscription access is now fairly standard. The last week alone has seen the launch of Dellnet, TheMutual, ICLNet and FreeBeeb (from the commercial arm of the BBC). The market, and the concept of the free subscription model, do not stay still. Dell is launching as a pan-European ISP that has just rolled out in the UK. Germany and France are to follow shortly with other European countries to receive service within the year. Not only will the software be pre-installed in Dell PCs, but non-Dell users will be able to sign up to the service by accessing the DellNet Web site.

Rumour has it (from industry insiders and, far more interestingly, a UK MP) that BT is to provide a straightforward unlimited access offering when it launches ADSL in the Autumn. There must still be a question as to whether the existing free access model can survive as it is. Freeserve has a large number of users and it offers strong content, as well as a developing range of additional services. Yet the model of the free ISP might prove difficult to defend in the long run, as any new entrant can offer a cheaper service, and it is difficult to ensure loyalty when competing on price and commoditised services. It has become fairly commonly accepted that the subcription model will need to rely on the quality and bandwidth of access.

The BT ADSL offering, even with unlimited access, will still retail at 30 per month (or 360 per year). This is obviously not an entry level product, and will appeal to those who are prepared to pay for fast, reliable, fat pipe access. The appeal of the subscription model is that it appeals to the first time, or new, user. And, equally obviously, the offering would be much more appealing if the local call charges were free. One of the questions that must be asked is how strong Freeserve's model becomes if the defacto home use standard (during off-peak periods) becomes access through an 0800 number.

This is an evolution of the model which could be a requirement if the UK's internet industry (and indeed the European one as well) is to accelerate its growth curve. There is a great deal of debate about whether or not this can ever happen. Last weekend's European internet strike was reported to be a success, while the UK reported that traffic was up. A large part of the reason for this is that the UK is inundated with free services, so users no longer have to pay a subscription fee on top of their call charges.

But there is more to what is happening in the market at the moment than simply a question of free local calls. Agreeing something like that across the European market looks fraught with difficulty, even if it were possible. Even in the UK, with BT operating the majority of the nationwide network, putting a system in place which operates on this level looks very complicated. But the free ISPs are creating ever more innovative ways to encourage users to log on to their services, without necessarily having to resort to using free call access. The latest of these is TheMutual. This is a free ISP with a difference, using the old co-operative society or mutual model to ensure the loyalty of its user base.

The company has launched its site offering pre-registration for its service, and the site is due to go live in mid-July. The difference is that TheMutual is to offer 50% of the company to its customers, in the form of 2.1bn units. The first 10,000 customers to pre-register and sign up to the service when it goes live, will receive 10,000 units. The next 500,000 will receive 1,000. Each of these units will be automatically transformed into shares at the point of the company's flotation or sale (or at the discretion of the directors). It doesn't end there however. The next 1m customers will be allocated 500 units and so on, until all 2.1bn units are allocated. Those users who recommend friends and family to the service will receive 10 bonus units for each introduction. The company hopes to recruit 100,000 customers by its launch date and the idea of giving them ownership of the company in this way suggests that they may well succeed.

There is an attitude in the market at present that the momentum towards permission marketing and loyalty drives is accelerating. When much of the press reports the enormous gains from internet business, TheMutual is offering users a chance to be a part of that. For every moment they use the service, they will be adding value to something which they own (in however small a part). With an opportunities like that, if successful it seems likely that further moves of this sort will be made. If that is the case, it remains to be seen how the straightforward free access model can survive. There are suggestions that Freeserve may use its own finance channel to allow its users to buy into the public share offering. Its possible that this may not prove enough. Freeserve has a huge advantage from being the first mass market player in the UK but it still has a lot to prove. If its flotation valuation is in the realm of 2bn, the service must look to Europe and beyond, while evolving its model in order to survive. The internet has proved a roller-coaster ride for investors to date, and it looks set to continue that way for quite some time to come, and investors in the internet market will need to have strong nerves to survive.