The internet as we know it today has evolved in a number of important ways since its growth spurt in the late 90’s. Most notably, the increased availability and adoption of broadband technology provides users with a much faster and more efficient internet experience. And as web surfers continue accessing YouTube and other online video content in droves, the demand for even more bandwidth will continue to rise.

Versatile and powerful infrastructure is needed to support the skyrocketing demand for bandwidth, and this is where we’ve found compelling investment opportunities. Rest assured, we’re not talking about a market environment even remotely similar to that in the late 90’s, when any company with a .com in its name was considered a sure thing. Instead, we believe that a number of converging factors bode well for companies that focus on building, improving and supporting the infrastructure of the internet.

Digital Media’s Appetite for Bandwidth
Research firm eMarketer Inc. estimates that 123 million Americans will view online video at least once a month in 2007. This should come as no surprise when considering that in 2006, YouTube used as much bandwidth as the entire internet in 2000. Much of this demand is being driven by extremely tech-savvy teens and young adults who now regard the internet as an indispensable part of their everyday lives.

According to a recent consumer study, three in four Americans between the ages of 12-24 have viewed digital video content online. This audience is extremely coveted by advertisers, and we expect to see continued growth in video offerings to appeal to this demographic. Until recently, user-created videos have been the primary driver of growth in the segment, but the undeniable popularity of web video has also caught the attention of traditional content providers such as television networks and movie studios. As the demand and diversity of online video content continues to grow, so too will the need for a faster and more efficient internet infrastructure. This has been evidenced more recently by the billions of dollars being spent by giant telecommunication companies to upgrade their networks, which already carry much of the world’s internet traffic.

OpCap’s Investment Thesis: A New Phase Is Underway
The internet is only about 15 years old, yet it has dramatically impacted the way we live, think and behave. The tech bubble created awareness of the internet’s potential, not to mention a fever of investment activity. Initially, consumers used the internet for online shopping, news distribution, and social interaction, to name a few. But the majority of the companies that helped drive the early growth began to collapse as it became clear that many of the .com companies were not sustainable business models. And this discovery came at investors’ expense.

The access to capital and investor interest for companies with .com in their names rapidly dried up, as did the market environment for anything technology-related. Yet it was this overswing of the pendulum that created many attractive acquisition opportunities for far-sighted companies.

Today, the internet serves not only as a web-surfing tool and shopping mechanism for consumers, but as a delivery network for the digital media that powers many of the world’s largest industries, as well as the engine behind more efficient and distributed business processes. As global bandwidth demand keeps increasing, we will acknowledge all too soon that the existing infrastructure is finite. And without spending to both maintain and advance the existing infrastructure, the internet could very quickly become capacity-constrained and unable to handle the demands of consumers and enterprises.

Our research indicates that the companies that own, operate, and innovate strategically-valuable assets have an inside track to lead this new phase of growth, as vast numbers of people around the world increasingly rely on the internet everyday.

Visualizing the Internet Infrastructure
The diagram at right depicts the many components of the internet infrastructure that provide bandwidth and related services to consumers and corporate users. There are several compelling market segments we’ve uncovered in our research, including:

Corporate bandwidth providers: By being wired into central business district (CBD) buildings and corporate data centers where huge traffic flows originate, companies that provide broadband access to the corporate market occupy the internet’s high-value real estate and have competitive advantages in capturing corporate tenants. Other attractive markets for bandwidth providers include data centers and co-location facilities, universities, and software application service providers (ASPs).

Corporate data centers: Many large corporations have realized that IT infrastructure is not their core competency and as the demands on their infrastructure continue to expand, they are becoming space-constrained and have insufficient resources to handle their own technological needs. As a result, corporations are outsourcing an array of services to dedicated data center providers. In addition to the basic services of bandwidth access and collocation, data center providers are generating incremental revenue through expanded managed services such as hosting, storage and security.

Infrastructure management software: As infrastructure needs increase and the number of servers, and storage and networking devices expands, Enterprise customers are being overwhelmed. Software companies compete in this space to offer solutions for server automation, enhanced system performance, and optimized network configuration. The market for packaged software programs designed to manage enterprise systems and internet infrastructure is expected to exceed $12 billion by 2010.¹

Digital media hardware: The digital media revolution is pressuring the internet’s hardware infrastructure to move far denser and greater volumes of traffic faster, more efficiently and securely. Several small-cap companies, in particular, have specialized in developing network-enhancing intellectual property and products. These products optimize efficiency of internet traffic routing to ensure the delivery of data with little or no information loss.

A Growing Dependence on Innovation
The faster digital media and content delivery companies grow, the more they will become dependent upon the internet’s infrastructure. As a result, internet infrastructure is likely to keep growing at a breathtaking pace just to keep pace with the spike in bandwidth demand (see chart at bottom of page 2). The internet also must continue to reinvent itself with innovations, because more and more speed, reliability and data integrity will be required. After all, even a few seconds of data loss can make watching a digital video or holding an internet phone conversation frustrating. Data file sizes are expanding exponentially. Therefore, sufficient bandwidth is required not only to handle the accelerated pace at which online video demand is growing, but also to ensure uninterrupted service, at times for hours on end.

Our fundamental analysis has uncovered the earnings growth potential of companies being underestimated by the market that own and/or are upgrading valuable infrastructure assets. There is a wide array of business models that are particularly interesting, including those companies that acquired assets in the aftermath of the tech bubble collapse, and/or companies with business models anchored in strategic hardware, software or networking niches. As corporate dependence on the internet increases and as digital media flourishes, we fully expect the conventional perception of internet infrastructure to change.

Market Perception vs. Research Perspective
Why are internet infrastructure stocks sometimes misunderstood? Here are two examples of what our analysis has uncovered:

1. New pricing power: In the early 2000s, the vastly overbuilt capacity put infrastructure suppliers at a pricing disadvantage. In a buyer’s market, large customers were able to lock in low-rate, multi-year contracts significantly below current market rates. As excess capacity is absorbed and old contracts come up for renewal, suppliers benefit from contracts resetting to higher current market rates with little or no incremental operating costs. Simultaneously, many suppliers have developed a variety of premium-priced value-added services that move corporate buyers up the value chain to more robust, higher-profit margin services.
2. Low-cost acquisitions: At the turn of the century, opportunities arose for far-sighted companies to make strategic acquisitions at bargain prices in order to build an infrastructure with significantly lower capital expenditures than their current competitors. For example, a leading optical internet bandwidth provider that serves 11,300 corporate customers and carries 12% of all internet traffic acquired infrastructure assets valued at $14 billion from former high-flyers like Verio, PSINet and Carrier 1. The company’s total acquisition cost for these assets of just $60 million has allowed it to become the lowest-cost provider of bandwidth on the internet, creating economies-of-scale and a competitive barrier to new entrants. Our analysis suggests that enough capacity exists for the company to increase its traffic by about 10 times with minimal capital expenditure.

Capitalizing on Unique Opportunities in Small-Cap Companies
We see internet infrastructure as a domain in which smaller companies can exploit advantages in specialized niche technologies. By integrating their strengths in intellectual property, hardware, software, and sales/marketing, small companies can recognize emerging trends and exploit first-mover advantages. These companies are able to establish an early presence in an emerging, high-growth market and reap the benefits of that rapid growth without the drag of legacy businesses with slower growth rates.

Compared to many of the companies that folded early on, we see companies today with business models that are more likely to survive because they are less dependent on a fragile customer base. In other words, past failures largely occurred because companies had too many unprofitable e-commerce and .com businesses as customers. Now, however, we see an internet infrastructure in which major Fortune 1000 companies (and their global counterparts) form the primary customer base. Although IT spending will always be somewhat cyclical, large corporate customers are projecting long-term growth in their bandwidth and data management needs. These customers also have the staying power to continue spending on technology during economic downturns and throughout technology cycles.

Another key difference lies in capital expenditure and cash flow needs. When the stock market started losing interest in the tech sector in 2000, access to capital dried up. Many of today’s most attractive small-cap infrastructure companies, on the other hand, have already cleared capital spending hurdles, often by buying assets of bankrupt companies at significantly discounted prices. Most of the attractive companies have modest continuing cap-ex requirements that can be funded through their existing balance sheets and/or their internal cash flow generation. Therefore, their profitability is neither reliant upon the cyclicality of capital spending nor the companies’ ability to raise debt or equity capital.

Research: Sorting Real Investment Opportunity from Speculation
The weight of technology and telecommunication stocks in major indices is much less significant today than it was seven years ago (see chart at right). Appropriately, our bottom-up approach to portfolio construction at Oppenheimer Capital will always emphasize diversification in small-cap stocks across many industries and sectors. We want to capture distinct investment themes – such as bandwidth demand – where our research finds strong potential earnings growth.

We’ve allocated our resources to focus on companies that broadly meet the following criteria:

1. Long-term revenue and EPS growth potential capable of driving share price appreciation over holding periods of 12-18 months
2. Strong competitive positioning in secular growth markets
3. A sound balance sheet with reasonable debt levels and adequate cash
4. Projected cash flow capable of sustaining the business and its R&D and capital expense needs over time

We understand that the level of enthusiasm for today’s internet infrastructure sector is significantly more tempered and cautious, yet it’s hard to overlook the fact that the demand for more bandwidth and related services is growing so rapidly. We also recognize how essential it is to be highly selective in choosing among all of the publicly-traded infrastructure providers. We know that there will be distinct winners, as well as many underperformers in these sectors. This is exactly how research resources can make a big difference in meeting our clients’ investment objectives.