Even now, more than a decade after the tech bubble burst, investors can be very wary of online businesses.
There’s nothing wrong with healthy scepticism. But it’s a mistake to shun internet businesses altogether. They can in fact be very lucrative investments.
That’s because the online-only model can be very profitable once a business reaches a certain size.
Web-only businesses tend to have high ‘operational gearing’. In other words, they have high fixed costs, such as warehouses and websites. But once the business has reached a certain level of sales, those costs are covered and profits then take off.
In fact, one of the UK’s most successful fund managers has made some of his biggest profits in this sector. And I rather like the look of two home-grown internet stocks he’s holding right now…
The secret to this star fund manager’s success
Harry Nimmo is one of the UK’s top fund managers. He runs the Standard Life UK Smaller Companies Trust. The fund has grown by more than 200% over the last five years, and a lot of that success has to do with his interest in online businesses.
You can read more about his views on the sector in this Citywire interview.
His most successful investment to date has been online clothing retailer Asos (LSE: ASC). A few years ago, it was fashionable to say that the online retail market would be dominated by the most successful high street retailers. But Asos has proved all that wrong.
The company is a near-perfect example of how profitable a good online business can be. Having invested heavily – both online and offline – in building a strong position in its market, Asos is reaping the benefits. A recent trading statement revealed that group sales had soared by 46%.
The share price now looks high on many measures, and the company is still investing heavily. But the Asos story underlines that the UK can build successful, cash generative, internet-only businesses.
A fast-growing online payments stock
So what other options are there in the sector? Nimmo is also a big fan of an online payments business called Optimal Payments (LSE: OPAY). This company is at an earlier stage in the growth cycle than Asos, and it’s not yet paying dividends.
But there are already impressive signs of its investment bearing fruit. Revenue is rising fast and profit margins are soaring as a result. In the first half of this year, revenues jumped 50% to $118.4m (£74m) while pre-tax profit soared 800% from $1.7m to $15.5m.
That’s operational gearing for you.
What’s more, Optimal Payments operates in an area where we will probably see plenty of further growth. The company enables online transactions that cross international borders. It mainly serves online gaming sites, as well as internet retailers.
The opportunities are especially attractive in the US because some states are legalising online gambling. It’s thought that California could make this move in 2014.
Optimal Payments also has a strong balance sheet with a healthy net cash holding, so it can afford to make further investment in the business if it needs to.
Given the legal uncertainties with gambling, there’s a fair amount of risk here, but I can certainly see why Nimmo is so enthusiastic. This is an internet-only company with fast-rising margins and plenty of cash generation potential. With Nimmo’s track record for spotting good internet stocks, I think it’s worth a look.
An online business paying a decent dividend yield
But if you’re looking for something a little less risky, then you might prefer another company Nimmo has supported in the past, comparison website MoneySupermarket (LSE: MONY).
You’ve no doubt heard of it, but in case you haven’t, the company makes tons of money helping consumers to pick insurance policies, credit cards and the like. Like Asos, it has spent a lot of money building its position in this market. It has an attractive, robust website, and a well-known, trusted brand – it provides comparison tables to most national newspapers.
All of this means that MoneySupermarket no longer needs to invest as much money now that it has scale and volume. In turn, that means it’s been able to pay out two special dividends in the last three years. I expect it to carry on paying plenty of cash to shareholders in the years to come. At today’s share price of 146p, a 5% yield in 2014 looks likely.
Granted, the moribund state of the savings market with pathetically low interest rates on offer has been a challenge. But fundamentally, this is a business that has built its ‘virtual infrastructure’ and is prospering. It’s a great example of an internet-only business that generates plenty of cash.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.
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