I. Why has Netscape been so successful to date? What appears to be its strategy?

What must be accomplished if it is to be highly successful going concern in the long run? How

risky is its current competitive position?

Netscape has been so successful because of following reasons:

1. First to enter the broad Internet market - Netscape had the first-mover

advantage being the pioneer of web browsers in the evolving Internet market. They achieved the

market leader position in a short period of time with their Netscape Communicator and Netscape

Commercial server. For a while, it was the indisputable leader of its kind. This means that it

was able to command high brand recognition and strong customer loyalty at the onset.

2. High level of innovation - The product which Netscape introduced was

innovative. They catered to a market which was growing and where the information was valued

quite highly. Their product enabled the user to publish information at a single point and that

information being accessible everywhere publicly.

3. Less competition in the current market - While Netscape started their business,

it had little competition in the market. There were no dominant players in the market. This

enabled them to capture a bigger market pie and grow into the market leader position although

the future competition was seemingly going to be tough with multiple players coming in

including Microsoft.

4. Expansion stage - The business cycle for the Internet market was on the upside

as the market was growing very fast. This formed the basis for potential growth for Netscape.

5. Thought of application - As mentioned above, the idea of sharing information

was gaining momentum and the products of Netscape supported that which enabled

corporations/people to publish and access the information in a more convenient and free way.

Netscape's Strategy
1. The Netscape management used the "give away today and make money

tomorrow" strategy. They first created a customer base by allowing customers to experience the

product free of charge and then build the market based on that platform.

2. After having paid a one-time fee to Spyglass for the original code, Netscape created a
brand new identity for itself in the market.

3. To set new industry standards they created Mozilla and created rivalry among

its own products (Mosaic vs. Mozilla). For Mozilla it was able to create an impression of an

upgraded version of the earlier product, Mosaic. Finally as people migrated to Mozilla, they

changed its name to Netscape Navigator.

4. Focusing on the commercial browser market, they offered bundled packages

with Netscape server and browser functions as integrated application software as well as

marketing them as individual products.

As the Internet community and its demand continues to expand, Netscape's competitors is

also expected to grow in multitudes. Faced with a lot of competition, Netscape must be more

aggressive in crafting a strategic plan that would ensure its success in the long-run. To be

highly successful, its strategic plan must cover the following issues:

1. Positive financial performance - First and foremost criterion to become highly

successful is to have positive financial performance with higher and positive operating cash

flows followed by sustained and growing operating profits after a certain period of time.
 2. Competitive Strategy - Identify the possible competitors in future and formulate

a strategy to overcome competition. It can assume that Microsoft will be aggressively pursuing

the same market for web browsers. Netscape should work to establish some form of lock-in,

either due to the user interface, or proprietary functionality to at least get a price advantage.

Microsoft is clearly positioned to give a product away for the long-term to gain market share.

3. Broaden its product range (expand the focus from web browser) - Netscape

should consider broadening its product base to give the company sustainability. A larger product

range will lend them more stability and develop more competences in the market. This can be

done either through developing complementary products or through new products developed

through continuous innovation.

4. Control costs (sales and marketing) and R&D over the long-run - Another

significant aspect is managing costs. According to the case, Netscape's operating expenses are

quite high as compared to their revenues. This is due to the nature of the business characterised

by fast growth and innovative products which required high R&D cost. However, the company

should carry out cost benefit analysis and decide an optimum ratio for R&D expenses to

revenues.

Netscape's current competitive position is deemed to be very risky because of the following
reasons:
1. Spyglass targeting the corporate market - Spyglass was targeting the corporate

markets which formulated a larger percentage of market. This would create a strong strategic

position in the market for Spyglass more as a market leader.

2. Strong companies like Microsoft are under Spyglass licensees: rivalry is high -
Microsoft was a major threat as it has already dominated the Operating System space and if they

come out with a successful browser they can capitalize on their strong user base and destroy

Netscape's market leadership position (which they did!!!).

3. Emerging technology - Since this is an emerging technology, there is a risk of

creating an ample and sustainable business in the long run which enhances the risk associated

with it.

4. No proprietary technology - Since the browser technology is not a proprietary

technology, it makes for low barriers to entry and therefore threat of new entrants to capture the

market pie becomes high.

II. Can the recommended offering price of $28 per share for Netscape's stock be

justified? Given these assumptions, and starting from its current sales base of $16.625 million,

how fast must Netscape grow on an annual basis over the next ten years to justify a $28 share

value?

Based on our assumptions listed in Annexure 1 and the forecast in Exhibit 2 and 3, the

group determined a value per share of $ 29.78. Hence, a share price of $28 is justifiable. In

addition to the assumptions stated in the case, some of the critical assumptions the group made

are discussed below.

Revenue growth rate

In 1995, Netscape was in a growing phase and the IT industry was expanding rapidly.

Further, Netscape's has a competitive advantage through their innovative product and their

market leader position. Hence, very high growth rates can be assumed during the initial five year
period from 1996 to 2000. The following are the revenue growth rates assumed for the 10 year

period.

Year Revenue Growth

Rate % Year Revenue Growth
Rate %
1996 140% 2002 30%
1997 90% 2003 20%
1998 75% 2004 10%
1999 55% 2005 6%
2000 40% 2006 onwards 4%
2001 30%
Cost of capital
The Capital Asset Pricing Model (CAPM) was used to determine the expected rate of

return for the equity share holders. The market risk premium is assumed as 6% based on the

historical information. Being a startup, Netscape is assumed to associate higher risk than

Microsoft Corp (beta 0.72). Also the company is still in its growing stage. Hence, a high level of

price volatility is expected when compared to the market. Therefore, an equity beta of 1.1 is

assumed.

Due to lack of information, Cost of Debt is assumed to be equal to the average interest

rate of 7.32%. (I.e. interest expenses for the year/ borrowings).

Looking at a yearly growth rate, Netscape must grow at an average rate of 44.74%

annually (Exhibit 4) to be able to justify a $28 share price in its 1995 IPO.

III. As the manager of an institutional fund who was willing to buy and hold

Netscape's stock at the originally proposed price of $14 per share, would you be willing to buy

and hold at an initial offering price of $28 per share?

 As we understand from our analysis of question 2, for having an offering price of $28 per

share, Netscape must post an average annual growth of around 45% for next 10 years. A growth

of this kind is quite a lot even though if we consider the era of Internet bubble where growth for

the Technology companies was around 50% on an average for four years (1995-1999).

Considering this fact, growth of 45% is an incredible growth and that too for 10 years therefore

making the valuation of $28 per share a highly risky one.

As an institutional fund, whether to invest or not depends on the type of fund being

managed. If we were to assume the position of a manager of an endowment or pension fund, then

we would like to take lower risk and therefore not consider the share at $28 but would consider a

lower risky share price of $14. Investing on a company that has not turned in a profit yet is

actually a big risk already.

A manager of a mutual fund or hedge fund would probably take a more risky stance and

still invest in the $28 share price while hedging it with some lower risk investment. To some

extent, increasing the share price from $14 to $28 may be seen as a good sign as it actually

reflects the market sentiments where technology companies are able to command premium.

During this period, a lot of investors would think that new companies in the Internet industry like

Netscape had limitless opportunities and that things could only go up.

Notes to Exhibit 1: Assumptions

In addition to the financial information and assumptions stated in the case the following

assumptions were made to forecast the value of the equity stake of Netscape.

1. The Exhibit 1 contains the main assumptions in arriving at the free cash flow to firm.
2. It is assumed that same performance of the first two quarters can be achieved during the
3rd and the 4th quarters of FY 1995.

3. Corporate taxation rate is assumed to be 35% of the taxable income. Further, it is

assumed that tax losses cannot be carried forward.

4. It is assumed that the book value of equity, debt and Preferred shares are equal to the
market values.

5. The market risk premium for shares is assumed as 6% (For the last 60-year or

80-year period, the average difference between the return on the stock index in the U.S. and the

return on US Treasury securities has been approximately 6% )

6. Beta for Netscape assumed as 1.1. According to the case America Online Inc

and Microsoft Corp have equity beta of 0.73 and 0.72 respectively. Since, Netscape is still in the

early stages of the growth phase a higher volatility is assumed. Therefore, beta is assumed as 1.1.

7. Cost of debt is assumed to equal to interest expense / total borrowings as a June 1995.

8. Cost of preferred shares is assumed to be equal to Cost of debt +1%.

A premium of 1% is assumed for preferred shares since the preferred share holders have

lower priority than debt holders. Further, company has the option of delaying the preferred share

dividend payment unlike in the case of debt. Hence, preferred shares are assumed to be more

risky than debt.

Notes to Exhibit 2: Forecast of free cash flow to firm and value of the share price
1. Exhibit 2 depicts the forecast of free cash flows to the firm based on the assumptions
stated in Exhibit 1.
Value of the firm = Net Present Value of future cash flows from July 01, 1995 onwards + cash in
hand and bank as at July 01, 1995

2. Terminal value is calculated = FCFF2005* (1+g)/(WACC-g)

Where:
FCFF2005: Forecast Free cash flow to firm in year 2005
g: Long term growth rate of 4%
WACC: Weighted Average cost of Capital.

3. Determination of cost of equity (Ke)

Ke = rf+ B(rm - rf)
Ke = 6.71%+ 1.1* (6%) = 13.31%

4. Determination of cost of debt (kd)

Kd= interest expense/ total debt
= 128.655*2/ (725000+1511331+551449+725000) = 7.32%

5. Determination of cost of Preferred Shares (KPS)

KPS =Kd + 1%
= 7.32% +1% = 8.32%

6. The Weighted Average Cost of Capital (WACC) is calculated as follows:

WACC = Ke (E/(D+E+PS)) + Kd (1-t) (D/(D+E+PS)) + KPS (PS/(D+E+PS))

Where
E: Book value of equity
D: Book value of Debt
PS: Book Value Preferred Stock

Securities Book Values ($)

Debt 3,512,780
Equity 16,473,620
Preferred stock 901
D+E+PS 16,474,521

Based on the above equation WACC = 12.26%

7. Calculation of the value of equity stake:

Value of equity stake = Value of the firm - Value of Debt- Value of Preferred shares

8. Valuing the share price of Netscape:

Price per share = Value of equity stake/ existing number of shares

9. The average revenue growth rate is calculated using the "Goal Seek" option of EXCEL
if the offer price of $28 to be justified.
Exhibit 1: Assumptions

Exhibit 2: Forecast of Free Cash flow

All figures are in USD '000

Exhibit 3: Valuation of the Share price

Exhibit 4: Forecast of Free Cash flow based on an annual average revenue growth of 44.74%.