One of the more successful investment themes in the Australian market in recent years has been internet companies. Over time, the best internet businesses have demonstrated an impressive capacity to generate free cash flows from a limited asset base, and to steadily grow those cash flows with minimal additional capex.

Some of the most sought-after internet businesses are the ones that are able to establish a leadership position and exploit network effects – a virtuous circle whereby visitors are attracted to a site because of its comprehensive advertiser base, and advertisers are attracted because of the large volume of visitors. Classified advertising sites like Seek, REA Group and Carsales.com are good examples.

The performance of some internet businesses, however, has significantly lagged others. For example, while the share price for REA Group is up around 60% year to date (YTD), the share price for Webjet Limited (WEB) is essentially flat for the same period. With WEB now trading on relatively undemanding earnings multiples by internet business standards, it is appropriate to ask whether WEB now represents a value opportunity.

To buy or not to buy?

In terms of financial performance, WEB ticks a lot of boxes. Revenue and earnings have been rising strongly for many years, ROE has been trending up, and cash flows have been very healthy. As a result, WEB’s balance sheet has grown to a material net cash position. Guidance for FY13 also indicates a continuation of strong double digit earnings growth.

If WEB can sustain this trajectory, then the current share price will look like good value in retrospect. However, there are some issues to consider.

Firstly, network effects are perhaps not as robust in WEB’s core market. Compared with the number of new cars on Carsales.com or the number of employers on Seek.com, the number of airlines that Webjet can offer its users is relatively limited. This means that it is not as difficult for users to access the same information from alternative sources, and WEB’s market power is correspondingly limited. This may not be a major issue, however.

Including its accommodation business, WEB claims to be the largest online travel business in Australia and New Zealand, and as mentioned previously, its economic performance to date has been very good.

Domestic growth limitations

Another issue is the long-term sustainability of growth. The Australian market is finite, and the migration of travel business from traditional retailers to online can only go so far. Accordingly, WEB arguably needs to deal with a domestic growth ceiling by finding and successfully developing international growth options.

Initially, WEB sought to achieve this via joint ventures and organic growth in Asia. However, after experiencing slow progress with this approach, in December 2012, WEB acquired Zuji for $25 million cash, and with it the number one online travel position in Singapore and Hong Kong.

Internet penetration and the online migration is less advanced in Asia than in some markets, and if Zuji can maintain a leadership position in key markets as the industry matures in the region, the value of the business could grow very substantially. However, this may not be straightforward. Many others have also recognised the potential upside, and competition in online travel in Asia has become vigorous. Competitors including Expedia, Agoda, hotels.com and Priceline all have similar objectives to Zuji.

Rather than relying on first mover advantages, in Asia, WEB may need to find ways to gain an edge over capable and well-resourced challengers. At this stage, it is difficult to be certain how it will do this, but management skill, understanding of the relevant markets, and depth of resources all seem likely to play a role in deciding the outcome.

Call for concern

For the time being, we see reasons to be concerned on this front. Our analysis of internet traffic and search volumes suggest that some of the competitors named above may have outpaced Zuji in the most recent half year. Recall that the online world tends to be winner-takes-all, and the loss of market leadership would be a significant setback.

Time will reveal whether WEB and Zuji can translate success in Australia into success internationally. In the meantime, potential investors should pay close attention to management’s commentary at the full year result; to better understand the strategy being followed in Asia, and for signs that the strategy is working. If Zuji is losing ground, WEB’s growth prospects and valuation may need to be revised downwards.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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