How the Law Is Shaking the Net

- eBay (EBAY ; S&P investment rank: 3 STARS, hold; recent price, $36) has been wrangling with a private company called MercExchange over patents related to online auctions and fixed-price sales. A court essentially affirmed a $25 million judgment against eBay in March, 2005, and at that time, we estimated that additional damages could approach $100 million. In May, 2005, the Net auction outfit was granted a stay in the case, pending a prospective review by the Supreme Court.

• RealNetworks (RNWK ; 4 STARS, buy; $5.25) has spent more than $16 million pursuing an antitrust case against Microsoft (MSFT ; strong buy; $26). The company's complaint alleges that Microsoft illegally used monopoly power to restrict competition, limit consumer choice, and attempt to monopolize the digital media segment. When it filed the lawsuit in December, 2003, RealNetworks opined that Microsoft could be liable for damages exceeding $1 billion.

• Yahoo! (YHOO ; buy; $37) has been actively enforcing its claims to sponsored-search-related intellectual property. Google (GOOG ; buy; $239) settled patent infringement and other claims with Yahoo by issuing 2.7 million shares to the company now worth some $645 million. Yahoo is also engaged in patent litigation with FindWhat.com (FWHT ; not ranked; $5), whose stock surged 9% the day a mistrial was announced in mid-May.

BIG DECISION. Notwithstanding the importance of these matters, we at Standard & Poor's believe decisions from the Supreme Court (one recent and one forthcoming) could have an even more dramatic influence on the Internet industry and many of its businesses.

In mid-May, the Supreme Court ruled that state governments cannot prohibit their residents from ordering wine directly from out-of-state vintners (based solely on locations of the would-be consumer and winery in different states). Roughly half of the states restrict such purchases (see BW Online, 5/17/05, "A New Age for Wine Sellers"). We believe this decision will contribute to greater e-commerce opportunities for wineries and should aid outfits like privately held Wine.com. Interestingly, Wine.com announced a partnership with Amazon.com (AMZN ; sell; $35) earlier this month.

We believe this judgment could lead to greater online sales not only of beer and spirits, but also cigarettes, contact lenses, cars, and even real estate (which are all heavily regulated by state and local governments). Reduced distribution costs and regulation would also bolster the profitability of these sales, in our view.

P2P PROBLEMS. As a result, we think Internet companies that could benefit from this decision include publicly traded 1-800 Contacts (CTAC ; not ranked; $20), Autobytel (ABTLE ; not ranked; $4.10), eBay, Homestore (HOMS ; not ranked; $2.15), and IAC/InterActiveCorp. (IACI ; buy; $24). 1-800 Contacts and eBay are members of NetChoice (a coalition that filed an amicus brief in the wine case and whose goal is to promote convenience, choice, and commerce on the Internet).

Next month, the country's highest court is expected to issue a decision regarding the future of file-swapping networks. Media concerns want the court to rein in peer-to-peer (P2P) systems and software, which are frequently used for illegal downloads of copyrighted music and video content.

Many technology companies consider file-sharing networks a compelling innovation that should not be eliminated simply because they're sometimes used for unlawful purposes. We think the Court may try to pursue a middle ground by taking aim at peer-to-peer services that encouraged illicit activity.

STABILIZING SITUATION? We believe Internet businesses that provide legal online music services, like Apple (AAPL ; buy; $37), Napster (NAPS ; not ranked; $4), RealNetworks, and Yahoo (following its recent introduction of a subscription and download music service), are going to be the most affected by the P2P decision. If the court moves decisively to curtail illegal activity on file-sharing networks, we believe these companies would benefit significantly. If the decision doesn't call for notable changes to at least some kinds of usage of P2P systems, we think they would be adversely affected.

(As an aside, I wanted to point out Baker Capital, which has two portfolio companies that have been front and center in the two Supreme Court cases described above. The private-equity firm's major investment in Wine.com was announced in September, 2004, months before the court decided to allow more interstate sales of wine. In April, 2005, Baker bought MusicNet, a leading business-to-business provider of online-music services. A month later, Yahoo introduced its consumer music offering, which is enabled by MusicNet.)

I've been covering Internet stocks for more than five years and cannot remember a time when legal disputes and resolutions were having a greater impact on the industry and its companies. Perhaps this is indicative of a segment that's becoming more stable and mature. Maybe the legal activity evidences the growing importance of intellectual property in the Net area, as companies increasingly employ it to establish and extend competitive advantages. We at S&P do think the Internet field is more crowded than it was a few years ago, and players are striving for proprietary differentiation.

The world's largest Web companies and at least one equity analyst who covers them are taking notice. Today's competition is taking place in the marketplace and in courtrooms. Corporate success for online businesses seems predicated on both good products and services and associated legal protections. Perhaps there's a certain logic to having a former lawyer trying to make sense of this stuff after all.

Source: Business Week