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Time to Jump Back to the Net?

Despite the meltdown in technology stocks, which hit Internet names especially hard, there are still some Net stocks deserving a buy or accumulate rating. So says Scott Kessler, Standard & Poor's analyst of Internet software and services stocks.

Kessler currently has only one buy: Citrix Systems, which he sees as combining both value and growth advantages. But he has several accumulates, including AOL Time Warner, Adobe Systems, Akamai Technologies, and RealNetworks. Kessler points out that although many stocks in this sector have scored significant gains since their post-September 11 lows, they are still far below their highs during the tech boom.

Overall, he thinks Net stocks will perform pretty much the same as the overall market, beyond the "nice opportunities" he cites. Kessler made these comments in a chat presented Oct. 30 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and BW Online's Jack Dierdorff. Edited excerpts from the chat follow. A full transcript is available on AOL at keyword: BW Talk.

Q: Scott, you were scheduled to be our chat guest on that infamous Tuesday, September 11. We all know what happened instead. What's happened to Internet stocks since then?

A: Clearly, the fundamentals of many companies across the Internet landscape have deteriorated since September 11. The economy was further thrust into a recessionary climate, and there were notable business interruptions. Many Internet companies suffered.... From a valuation perspective, as we all know, many if not all of these stocks fell precipitously when the market reopened in mid-September. It appears as if stock prices have stabilized.... I'll say that although I expect the Internet sector as a whole to perform on par with the broader market, I definitely see some nice opportunities in this market segment.

Q: Is there any value Internet play?

A: One that comes to mind quite quickly is Citrix Systems (CTXS). I recently upgraded the shares of this leading thin-client-server technology company. Its appeal comes on many fronts. First, from a fundamental perspective, the company was able to overcome the challenging economic circumstances and posted an impressive third quarter in terms of revenue and earnings growth.

The company not only benefits from a variety of remote-computing solutions that are in greater demand as a result of the attacks but also has opportunities in the more general enterprise-software space. In addition, the company is poised to capitalize on the recent launch of Windows XP, and we expect the introduction of a new portal software product by early next year. From a valuation perspective, Citrix recently traded at a very reasonable 21 times our 2002 EPS [earnings-per-share] estimate of $1.10. That's extremely attractive as compared with peers and the S&P 500, of which Citrix is a component. The stock offers a unique combination of growth and value in light of an expected growth rate of 25% per year.

Q: What's your judgment on AOL Time Warner stock?

A: AOL is still a stock that I like, despite the fact that the company had to preannounce a disappointing third quarter following the attacks.... However, we think that AOL is an extremely well-positioned media company encompassing the marriage of content, distribution, and usership better than any other media company. We expect the company to benefit from high-profile movie releases coming over the next few months, including Harry Potter and Lord of the Rings. Clearly, AOL has taken a hit along with the economy, but the company will surely rebound along with consumer spending. And I think it's fair to say that AOL is as attractive an Internet value play as there is.

Q: How about Internet entertainment -- music, movies -- any predictions?

A: Well, I think that the best possible prediction I can make is that the Internet will increasingly become an important distribution medium for mainstream and customized entertainment content. One of the stocks that I like in this category is RealNetworks (RNWK). The company has effectively transitioned from a software play to a content play. And its GoldPass service offers exclusive premium content from the likes of ABC News, Survivor, Major League Baseball, and the NBA, and has achieved subscribership of over 300,000. We expect the company to be an important distributor of other premium content in the future, including the widely anticipated MusicNet service.

Q: Scott, last Thursday's guest was Peter Cohan, author of e-Stocks, and he told us his own index of Net stocks has jumped 88% since September 11 -- have you seen anything that dramatic? That is, since the post-attack low.

A: There have definitely been a number of stocks that fell dramatically after the attacks but then surged in a kind of calming phase that came over the market. Stocks across the technology landscape have appreciated from lows achieved in mid-September. However, I'd point out that a very large percentage of the names in my universe, even with this positive price action post-September 11, are still sharply below 52-week and all-time highs.

Q: Any ideas on BroadVision (BVSN)?

A: BVSN is a company I cover, and I think that many wrote the company off as "dead" upon the announcement that it was going to be removed from the S&P 500. However, the stock has recovered nicely from recent lows of well under $1. At this point, BroadVision is a waiting-game kind of stock, in that I'm confident that the company will be a survivor.... Ultimately, if you have a long enough time horizon, BroadVision might be a place to look. However, I maintain my hold recommendation, as I think that it's too early to expect the stock to outperform the broader market. Keep in mind that my time horizon is six to 12 months.

Q: What about Salon (Salon Media Group -- SALNC) -- any long-term hope?

A: Although I don't cover shares of Salon, from what I understand, the company has made some nice progress in shoring up a significant paying subscriber base, which in this type of economic backdrop is nearly essential for smaller Internet-content plays.

Q: Now for the big question -- what stocks have your buy blessing now, Scott?

A: In addition to CTXS, which is my only buy-rated stock, I rate the following stocks accumulate (or 4-STARS): Adobe Systems (ADBE), Akamai Technologies (AKAM), AOL Time Warner, and RealNetworks. I also cover beta-processing companies, and two of them, First Data (FDC) and SunGard Data Systems (SDS), are rated accumulate.

Q: And aren't some people advising e-mail instead of paper because of the anthrax scare? Which should help the Net service providers.

A: I actually think that from a usership and usage basis, growth to a certain extent has been fueled by the attacks and continuing related events. People have been using the Internet to obtain information and to communicate with others more than they ever have. This is a positive for the Internet sector because it underscores the medium's importance to our everyday life.

That being said, however, the companies that seem to participate most when it comes to online content and communication benefit only marginally from a financial perspective as a result of the uptick in activity.... However, one stock that comes to mind that may in fact benefit from the anthrax scare, for example, is DoubleClick (DCLK). The company has a burgeoning e-mail marketing business.

Q: What do you think of some of the China/Asia-related Internet stocks, such as Chinadotcom (CHINA), Asiainfo Holdings (ASIA), etc.?

A: Well, I don't cover any of those particular companies. However, I will offer a plug for a China-related telecommunications play, which also happens to be the S&P stock of the week. Although I don't cover it, our telecom-equipment analyst, Ari Bensinger, recommends UTStarcom (UTSI). The stock offers significant growth driven by increased telecommunications growth in China, and a valuation far below its long-term earnings growth rate.

Q: What about (PCLN)?

A: I do cover Clearly, the online travel industry was deeply affected on a negative basis by the events of September 11. However, the company has reported that demand across all categories has bounced from recent lows. Although air travel appears to be the segment that is taking the most time to recover, the hotel and rental car categories are faring relatively well. While we believe that Priceline is a survivor...we wouldn't be surprised if the company entered into a significant alliance with an Old Economy media player or travel firm, like its competitors Expedia and One possibility could perhaps be Cendant (CD), which has shown an inclination to be accretive in the travel segment.

Q: Have you downgraded any stocks recently, Scott? Anything we should avoid or sell?

A: The short answer to that question is yes. The list includes: eBay (EBAY), Interwoven (IWOV), Intuit (INTU), and Yahoo! (YHOO). EBay and Intuit I downgraded from accumulate to hold, based strictly on valuation concerns. However, I believe that the fundamentals and valuations of Interwoven and Yahoo warrant negative recommendations. In fact, my rating on Yahoo is a sell, or 1-STAR. That's because the company has not effectively diversified its revenue mix beyond online advertising and is valued at levels well above its peers in the broader market. My suggestion is to sell and put your money elsewhere.

Q: Any business-to-business (B2B) company you like?

A: I can't say that I like any B2B companies at this point, although I do believe that Ariba (ARBA) and Commerce One (CMRC) will survive, notwithstanding their precipitous price decline. With Germany's SAP as a 20% holder of Commerce One's stock, I wouldn't be surprised to see SAP buy the rest of Commerce One. Of course, the ultimate question is at what price. I leave that to you to think about, but my recommendation remains a hold.

Q: Any final words of wisdom for us on Net stocks, Scott?

A: My suggestion is to identify companies with diversified revenue streams and healthy balance sheets. Clearly, some companies are losing money now, but they are becoming stronger and taking market share. Assessing a company's future based upon the value of its cash and investments is a good place to start.

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