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Internet Outfits That Can Go the Distance

With the fighting in Iraq over and the economy looking a bit brighter, the travel market may have bottomed -- and that opens the door for Standard & Poor's to stamp buy recommendations on three Internet-related stocks.

That's the report from Scott Kessler, S&P analyst of Internet software and services stocks, who points out that even in the Net boom, S&P wasn' enthusiastic about Internet stocks. However, he says, on Apr. 25 S&P recommended as strong buys the stocks of USA Interactive, Expedia, and He notes that USA Interactive is in the process of acquiring the other two companies and that their stock -- especially that of Expedia -- would be a bargain route into USAI. Kessler adds that, in addition to travel, USA Interactive is strong in online personals through and in financial services through LendingTree.

Other well-known Internet names such as Yahoo! and eBay he considers overvalued and ranks Yahoo as a sell and eBay as a hold. And on the seeming promise of the Internet market in China, he suggests playing it via U.S. companies such as First Data and UTS Starcom, which have a large presence there.

These were some of the points Kessler made in an investing chat presented May 6 by BusinessWeek Online and Standard & Poor's, in replying to questions from the audience and from Jack Dierdorff of BW Online. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Scott Kessler is an analyst with Standard & Poor's Investment Advisory Services. He has no affiliation with or ownership interest in any companies under discussion. Other S&P affiliates may provide services to the companies under discussion.

Q: Before we log on to the Internet, how does the overall market look to S&P?

A: Overall, S&P is cautiously optimistic on the stock market. We believe that the conclusion of the war with Iraq, easing of geopolitical tensions, and indications of economic improvements, as evidenced by what we believe have been some good quarterly corporate [earnings] reports, bode well for the stock market over the near term.

Q: And how have the Net stocks you track been doing through all of this?

A: Now that's a topic that I can expound upon. The S&P Internet Software & Services index had appreciated nearly 34% this year, as of Friday, May 2. This performance was actually outpaced by the S&P Internet Retail Index, which appreciated over 40% during that period. These indexes have really led the market rebound that we've seen in recent weeks and months.

Q: What are your favorite Internet stocks?

A: Well, it's interesting because S&P hadn't been overly enthusiastic on Internet stocks for some time. In fact, with the exception of one stock or two, I don't think we necessarily were extremely positive on any Internet stocks during the Internet boom and bust. However, on Friday, Apr. 25, we took a much more aggressive stance in the Internet sector by upgrading to 5-STARS, or strong buy [in S&P's Stock Appreciation Ranking System -- STARS], not one, not two, but three Internet names -- USA Interactive (USAI), Expedia (EXPE), and (ROOM).

On a macro basis, it's our view that a lot of the concerns that have dampened consumer spending and travel have been largely addressed. We believe, in particular, that the travel market has likely bottomed. Secondly, on a micro basis, USA Interactive has accumulated leading positions in some of the largest and most important e-commerce categories, including travel and tickets. It is also, through, the leader in online personals, which is a high-growth and profitable segment. We believe USAI's entree into financial services and real estate, through its acquisition of LendingTree, which was announced yesterday, will provide yet another growth engine.

From a valuation perspective, USAI trades at a discount to its peers and to our calculation of its intrinsic value, using discounted cash-flow analysis. USA Interactive is acquiring the remainder of Expedia and that it doesn't already own for stock, and thus our recommendation on those two stocks is also strong buy.

Other favorably recommended stocks that I cover include Fair Isaac (FIC), First Data (FDC), and Open Text (OTEX). These are not necessarily pure-play Internet companies, but they represent my best ideas at the moment, with Fair Isaac garnering a strong buy (5-STARS) recommendation, and the other two being rated accumulate or 4-STARS.

Q: Yahoo! (YHOO), (AMZN) -- obvious plays?

A: I don't cover -- that task is handled by one of my colleagues -- but it's rated 3-STARS, or hold, reflecting what we perceive as favorable prospects that are already reflected in the stock price. Yahoo I do cover, and I have covered it for a few years now. I think it has done many good things, particularly its efforts to diversify beyond advertising revenues. However, we believe Yahoo needs to do more in the areas of premium services, as well as e-commerce, before we are totally convinced of the imminent success of their operating model.

From a valuation perspective, Yahoo trades at a substantial excess as compared with its peers. For example, it recently traded at 68 times our estimate for 2003 earnings and has a p-e/growth ratio of 3. This compares with the S&P 500, which recently had a p-e of 17 and a p-e/growth ratio of 1.3.

Q: What do you think of Apple's (AAPL) attempt to sell music on the Web?

A: Very interesting and timely question. I don't follow Apple, which is covered by one of my colleagues and rated 3-STARS, reflecting a slow-growing PC market and about $12 per share in cash and equivalents. Although the implications of the new iTunes service are unclear in terms of its impact on the company's financials, we do think that the new service will have an impact on RealNetworks (RNWK), a stock that I do cover. RealNetworks is now facing increased competition for consumer online content, subscribers, and revenues.

There's also talk that AOL will partner with Apple to gain access for its subscribers to the iTunes service. With Yahoo recently launching its Platinum offering, competition in this category is intense. Early reports suggest that Apple has created a compelling service and business model in this area. Stay tuned!

Q: Do you think the Chinese Internet stocks are a good play?

A: I don't cover any of the Chinese Internet stocks. We do believe that, notwithstanding the SARS epidemic, China remains an attractive investment opportunity. And the way that we suggest playing China is through established companies that are pursuing opportunities there. For example, First Data, the world's leading data processing firm, entered China and India in 2001, and now has some 11% of all agent locations of Western Union based in these two countries. We think China will be a nice growth driver for First Data's most important business segment.

Another company that we recommend that's probably a better play on the Chinese economy, especially as it relates to telecommunications services, is a company recommended by one of my colleagues, UTS Starcom (UTSI), which S&P currently rates 4-STARS, or accumulate, based on strong fundamentals and an attractive valuation. Sales from China account for about 80% of its revenues.

Q: I own Priceline (PCLN) -- should I hold or buy more?

A: I rate the shares 3-STARS or hold. As I indicated earlier, prospects for the online travel market are improving, based on easing international tensions and prospects for an improving economy. However, Priceline has been struggling, to some extent, as a result of its reliance on what we consider to be an anachronistic, opaque air-ticket model. The faster it can address the problems it has been having with that business, and the more traction it continues to garner in hotels and packages, the better off Priceline will be in terms of both fundamentals and stock performance.

Q: Your opinion, please, on VeriSign (VRSN)?

A: VeriSign has mounted an impressive comeback from a stock performance perspective over the past year or so. This is reflective of improvements from the demand side related to info tech and telecom spending, and solid and effective restructuring efforts last year. While we do have some questions about the company's network-solutions business, which is focused on domain-name services, we believe that the stock is fully valued at current levels, and it is rated 3-STARS, or hold.

Q: What do you think about the B2B sector?

A: The only company that I cover that could be characterized as a B2B company is BroadVision (BVSN). It has done a good job right-sizing itself and sharpening its focus on the enterprise-portal opportunity, which we see as significant. However, given uncertain technology demand, a number of pro forma financial items, and recent inconsistent financial results, we recently reiterated our 3-STARS, or hold, recommendation.

Q: What's your take on eBay (EBAY) for the next 12 months?

A: I'm surprised that I wasn't asked about this earlier. eBay is a great company -- it has an excellent business model and is extremely well run. The question: Is it a stock worth buying at today's price of $95 a share, or 64 times our earnings estimate? We think not. We rate the shares 3-STARS, or hold.

Q: Finally, Scott, do you think the Net will continue its dramatic growth?

A: I think that a lot of the growth that we've been seeing in terms of Internet users and usage will be more dramatic outside of the U.S. than domestically. That being said, the increasing adoption of broadband will, in our judgment, spur further gains in Internet activity as a whole. We are enthusiastic about the sector's underlying fundamentals, reflecting an industry that has undergone three years of consolidation.

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