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What's Pushing Those Surging Net Stocks

Internet stocks are doing better than the market as a whole -- and the trend should continue, according to Scott Kessler, Standard & Poor's analyst of Internet software and services stocks. He reports that S&P's two indexes of Net stocks were up 7.3% in the first quarter of 2004, vs. a 1.3% gain for the S&P 500-stock index.

Among the factors behind these numbers are increased Internet usage, including e-commerce; a rebound in advertising revenues on the Net; and continued merger-and-acquisition activity, Kessler says. And e-commerce is definitely a key to one of Kessler's two buy-ranked stocks, eBay (EBAY), which he says has become a "mainstream shopping destination." He now considers eBay a core holding.

The other buy in Kessler's universe is Adobe Systems (ADBE), largely on the strength of its Acrobat franchise but also because of the "unexpectedly strong" success of its Creative Suite, introduced last October as a way to unify the various Adobe systems and make them easier to use.

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

Note: Scott Kessler has no affiliation with or ownership interest in any of the companies under discussion today. He is a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Q: Have your Internet stocks been performing better or worse than the overall market in recent days?

A: In recent days Internet stocks have done quite well, largely outperforming indexes such as the S&P 500. In terms of first-quarter performance, the S&P Internet software and services subindustry [index] was up 7.3%, and the Internet retail subindustry was also up 7.3%. -- outperforming the S&P 500, which was up 1.3% year-to-date through Mar. 31.

Q: Among other things, does that mean that with the economy improving, Internet advertising is up?

A: I think the rebound in Internet advertising has definitely played a role in terms of improving revenues for many Net companies, as well as more favorable investor sentiment regarding Internet stocks. I'd also point to still-growing Internet users and usage, as well as e-commerce transactions. Moreover, M&A activity continues in this segment, which is contributing to investor interest as well.

Q: So what are some of the best stocks in this situation?

A: Currently, I rate two stocks in my Internet universe 5-STARS or buy [in S&P's Stock Appreciation Ranking System, or STARS]. eBay (EBAY) is my favorite pure-play Internet stock right now. The shares have done well this year, up some 15% year-to-date, reflecting a strong first-quarter report that indicated that growth, margins, and other important metrics were showing impressive gains. Following that first-quarter report, we upgraded the stock to accumulate, or 4-STARS. Then, following a subsequent pullback, we upgraded the shares to buy on Feb. 3.

Basically, the thesis for eBay is quite simple: We believe that it has become a mainstream shopping destination and that its popularity will continue to rise, not only here in the U.S. but also in the 28 other international locations it offers specific Web sites for.

Now, the one knock on eBay seems to always be one word -- valuation -- and I don't dispute that in some ways the stock can be considered pricey. However, based on the company's PEG [p-e/growth] ratio, the shares actually trade at a modest discount to the S&P 500.... We believe eBay has become a core holding, given its market position and staying power.

Q: So what's the other buy among your stocks, Scott?

A: My second 5-STAR, or buy, stock is Adobe Systems (ADBE).... They already reported their first-quarter results a couple of weeks ago. Those results widely exceeded my expectations in terms of revenues, margins, and EPS [earnings per share].

What's really driving this performance, in my view, is Adobe's omnipresent and pervasive Acrobat franchise, as well as the unexpectedly strong success of its Creative Suite, which the company introduced in October, 2003. The Creative Suite embodies Adobe's efforts to unify several of its products in a way where their interfaces and content can be easily utilized. So far, the product has been successful throughout the world.

Although shares of Adobe have appreciated...we're still more optimistic on the stock than most other Wall Street analysts, based on our earnings estimates for this and next year.... We simply believe that others are underestimating the company's growth potential and believe the shares have further upside.

Q: Do you see any impact in your area from the peace pact between Microsoft (MSFT) and Sun Microsystems (SUNW)?

A: Not directly. However, I would point out a few things. The most obvious is that there has been speculation that the settlement with Sun is going to have a negative impact on the European Union's recent decision involving Microsoft, vis-à-vis the company I cover, RealNetworks (RNWK).

As you may know, the European Commission recently ruled that Microsoft would have to provide a version of Windows to PC manufacturers that does not include Windows Media Player, which competes directly with RealNetworks' RealPlayer.

We believe that if this decision were implemented, RealNetworks would gain market share in Europe, not only with respect to RealPlayer but also with respect to the software it develops to create and manage multimedia content. However, we maintain our hold or 3-STARS recommendation on RealNetworks, based on competitive threats from the likes of several players in online music and gaming, as well as what we perceive as a full valuation.

Q: What Net stocks are in the tier just below buy -- accumulate?

A: The first one that comes to mind is InterActiveCorp (IACI). IACI is really a multifaceted play on online commerce and content, with businesses including Expedia,, HotWire, (Home Shopping Network),,, Lending Tree, eVite, and, to name a few.

Based on both p-e/growth relative to peers and even to the S&P 500, as well as discounted cash-flow analysis, the stock looks very attractive. However, the complexity of the company and its many businesses, in my opinion, has made the company modestly less attractive to investors. Nonetheless, we like the stock and have a 12-month target price of $40 a share.

[Another name] I'd like to mention is EarthLink (ELNK), which is one of the country's foremost Internet service providers. We believe people are underappreciating EarthLink's growth potential, particularly in broadband, and overestimating the competition. EarthLink has a well-established ISP franchise and is also beginning to explore alternative offerings via power lines and VoIP [voice over Internet protocol]. Given the company's substantial cash balance and relatively attractive p-e multiple of what we estimate this year at 19, and PEG of 1.2, we have a 12-month target price of $12 a share.

The final company I'll mention here is VeriSign (VRSN). Essentially, VeriSign is a multifaceted provider of infrastructure services enabling e-commerce and communications, as well as value-added telecommunications offerings, such as voice mail, for example.

We believe VeriSign is attractively priced at what we forecast as 25 times our 2004 EPS estimate, and with a p-e/growth of 1.6 -- both of which compare favorably to the company's peers. Our 12-month target price is $21 a share. We believe VeriSign is a great way to play a resurgence in telecommunications spending, as well as the emerging trend of RFID [radio-frequency identification], in which VeriSign is notably involved.

Q: How is the rapid movement toward wireless and handhelds -- and broadband -- affecting your area? Who will benefit most?

A: In terms of my specific stocks, I think a lot of companies stand to benefit incrementally. Think about it: More people are going to be accessing the Internet for more time than ever before, and that portends favorably for content companies, commerce companies, and software and infrastructure companies.

So I think that a lot of the names that we've been discussing -- including (in no particular order) Adobe, eBay, InterActiveCorp, and VeriSign -- all stand to benefit. EarthLink is a company I mentioned favorably that's the most direct play on more expansive online access via a variety of devices employing broadband. But clearly, more users spending more time online is better for Internet companies.

Q: Where does Yahoo! (YHOO) stand in the Net race currently?

A: Timely question, given that Yahoo is scheduled to report first-quarter earnings tomorrow -- Wednesday, Apr. 7. We think Yahoo is doing very well from a competitive standpoint and is making inroads of note in the search category, where the company's preeminence of a few years ago was overtaken by onetime partner Google.

Yahoo in mid-February began replacing Google technology on its Web site with technology Yahoo had acquired in 2003. Instantaneously, Yahoo gained market share. We expect the company to continue prioritizing its search, which is a primary driver of growth in both revenues and profits in 2004.

From an online-advertising perspective, Yahoo continues to be successful in garnering revenues from high-profile and well-moneyed Fortune 500 advertisers. However, notwithstanding the rosy fundamental picture, we believe Yahoo is fully valued currently. Our target price for the next 12 months is $51 a share.

Q: Glad you mentioned Google -- is its announcement of e-mail service part of an even bigger presence overall?

A: Although I don't cover Google, which I imagine is obvious, given the fact that the company isn't publicly traded at this point, we believe that its strategy is well beyond that of traditional search. The company in its public communications regarding Gmail suggests that e-mail is simply to some extent a logical extension of search -- and will be affording its users substantial storage and search capabilities.

However, as has been discussed over the past few days in many national publications that I've read, the company also plans on making use of its search technology to deliver targeted advertisements to its users.

It's my sense that Google's aims are much larger than traditional search, because ultimately it can deliver and garner greater value based on closer ties with users, as well as more information about them. This is why, in recent months, the company has really expanded from traditional search to everything from personalized news alerts to social networking to e-mail. I expect this trend to continue.

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