Net Stocks Worth a Little Insomnia

A wary eye on the the sector's valuations and volatility hasn't stopped S&P's Scott Kessler from spotting a handful of appealing buys

Internet stocks deserve a place in a portfolio, even though "their relative volatility might cause some sleepless nights." So says Scott Kessler, Standard & Poor's analyst of Internet software and services stocks, who notes that valuation is also an issue. (Like BusinessWeek and BusinessWeek Online, Standard & Poor's is a unit of The McGraw-Hill Companies.)

As a whole, Net stocks in 2003 have outperformed the S&P 500-stock index this year through Aug. 1 but have since lost ground because of investors' concerns over the latest earnings reports from the sector, says Kessler. For the future, he sees promising developments in areas such as music downloading and online search engines.

These were among the highlights of an investing chat with Kessler presented Aug. 5 by BusinessWeek Online and Standard & Poor's on America Online. Following are edited excerpts from the chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

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

Q: How have the stocks you cover been performing?

A:

Interestingly, through Aug. 1, Internet stocks have substantially outperformed the S&P 500. However, in recent weeks we've noticed a divergence in relative performance. Internet stocks have actually underperformed the broader market, basically as the beginning of earnings season kicked off with Yahoo!'s (YHOO ) second-quarter results that were good -- but not good enough for some investors.

Q: What is your opinion of InterActiveCorp (IACI )?

A:

A very timely question, given that this morning, IACI reported its second-quarter results, and the stock actually fell some 8%. Based on what I consider largely favorable revenues and margins for the second quarter, as well as encouraging guidance for free cash flow for 2003, we actually decided to take advantage of the disconnect between perception and reality, and upgraded the shares to buy, reflecting fundamentals that are better than we had thought and a discounted valuation due to some confusion, perhaps associated with the results.

We believe that IACI's results will continue to be driven by its travel-services segment, which continues to gain market share and increase revenues at a higher-than-expected rate and improve profitability. We think IACI is a perfect way to play an economic recovery and continued secular migration online, particularly with the increasing popularity of broadband.

Q: What do you think of Ask Jeeves (ASKJ )?

A:

We don't cover the stock, but on a more general basis, you probably know that online search has been one of the most active areas for merger-and-acquisition action over the last several months. We expect this consolidation to continue, with Microsoft (MSFT ) being in a position to potentially acquire some more sophisticated search technology, especially following the announced and now-pending acquisition of its important search partner, Overture Services (OVER ), by one of its fiercest Internet rivals, Yahoo.

We believe that there are probably a few more acquisitions, or at least enhanced partnerships, that will be disclosed by yearend. So companies that we look at as potential acquirees in this space include Ask Jeeves, FindWhat.com (FWHT ) (which is in the process of acquiring a British search company), and LookSmart (LOOK ), to name a few.

Q: Update us on the Internet music downloaders (legal), please.

A:

A lot has been happening. Recently, Jupiter convened a conference focused on the Internet music segment, and the overarching theme heard again and again is that companies, whether they currently offer these services or are planning to do so, have circled Dec. 25 -- Christmas Day -- as the date by which they hope to have launched substantial new services and functionality. Major players expected to participate in this rush include Apple Computer (AAPL ) through its successful iTunes Music Store. A Windows offering is expected from Apple for the holiday season. Also, RealNetworks (RNWK ), whose RealOne Rhapsody service is expected to debut new functionality for the important upcoming shopping season. And then there's Roxio (ROXI ), which is anticipated to launch Napster 2.0 as a legitimate music-download service sometime in November.

In addition, there's talk about giants like AOL Time Warner (AOL ), Amazon (AMZN ), and Microsoft entering the arena. It should be an exciting time for the industry and its consumers.

Q: Does wireless broadband access look promising? What stocks are the best way to play Wi-Fi?

A:

We believe there are a few ways to play this evolving trend. The most obvious is to focus on buy-rated Internet stocks that will benefit from the increased usage, such as InterActiveCorp, Expedia (EXPE ), and DoubleClick (DCLK ). Another way to potentially capitalize on this development is to buy some of the companies that manufacture wireless devices that enable Internet access and firms that make the chips that power these devices. Some buy-rated names include Nokia (NOK ) on the devices side and Intel (INTC ) and Texas Instruments (TXN ) on the chip side.

Q: Would you go long or short on Yahoo, eBay (EBAY ), and Amazon at today's prices?

A:

The trinity of the Internet! Let's go alphabetically. We currently rate Amazon 3-STARS [in S&P's Stock Appreciation Ranking System], or hold. The analyst who covers the stock believes that the company's improved earnings outlook is already fairly reflected in the shares. eBay is a great, great company. But again, our concern here is valuation. The stock is down notably from its recent high and trades at a price-earning multiples well in excess of the broader market.

Yahoo, in our opinion, has been the most aggressive of the three over the past several months, having acquired Inktomi (INKT ) and announced the pending acquisition of Overture Services to bolster its search offerings, as it competes with Google. Despite a recent pullback, however, we see the shares as fairly valued. These are all excellent companies with compelling opportunities, but I believe that much of their prospects are already reflected in the stocks.

Q: Are Internet stocks a safe place for your money these days?

A:

Safe is obviously a relative term, right? It's important to assess any company, Internet or otherwise, based on both fundamentals and valuation. Therefore, we believe that there are Internet companies with real profitable and sustainable businesses that will continue to grow. However, at what price is purchase of these stocks appropriate?

We rank only a few companies in our current coverage universe as buy, largely due to valuation-related issues. That being said, I think there are a number of Internet companies that you could buy and hold and feel comfortable with. It's just that their relative volatility might cause some sleepless nights. However, as part of a diversified portfolio, exposure to the Internet sector surely makes some sense, especially given the companies' propensity for growth.

Edited by Jack Dierdorff

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