Time To Buy Net Stocks: No Or Yes?


By Dean Foust

First, a confession: I'm an Internet junkie. I've burned thousands of hours surfing the Web to research the articles I've written, the cars I've bought, the investments I've made, and, oh yeah, the latest news on my beloved North Carolina Tar Heels. I've used "E-tailers" like Amazon.com Inc. and Microsoft Corp.'s Expedia to purchase books, stocks, music CDs, flowers, airline tickets--you name it. My advice? Don't buy Internet stocks. If you own any, dump them and don't look back. Because if there's any term that describes Wall Street's love affair with Net stocks, it ain't Revolution or New Paradigm. It's Bubble.

Make no mistake, I believe the Internet is profoundly improving how we perform many routine tasks and will continue to transform entire industries. But it defies logic that the Internet's growing influence over the U.S. economy justifies the $2 trillion valuation that Net-related companies have been given by investors. That's roughly 20% of all U.S. equities, and three-quarters as much as all the companies in the Japanese stock market, says Morgan Stanley Dean Witter economist Stephen S. Roach.

GONE OVERBOARD. In their rush to cash in on the Internet, investors have gone overboard. The valuations afforded bellwether stocks such as Amazon.com, Yahoo!, and eBay--which trades at 900 times last year's earnings--have soared beyond what these companies' earnings could ever justify.

Think about it: Even if priceline.com Inc., whose site auctions empty airline seats, succeeded in filling every vacant seat on every major carrier, the commissions from those transactions still couldn't justify the company's current $21 billion valuation--one that exceeds the combined market capitalization of Delta Air Lines, US Airways, and United Airlines. The market is valuing each dollar of priceline.com revenue at $109, compared with $2.41 for IBM. Granted, priceline.com believes it can branch out to auctions of hotel rooms, cars, and mortgages. But those markets are unproven. Besides, if priceline.com does make it big, what's to stop the companies that supply the goods it auctions from cutting out the middleman and conducting their own auctions? Nothing.

For all the rhetoric about the boundless potential of cyberspace, at some point these upstarts have to grow up and be valued like real companies. But when? New Jersey money manager David Dreman recently applied the traditional dividend discount model to 10 bellwether Internet stocks. His assumption: Earnings grow 50% for the next three years and 25% for the five years after that, gradually trending down to a mature 7.5% growth rate around the year 2020. By that measure, eBay should be worth not $187 per share, but somewhere between $3 and $6, depending on the risk premium you apply. Yahoo!, which currently boasts a p-e of 470, should trade not at $161, but as little as $13. Ditto for all the other stocks that Dreman examined, including Amazon.com, America Online, and E*Trade Group.

Even at that, Dreman may have been too generous. The reason to be bearish on Internet stocks at their current valuations is that many Net players may be facing the paradox of Profitless Prosperity: robust revenues and wafer-thin profits.

LOW-COST INVADERS. The same low barriers to entry that enabled sites such as Amazon.com and E*Trade to sneak up on the old guard will leave them similarly vulnerable to low-cost upstarts. Actually, not all of the invaders are new kids on the block: Even Yahoo! is getting in on the action by undercutting eBay, which charges sellers a 2.5% commission. (Yahoo! offers sellers its online auction service for free, relying on ad revenues to make a buck.)

Heightening the competition are super-search sites such as Best Book Buys. It provides head-to-head price comparisons between book retailers--and will link you to six online booksellers that will sell you Tom Wolfe's A Man in Full for as much as 28% below what Amazon charges. Given the lack of barriers to competition, how can Web players like Amazon ever hope to enjoy the kind of pricing power that a Gillette or a DaimlerChrysler enjoys in the real world?

For all the dollars I've spent on the Web, it isn't clear any of these sites has made a dime of profit from me. Every time I book a flight through Expedia, Microsoft earns roughly $10--part of which goes to the airlines for use of their reservation systems. But any profits are certainly offset by the countless times I've searched Expedia for a fare but didn't book a flight--leaving Microsoft on the hook for the fees to airlines. This is the stuff that p-e multiples of 1,000 are made of?

Foust is Atlanta bureau chief.


By Linda Himelstein

Maybe I'm crazy. I'd have to be to think that America Online Inc. is worth 40% more than mighty Time Warner Inc., right? Or that money-losing Amazon.com's value is justifiable at seven times the combined market value of giants Barnes & Noble and Borders Group? But when it comes to the next-to-impossible exercise of valuing these and other Internet superstars, I'm simply a believer.

Forget all the financial wizardry. Virtually every Wall Street analyst has tried to concoct some formula to pinpoint the correct valuation of Internet stocks. But those efforts are pretty much shots in the dark. The stock prices of these companies are based largely on what the future holds for the Web, and no crystal ball can predict that. So you've got to make a gut call. My gut tells me the Internet is going to be big. No, huge.

STILL A BABY. First, some basic facts. The Internet is still just a baby. Some 160 million people around the globe are logged on to the Net now, according to International Data Corp. By 2003, IDC expects that figure to mushroom to 500 million. Online spending is also in for a considerable bump. IDC predicts that businesses and consumers, which spent a combined $50 billion online in 1998, will fork over $1.3 trillion in 2003.

So now we're talking real dough. Apply that to a company like online auctioneer eBay Inc., which is the Web's most trafficked site as measured by page views and average time spent perusing goodies like Beanie Babies and antique pickle jars. The four-year-old upstart is already racking up $690,000 in revenue per employee, more than four times the ratio of super-efficient Wal-Mart Stores Inc. That edge will grow because already profitable eBay won't have to add many employees to ratchet up its offerings. Much more revenue, not much more cost: It doesn't take a rocket scientist to figure out that economies of scale like this--enjoyed by numerous Web leaders--will lead to a rosy future. Maybe a market cap of $26 billion doesn't sound so far off after all.

A similar calculation could be made for Amazon.com--despite the expectation that it will continue to lose millions of dollars for at least three more years because of growing marketing and infrastructure spending. Here's a company with $294 million in revenue in its most recent quarter. That represents an annual growth rate of 328% in the past two years, compared with 8% for IBM (table).

And this is before Amazon's expansion into new products and services has kicked in. CEO Jeffrey P. Bezos wants to make Amazon the place for millions of consumers to find "anything that they might want to buy online." So far, he has been able to do that no matter what product he's peddling. Some 66% of Amazon's customers are repeat buyers, and the company ranks at the top in surveys of customer service. Is it such a stretch to say that Amazon, with a current market cap of $24 billion, could be the Wal-Mart of the Internet? (Wal-Mart's market value is $200 billion.)

STANDARD SLAMS. The two standard slams against Net stocks are that Internet revenues can't possibly grow as quickly as fans expect and that Net companies are vulnerable to new entrants. But as time goes by, both arguments are steadily weakening. Companies like AOL and Yahoo! Inc. have consistently blown through Wall Street's revenue projections. This is particularly impressive for Web granddaddy AOL. And as for those supposedly low barriers to entry, AOL and other Web leaders are proving they have two powerful advantages over newcomers: brand loyalty and hard-won technical expertise.

All this is not to say that there won't be a heap of overvalued dogs in the Internet space. And even good stocks will gyrate--with its latest tumble, for instance, Amazon.com is off nearly one-third from its high last month. But if you believe the Internet is a revolutionary force that will change the way we conduct business and how we buy everything from cars to cribs, then snapping up stocks valued at several hundred times earnings today may not be crazy at all. Indeed, it may be crazy not to.

Himelstein is Silicon Valley bureau chief.