Commentary: Dot Coms: Buy Ratings Vs. Burn Rates

Quick, what goes up but hardly ever comes down?

It's not only the bonuses of Wall Street hotshots or the number of penny-stock scams. It's analysts' recommendations on dot-com stocks. Business Week reviewed the 125 dot-coms that went public before the end of 1999, are at least 40% below what they were trading at when the Nasdaq peaked on Mar. 10, and have less than 30 months until they burn up all their cash, according to Pegasus Research International, an Internet company research firm.

Out of these 125, 82 have at least one analyst who has rated it a "strong buy," according to Zacks Investment Research. And a staggering number--100 of the 125 stocks reviewed--have "buy" ratings on them by one or more analysts. "They're overwhelmingly optimistic," says Chuck Epstein, spokesman for Zacks. A "strong buy" is generally considered the highest rating for a stock, with a "buy" being the second highest.

SLIM PROSPECTS. What's more astounding, scores of these companies have financial problems. They've run through most of the cash they raised during their initial public offerings, and some are fast becoming penny stocks. According to I/B/E/S, the earnings research firm, analysts are projecting slower revenue growth for dot-coms this year--102% year over year vs. 190% in 1999. And because the market has ceased rewarding companies that went public on a mere hope of ka-ching and a prayer, they have slim prospects of securing additional financing. "Many of these companies will disappear altogether," says Greg Kyle, president of Pegasus.

It seems inconceivable that analysts would hang on so tightly to their buy recommendations in the face of such devastation. But that's what's happening, and it will continue even as the stock prices go lower. Analysts are not about to alienate the companies they cover, especially when their firm has underwritten an IPO. "The bread and butter of these analysts' firms is on the investment banking side. They can't afford to lose that business," says Kyle. In a recent study by Investment Dealers' Digest, the underwriting analyst still had buy recommendations on 80% of 20 IPOs reviewed, even after these stocks had slid substantially from their 52-week highs. Analysts argue that if their firm believes in a company strongly enough to take it public, they should maintain a high recommendation on the stock. "If they liked the stock at 20, and it's now at 2, it ought to be a good buy as long as there aren't fundamental problems with the company," says Roy Smith, a New York University finance professor and former Goldman, Sachs & Co. partner.

HANGING TOUGH. According to First Call, the earnings research firm, of the 125 companies reviewed, the average consensus recommendations have remained unchanged since the Nasdaq high, when dot-coms began their recent dive.

Even when there are problems with these companies--like management woes and flawed business models--the analysts hang tough. Never mind taking a cold, hard look at the merits of the individual companies. "These stocks are difficult, if not impossible, to put a value on in the first place. So the analysts figured it's their job to pick stocks that are going up, and that's often what they did while the market was hot," says NYU's Smith. Hence many recommendations, which are often based on 12-month stock-price targets, were classified as "strong buys." And analysts have maintained those ratings, saying that dot-coms are merely in a summer slump and will revive in the fall. Call it a back-to-school dot-com rally, though it's likely most stocks won't make the grade.

Because many dot-coms are fledgling companies with scant fundamentals to get their arms around, dot-com analysts have practiced financial voodoo, using things like "customer acquisition values" and "revenue multiples" to justify their buy recommendations. And the methods analysts use to project future revenues for dot-coms tend to assume "best case scenario" variables such as strong market conditions and optimal margin structures.

`BEST SPIN.' To some dot-com analysts, patience is a great virtue. One analyst who has "strong buys" on five of the 11 Internet stocks he covers and "buys" on the remaining six, says he bases his recommendations solely on a discounted cash flow model looking 10 years out. But that's looking at strong market conditions and the best margins possible in the company's industry. "Even I don't give a lot of credence to that because who knows what a company will look like in 10 years. It's putting the best spin on it," he says.

After talking to some analysts who have adorned dot-coms with strong buys, you'd think they should be rated strong sells. U.S. Bancorp Piper Jaffray Inc. analyst Timothy Klein has a strong buy on, a company that allows consumers to research and buy new and used cars online. Yet he says, "There are a lot of concerns over whether or not Autoweb's concept will actually work." He even says that the company's "burn rate" is extremely fast, and that there is a lot of "noise," or competition, among automotive sites.

What's more, Klein says, the company isn't expected to turn a profit until late 2001. The stock, which traded as high as $40 a share after its IPO last March, is now around $3. So why the hearty recommendation? He attributes it to Autoweb's "good brand name and content."

Then there are analysts who, unable to find a few redeeming features in a company, cry takeover. Vik Grover, an analyst at Kaufman Brothers, likes the fact that ZipLink Inc., a small business-to-business Internet service provider, has such big-name clients like NetZero Inc. and WebTV, but he really likes the stock because ZipLink is prime for a takeover. "They could make one phone call and have a buyer in a minute," he says, citing recent takeovers in the area, like McLeod USA Inc.'s purchase of Splitrock Services Inc. for a cool 10 times revenue.

Finally, some analysts, while maintaining lofty recommendations on stocks, are trying to hedge their bets. Take Mary G. Meeker, Morgan Stanley Dean Witter Inc.'s star Internet analyst. Though she has said repeatedly that many dot-coms will fail, she has barely budged on her bullish recommendations. Others say they attach "risk factors" to their recommendations.

Jeffrey Klinefelter, a U.S. Bancorp Piper Jaffray analyst, has a strong buy on Bluefly Inc., a fledgling online purveyor of discounted designer clothes. Says Klinefelter, "There's very little competition, due to the fact that funding for other dot-coms has dried up." But he is quick to add that he has also called "speculative." "Despite its very significant upside potential, we think it's high-risk." Problem is, only a select few ever see the research reports that include such risk factors. They only see the "strong buy" rating.

So if you're ready to buy some of these beaten-down dot-coms on a buy recommendation, have I got a bridge to sell you.

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