Playing Survivor With Net Stocks

A few names still deserve a look, says S&P's Scott Kessler, and those still standing could see brighter days by the time the hit TV series returns

The Internet stock landscape is strewn with debris, but Scott Kessler, Internet stock analyst for Standard & Poor's, sees a few names still worth investing in. He has only two "strong buys" on the list of stocks he covers for S&P -- Adobe Systems and Macromedia.

However, Kessler adds a few other names, including, eBay, and AOL. What makes an Internet stock a "keeper," he believes, is a combination of factors -- among them the business model, competitive position, management, and the ability to execute.

On the negative side, he has a "sell" rating on EarthLink, and he reports that the S&P Ratings group sees eToys as in serious trouble. And he thinks AOL would be in worse shape on the market today were it not for the potential of the Time Warner merger.

Kessler was a guest in a chat presented on Dec. 26 on America Online by Business Week Online and S&P Personal Wealth. These were among the responses he made to questions from the audience, and from BW Online's Jack Dierdorff. Following are edited excerpts from the chat. A full transcript is available on AOL at keyword: BW Talk.

Q: Scott, it looks as if the broad market has made something of an attempt at a Santa Claus rally, but not necessarily for the stocks you cover.


This is definitely a challenging time for equity analysts -- particularly those of us who cover Internet stocks. I believe that the next week of trading, to a great extent, will be dictated by two factors: (1) tax-loss selling and (2) mutual-fund window dressing...I am, however, optimistic that a short-term bottom has been established with respect to many Internet companies.

Q: We advertised you as talking about the hunt for survivors in 2001 among Net stocks. How much hope is there?


January, as many of you probably know, will mark the return of the Survivor series on network television. And I think it will also mark a return of Internet stocks to more favorable performances than we've seen in the recent past. I definitely think that there are still some questionable business models and companies that are still in existence in the Internet space. However, there is absolutely no question that there are a number of blue-chip online plays that are built to last and will provide healthy returns to investors for years to come.

Q: What are some of the blue-chip online plays you see as built to last?


Of the companies that I cover, I'd list Adobe Systems (ADBE ), (AMZN ), DoubleClick (DCLK ), eBay (EBAY ), Macromedia (MACR ), Yahoo! (YHOO ), and, of course, AOL (AOL ), in that category. I'd also like to point out two additional companies which I recently picked up coverage of: BroadVision (BVSN ) and RealNetworks (RNWK ). These are just a few.

Q: When can we hope to see appreciation in AOL?


...If you look at AOL's stock performance over the past year, as compared to many of its online peers, you'll see that the shares have fared reasonably well. This is probably due to the fact that the company has a substantial subscription-revenue base, which is for the most part recurring, and has been in the process of merging with Time Warner (TWX ). I believe that the stock would have performed much worse if this transaction were not in the offing...However, I would caution you that I have a "hold" recommendation on AOL, primarily as a result of both slowing online ad spending and a possible hard-landing scenario playing out in the U.S. economy.

Q: Could you amplify a bit on RealNetworks?


I like the pun, and I also like the stock, notwithstanding the disappointing preannouncements the company reported less than one week ago. At this point, you have to consider RealNetworks the top play in online streaming technology, where it has something like an 85% market share...I currently have an "accumulate" recommendation on the stock at these very low prices.

Q: It's hard to talk about the Net without this name -- how about Microsoft (MSFT )?


I don't cover Microsoft. That's the task of my colleague, Jon Rudy...Currently, Jon has a "hold" recommendation on MSFT, reflecting a slowdown in PC sales and perhaps in the company's small-business segments.

Q: Opinion on Redback Networks (RBAK )?


Redback isn't covered by S&P. However, I would say that we do maintain an "accumulate" rating on shares of Ciena (CIEN ), which recently agreed to acquire Cyras, a privately held competitor to Redback. I'd look to Ciena as a nice way to participate in the emerging telecommunications-equipment market.

Q: Thoughts on Exodus (EXDS ) and Web hosting, please.


We do cover Exodus here, and our recommendation is "accumulate." I would add Exodus to the list of Internet companies that are here to stay -- and succeed. Although I don't cover the stock (and I thought that I'd point out that I also don't cover Ciena), we like it because it is the leader in what still is a rapidly growing Web hosting space...The key for Exodus is to ward off large, would-be competitors while expanding its services operation, and at the same time expanding margins...

Q: What is your opinion on eToys (ETYS )?

A: colleagues at S&P Ratings seem to think that the company might be on its last legs. Apparently, the stock market agrees, as the stock has been one of the worst performers over the past year. Here, financing is really the key, notwithstanding a questionable business model. This holiday season will probably make or break eToys. I guess we'll have to wait and see what happens.

Q: What is your perspective on why Net stocks have slipped so dramatically?


...The reason that Internet stocks have fared so poorly, for the most part, in 2000 is relatively complicated. Some reasons include astronomical valuations, limited access to capital, and slowdowns in a variety of essential technology-industry segments -- for example, PCs, wireless handsets, online ad spending, telecommunications, and broadband deployments. The combination of nonsustainable business models, and the cutting off of these companies' lifeblood -- that is, additional equity or debt financing -- coupled with reduced revenues, has made for a very tough year. This playing out of Darwinian economics will continue. I think that Internet infrastructure is a great area to focus on, as the slowdown in demand has been far less pronounced than in some of the areas that I just mentioned.

Q: What do you think of At Home (ATHM )? I am in at 15 -- would you sell?


I actually have an "accumulate" rating on At Home. It has obviously been a tough year for the company, but I'll go on record right now by saying that 2001 will be the year for consumer broadband in the U.S. At Home is righting its ship and is poised to benefit. Right now, the company is merely going through some growing pains...

Q: What about EarthLink (ELNK )?


We have our lowest investment rating [sell] on EarthLink for three simple and important reasons: (1) decelerating narrow-band revenue growth (this segment recently accounted for some 84% of revenue), (2) worsening negative margins (the company has been spending exorbitant sums of money on advertising and marketing and is still in the process of absorbing and consolidating a company that was once on Barron's list of potential burn victims,, (3) cash balances that have eroded sequentially (this trend will likely continue). Add to that, tax-loss selling for the next few days, and it's a recipe for a lower stock price.

Q: Before we adjourn, how about reminding us of your "keepers" among Net stocks?


I have "strong buy" recommendations on only two stocks: Adobe and Macromedia. These companies will continue to benefit from increased Internet users and usage, have robust product pipelines, and are extremely well-managed. These companies are not only built to last but also to provide returns to their shareholders.

Edited by Jack Dierdorff

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