The Net-Stock Rally: Follow the Leaders

That's the advice from S&P's Scott Kessler, who sees big names like AOL and Adobe doing best

After months of pain for Internet stocks, the sector is now up 52% from its bottom. A long-term bullish period might not be far off, says Scott Kessler, Internet stock analyst for Standard & Poor's, who cautions that the stocks to focus on are the established leaders.

These comments came in a chat presented on May 29 by BusinessWeek Online and Standard & Poor's on America Online. Kessler was responding to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from the chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: How do you see the overall stock market right now?


...We are cautiously optimistic for the next 6 to 12 months, as we believe interest-rate cuts coupled with the recently enacted tax cuts will prop up the economy, resulting in renewed growth beginning in the second half of this year.

Q: On Net stocks, do you see any prospects for kind of recovery?


Despite a very difficult 2000 and first quarter of 2001, Internet stocks have bounced quite nicely off the bottom achieved on Apr. 4, 2001. In fact, the sector is up some 52% since that low, despite the residual impact of the dot-com crash and macroeconomic slowdown.

I think that we are at the beginning of a long-term bullish period for many of these stocks on the heels of what has been a dramatic and painful consolidation.

Q: What Net stocks have shown the best bounce?


Generally speaking, I'd say that the stocks that have fared best over the past month or two have been those that, in many cases, were most ravaged by the sell-off that began in March, 2000. That being said, there have been several stocks that have held up relatively well in this environment...[including] buy-rated stocks such as Adobe Systems (ADBE ), AOL Time Warner (AOL ), and even DoubleClick (DCLK ), which had a very difficult 2000 but has held up quite well this year.

Q: One analyst told us last week that he hears anecdotal evidence that Internet advertising is starting to revive.


My checks have indicated similar information. In fact, over the past few weeks, I've upgraded to "strong buy" both AOL Time Warner and DoubleClick, at least in part because I believe that the online advertising market has potentially bottomed.... More than likely, the demand for online advertising will accompany a rebound in the economy.

Q: How about Yahoo! (YHOO )?


It's a stock that clearly has been knocked off its pedestal over this period. Despite a huge user base that includes over 192 million registered users, and one of the Internet's best-known brands, the company is still in the process of transitioning from a business model reliant on advertising to one with more diversified components, including customer fees as well as business services.... Frankly, I think the jury is still out on Yahoo!

Q: There are two questions here about BroadVision (BVSN ).


...Although I was, and continue to be, optimistic about the company's long-term potential, the recent tumult in the business-to-business software space has resulted in dramatic shortfalls in revenues, margins, and earnings. Until BroadVision provides us with an indication that its customers are continuing to buy and deploy its products, we remain somewhat cautious.

Q: What business model do you expect to do best on the Net going forward?


If the downdraft last year into the first quarter of this year has taught us anything, it's that a diversified revenue model, coupled with a strategy to generate growth and earnings, is the best framework.... In addition, I think the past year has really demonstrated the essential importance of management with respect to these companies. Other things I look for in companies include large market share, competitive advantages, and continued improvements in fundamentals. Companies that come to mind include AOL, Adobe Systems, and eBay.

Q: Can you expand on your views about AOL?


I think the company is poised to easily outperform the market over the next year or so, for a number of reasons.... As Internet and media-company competitors struggled...AOL exceeded expectations that were untouched by preannouncements.... If AOL Time Warner can fare well in this tough environment, it surely will perform even better once the economy stabilizes.

There are several positive revenue catalysts in place...including the continued demand for digital cable offerings, the introduction of an Internet music subscription service, the launch of AOL broadband, and the debuts of many high-profile music albums and movies.

The company has, by far, the most valuable assets and deepest management team in its industry.... [It's] a "must own," not only for an investor interested in owning an Internet stock but for any investor interested in building a long-term blue-chip portfolio....

I think...sticking with the established leaders -- many of which are great companies and compelling values right now -- is the best strategy for Internet investing. [Other] companies I like include Akamai Technologies (AKA M) and RealNetworks (RNWK ). [They] are clearly market-leading companies, [and their] stocks...can appreciate significantly over a short period of time. I would also put DoubleClick in that category.

But I caution...that investing in Internet stocks is extremely risky, and as these companies provide significant upside opportunities, so too do they have notable downside risk. My advice: Stick with the leaders that have proven their ability to execute...

Q: Is now a good time to buy Ask Jeeves (ASKJ )?


Although I don't cover Ask Jeeves and it is not within S&P's coverage universe, I'm very skeptical about Ask Jeeves' business model.

Q: Is there any chance for Inktomi (INKT ) to recover soon?


Inktomi is not currently covered by an S&P analyst. However, I am somewhat familiar with the company, having visited them in Silicon Valley in November.... The company and the stock took a huge hit over the past year...specifically, because Internet service providers have been struggling mightily...However, as the company migrates its business model, focusing on more enterprise-related offerings, I think the company is quite well-positioned.

Q: What about Internet Capital Group (ICGE ) ?


Although ICGE is not covered at S&P, I think the past year has taught us that the incubator business model is definitely one that should be questioned, at the least. These companies tend to deliver results and performance on an extreme basis -- that being feast or famine. Rather than invest in an Internet incubator, I would recommend sticking with companies with more consistency and proven business models.

Q: Is there any future in media streaming?


I think there is great potential here and am bullish on several companies.... For example, RealNetworks is a company whose entire existence is predicated on the demand for online streaming solutions.... We also feel strongly that the company's MusicNet venture will be a major success.

...Another name we like in the streaming segment is Akamai Technologies. Akamai basically makes the distribution of streaming content faster and more efficient for content providers and -- perhaps more important -- corporate enterprises.

Q: What's your view of Extreme Networks (EXTR )?


Although I don't cover Extreme Networks, it is covered here at S&P. We believe that investors should avoid the shares.... Recent concerns with respect to the company's valuation are the primary motivation for this opinion.

Edited by Jack Dierdorff

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