What's Glowing Online Now

Smart buys are emerging from the Net's ruins

Two years ago, with online loan exchange LendingTree (TREE ) burning cash faster than all but 15 of 339 public Internet companies, CEO Doug Lebda looked like toast. But with mortgage markets hot, LendingTree's first profits under generally accepted accounting principles (GAAP) are on tap for the third quarter. "Back then, people were asking: `Can you survive?"' Lebda says. "Now, the question is: `How big can you become?"'

LendingTree's not alone. Now that the dust is settling, dot-coms that were built to last are whipping the market. BusinessWeek built a basket of Web companies that are profitable (at least by pro forma standards) and whose stocks Wall Street analysts rate buy or better. Our 20-stock Real-World Internet Index is up 3.2% this year (through Aug. 16), compared with an 18.2% decline in the Standard & Poor's 500-stock index. Real-World Net stocks are up 15.5% for the past 12 months and 5.9% for the past two years, beating the S&P by 36 and 42 points, respectively.

This time, Web stocks are on a much sturdier foundation. More companies are making money--about 50 of the remaining 200 public Net companies report GAAP profits, with at least 20 more profitable before noncash charges and interest. Key measures, especially for consumer-oriented companies, are still improving. Forrester Research (FORR ) expects e-commerce sales to rise 40% this year, to $72 billion. "People aren't giving up on the Internet, and the useless dot-coms are gone," says Forrester analyst Kate Delhagen.

Valuations are also much lower than in 2000, when Yahoo! commanded a price-earnings ratio of 1,826. Our index trades at 46 times this year's expected profits, according to San Francisco research firm Starmine Corp., vs. 18 for the S&P 500. Web winners share strong growth prospects, profitability, and enough size to give them operating leverage. That means that once they reach critical mass, their profit margins fatten as revenues grow. Pay-per-click search engine Overture Services is one example: It went from losing $10 million in the first half of 2001 to 20% net margins by the fourth quarter.

The brightest sector on the Web is e-tailing, commanding 9 of the 20 spots on our index (table). E-tailers have done much better than business-to-business plays such as purchasing site FreeMarkets and software makers such as Ariba (ARBA ), which have been hammered by slow corporate tech spending. E-tailers have also overtaken online stockbrokers, whose share of major-exchange trades has slipped to 17% from 45% since 2000, says Salomon Smith Barney analyst Guy Moszkowski.

Five of the 10 biggest e-tailers, based on sales just before the bubble burst in mid-2000, are profitable: Auction site eBay, hotel booker Hotels.com (ROOM ), travel site Expedia (EXPE ), Ticketmaster, and Priceline.com (PCLN ). Their ranks grow to six if you count Amazon.com (AMZN ), which makes money before interest and noncash charges but is still short of GAAP profits. The only profitable member of the Top 10 whose stock has gone down and stayed near its low is Priceline. Hard-pressed airlines have made fewer seats available to devotees of Priceline's name-your-own-price service since September 11.

E-tailers' financial models make sense once the companies get big enough. Except for bookseller/consumer-product merchant Amazon.com, which needs big warehouses and a large staff, top e-tailers sell services that are almost entirely virtual--an e-ticket from Expedia, an auction platform from eBay. Once fixed costs are covered, they're cheap to run, and a hefty share of incremental sales drops to the bottom line. E-finance companies such as LendingTree and Internet service provider United Online (UNTD ) have similar models. Jonathan Cohen, who has shares of LendingTree and United Online in his Royce Technology Value Fund, thinks each can grow fast with the facilities it already has, which should turn today's pro forma profits into solid GAAP performance.

What's cheap enough to buy? The best mix of risk and reward may come from 1-800-Flowers.com (FLWS ), Overture Services (OVER ), and Expedia and Hotels.com. All have had big drops this year, but each company's upside is still strong.

After a big runup in '01, 1-800-Flowers.com has fallen to $8 from $17 this year. One reason: Early venture capital is cashing out, says CIBC World Markets analyst Peter Benedict. But the stock trades at about 30 times this fiscal year's GAAP estimates, with operating earnings likely to grow 60% a year through fiscal '05 on 15% to 20% sales growth.

Overture's stock has also been hurt this year, falling 35% after rising fivefold in '01, as it lost distribution deals with America Online (AOL ) and Ask Jeeves (ASKJ ). Bears say competition from Google will hurt margins. Overture is already paying search-engine sites more to carry its listings, but it has also been able to raise ad rates 60% in the last year as other Web ad markets have collapsed. It has an unusual model: Advertisers pay only if a surfer visits their sites by clicking on search results.

Overture earned $46.8 million in the first half, vs. a $9.6 million loss a year earlier. Overture says GAAP profits will fall in 2003 because the company is just starting to pay taxes. But given its promising global expansion, rising prices, and GAAP p-e of 20, most analysts think it's a good buy.

Expedia and Hotels.com are tougher to figure. Each is down about 35% from the spring. In June, USA Interactive (USAI ), the holding company for CEO Barry Diller's e-commerce investments, made lowball offers for the shares it doesn't own in each. USA hasn't pressed its bids but still wants the companies. "We're focused, we're patient--and we don't overpay," says Vice-Chairman Victor Kaufman. The question: Can USA Interactive push through the deals at prices it chooses?

On fundamentals, Hotels and Expedia look smart. Prudential Securities (PRU ) analyst Mark Rowen says Expedia is worth $95, up from $55, based on 2003 GAAP estimates of $1.96 a share, up 100% from this year. Pacific Crest Securities (PCCI ) analyst Steve Weinstein reckons Hotels should boost 2003 pro forma earnings 50% or more, to $2.36 a share, pushing the $44 stock back to its peak of $70.

After the storm that drowned hundreds of Net companies, profits are seeping into the Web world. For those who don't mind the odd riptide, the water's inviting.

By Timothy J. Mullaney

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