Thinning Air for Some Net Stocks

Shares of Internet software and retail outfits have had a strong run. Now, S&P's Scott Kessler is wary about their heady valuations

By Sam Stovall

Amid the resurgence in technology-related shares this year, it should be no surprise that two key S&P subindustries -- Internet Software & Services and Internet Retail -- have been in the for several weeks.

But can the good times continue for these groups? While they're both displaying strong relative strength, Scott Kessler, the analyst who follows both subindustries for S&P, believes they're adequately valued. This has led him to assign S&P investment rankings of 3 STARS (hold) to well-known names like Yahoo! (YHOO ; recent price $40) and eBay (EBAY ; $53).


  S&P believes the dot-com shakeout that began in the spring of 2000 is finally over. During the past three years or so, Kessler notes, many Internet outfits have made profitability a top priority by paring down or eliminating money-losing businesses, cutting discretionary spending, and streamlining infrastructure and processes. This has led to improved margins -- and allowed Web concerns to preserve capital. In addition, many players bolstered themselves by making strategic acquisitions, often of weaker competitors, says Kessler.

Improved business models -- and capital structures -- bode well for a number of Internet companies, in Kessler's view, particularly as economies around the world have started to show signs of recovery. Following a period of consolidation, S&P believes the survivors face less competition for customers, revenues, employees, and investment capital. The analyst thinks many remaining dot-coms are poised to benefit from these favorable circumstances.

But it appears the market may be getting ahead of itself over these companies' improved prospects, notes Kessler. Despite what he views as largely attractive fundamentals, he remains neutral on the Internet Software & Services subindustry because many of the group's stocks appear to have appreciated notably in anticipation of a considerably healthier U.S. economy.


  His investment outlook on the S&P Internet Retail subindustry is also neutral, reflecting what S&P thinks is significant potential -- and a high relative valuation. Market researcher International Data Corp. projects that worldwide business-to-consumer e-commerce spending will increase from $154.8 billion in 2002 to $615.6 billion in 2006, amounting to average annual increases of some 41% over the next few years.

S&P believes this substantial growth will continue to be driven by several factors. Online merchants often offer a compelling combination of convenience, selection, information, and value as compared to traditional competitors. Consumers can use the Internet to quickly find and conduct research about items at attractive prices. Some Web purchases are currently free of state and local sales taxes or shipping charges.

Also, S&P believes technology advancements have made e-commerce transactions easier to make -- and more reliable and secure. Lastly, traditional retailers have been increasingly using the Internet as a marketing, sales, and customer-service vehicle, in S&P's view, to better communicate with and provide greater options to new and existing buyers.

Among stocks in the Internet Software & Services subindustry, Kessler's top pick is enterprise content-management company Open Text (OTEX ; $19), which he ranks 5 STARS (buy) with a target price of $26 (see BW Online, 10/7/03, "A Good Story for Open Text"). His favorite in the Internet Retail subindustry is InterActiveCorp (IACI ; $31), a leader in online commerce and content, which he upgraded to 4 STARS (accumulate) on Nov. 11 with a target price of $40.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Nov. 14, 2003.

Industry/Sector Company S&P STARS* Rank
Computer & Electronics Retail/Consumer Discretionary Best Buy (BBY ) 4 STARS
Computer Storage & Peripherals/Info. Tech. Storage Technology (STK ) 4 STARS
Consumer Electronics/Consumer Discretionary Harman International (HAR ) 4 STARS
Diversified Metals & Mining/Materials Phelps Dodge (PD ) 3 STARS
Gold/Materials Newmont Mining (NEM ) 4 STARS
Homebuilding/Consumer Discretionary D.R. Horton (DHI ) 5 STARS
Internet Retail/Info. Tech. eBay (EBAY ) 3 STARS
Internet Software & Services/Info. Tech. Yahoo! (YHOO ) 3 STARS
IT Consulting & Services/Info. Tech. Unisys (UIS ) 3 STARS
Semiconductor Equip./Info. Tech. Applied Materials (AMAT ) 4 STARS
Semiconductors/Info. Tech. Intel (INTC ) 5 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Sam Stovall is chief investment strategist for Standard & Poor's

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