Launching BusinessWeek's Real World Internet Index in August, 2002, struck many readers as a bad joke. But we thought an index of profitable Net companies would pay off because once e-companies get big enough to turn profitable, earnings usually ramp up fast and fuel big stock gains. Score one for us: The index rose 71% in Year One, beating the Standard & Poor's 500-stock index by 65 percentage points. When we revised the index in August, we said the good times would keep coming -- just not as fast. Right again: The index is up 24.5% since Aug. 15, vs. 16.0% for the S&P 500 and 19.8% for the NASDAQ.
The reason for all the mojo is that Web profits, once achieved, usually rise much faster than sales. Yahoo! (YHOO ), for example, saw 2003 profits jump 456% on a 71% sales gain. Much the same is true at several of our best performers, notably distance-education leader University of Phoenix Online (UOPX ) and e-broker Ameritrade (AMTD ). More operating leverage is coming: Piper Jaffray analyst Safa Rashtchy says profits before interest, taxes, and noncash charges will rise 37% or more in 2005 on just a 23% revenue gain. "As long as there's that leverage, investors are pretty much safe," Rashtchy says.
NEW PICKS SHINE
The Index's best performer by far in the past six months has been DVD rental service Netflix (NFLX ), with a 176% gain. Three of the four next-best joined the index when we added seven stocks (and dropped eight) last August: Security-software leader Symantec (SYMC ) is up 72%; Ameritrade, up 68%; and fellow online broker E*Trade (ET ), up 62%. Alas, not every new pick was quite so slick. Digital Insight (DGIN ), whose software runs e-banking sites, is flat. Search-advertising company FindWhat.com (FWHT ), job site Monster Worldwide (MNST ), and Priceline.com (PCLN ) have fallen. Indeed, valuations are strikingly sane, with the average price-earnings ratio of the index's stocks at 38, based on 2004 profit forecasts. At those levels, profit growth can back up the multiples. Still, the Net changes so fast that the list has to be altered to keep up with new trends -- and fix our bad picks. We're adding five stocks and deleting four: Monster, FindWhat, online bond exchange eSpeed (ESPD ), and domain-name registrar Register.com (RCOM ).
The biggest trend is the Net's rise in China, where several companies already make money even though only 6% of the population has Web access. We're adding leading Chinese Web portal Sina (SINA ) and online travel leader Ctrip.com International (CTRP ). Lehman Brothers (LEH ) analyst Lu Sun says Sina will earn $71 million this year, for a p-e ratio of 38. For Shanghai-based Ctrip, Merrill Lynch (MER ) sees net income of $12 million this year and $18 million in 2005. Considering the potential, Ctrip's 38 p-e doesn't seem so tall.
Two other trends are the comeback of Web advertising and consumers managing money online. We're adding DoubleClick, (DCLK ) which sells software and services to Web sites and advertisers. Analysts think DoubleClick will make about $44 million this year, for a 35 p-e. Checkfree (CKFR ), which sells software that lets consumers get and pay bills through banks' sites, is a new pick as well. Some 25% of consumers pay bills online, a figure that's rising fast. Checkfree trades at 28 times estimates for the year that ends in June. With long-term growth expected at 20% a year, that's reasonable.
The last addition is Websense (WBSN ), whose software lets companies monitor workers' Net use. It's at 28 times earnings, and estimates look low because of a big backlog. Profits are expected to grow 22% a year, making Websense a play on the common-sense idea that Web security will stay a priority.
The market for Web stocks is more rational than bubble-phobic skeptics think. Valuations have fallen, and Net companies still run cheaper than off-line rivals and grow faster. They ain't risk-free. But can they keep beating the market? The bet here is yes.
By Timothy J. Mullaney