"Halftime Review"--Multex/MarketGuide:>>>Cyber Corner Attitude Adjustments
By Marc H. Gerstein
June 28, 2000
Once upon a time, a dot.com suffix was all a company needed to become a stock market winner. Then, the tag turned to poison. Where are we now and what lies ahead?
1984?
Thinking about what internet stocks have been through in the first half of 2000 reminds me of a portion of the movie based on George Orwell's futuristic novel 1984, obviously written at a time when people really did see 1984 as far off in the future. Orwell envisioned a totalitarian state in which one's every move is monitored by "Big Brother."
There's a scene in which people are rallying before their leader (or at least his image on a TV-style monitor) raising their fists and screaming down with so-and-so country (the enemy). Suddenly, the leader announces a treaty with so-and-so and that war has been declared on somebody else. Immediately, the crowd resumes their fist-waving shouts, only this time, they yell about the other guys.
I can picture investors doing the exact same thing. First it's hooray for anything dot.com. Next we hear hooray for content. Then, it's hooray for e-commerce. Next, it's down with B2C e-commerce and content hooray for anything B2B. Then, comes down with B2B and hooray for infrastructure. Next, it's down with all dot.com.
I think we're back to liking infrastructure now. But I can picture a crowd of investors standing in front of the monitor waiting for Big Brother (or a popular sell side analyst) to announce who should be cheered and jeered next.
Underlyng Realities
With so much back-and-forth hype, it's not east for investors to maintain a clear view of this sector. For one thing, it's widely believed an internet stock bubble has burst and that internet stocks are passe. But consider this. The average 52-week share price change for the 778 stocks in the Market Guide internet database is +93.07%. The market capitalization weighted average is +105.20%. Yes, we're well below peak levels. But the overall 52-week performance is not shabby.
Over the past three months, dating more or less from the beginning of the so-called internet crash, the average share price change was -48.29% and the market capitalization weighted average change was -23.72%. The 48.29% drop was certainly severe. But it ought not raise eyebrows in this day and age, when shares of even the most solid of blue chip companies can drop that much in a day or so if they fail to meet analyst expectations.
It's true the internet sector presents more opportunities to incur losses like that than you'd get from the S&P 500. But the whole point of investing in internet at all is an expectation of unusually high returns, and we need not go any further than Finance 101 to learn that those who aim for exceptional returns typically expose themselves to exceptional risks.
As has been discussed here in past Cyber Corner columns, much of what's happening in this business pretty much lines up with what we've seen time and again in other startup businesses. Big losses are incurred early on. CFOs scramble to maintain adequate funding during the period when the company can't yet fund its own operations. Shakeouts occur as the marketplace separates strong from weak with the latter going by the wayside or being acquired by stronger entrants. Etc.
What's different with internet is the early appeal this startup sector has had for the public equity markets, especially individual investors. Companies like this usually get their initial equity financing in privately negotiated deals with venture capitalists. The current situation has been a curse and a blessing.
It's been a curse in that individual investors in the public equity markets can't expect terms nearly as favorable as those that would be negotiated by venture capitalists. But it's been a blessing for the companies in that the easy availability of cheap equity capital has made it easier for many to get off the ground quickly. The equity markets now aren't nearly as friendly toward internet companies as they were a year ago. But after experiencing such extreme generosity, the companies ought not be heard to complain that things have settled back to a level not significantly worse than what earlier generations of startups regarded as normal.
Bear in mind that however much of a shakeout we'll see is nothing compared to what we'd be facing if internet firms had to rely as heavily on debt as have other kinds of startups. (See 12/8/99 Cyber Corner article.) Amazon.com (AMZN) stands out as a noteworthy exception, a big-name net firm that has been willing to borrow heavily. But now, we legitimately wonder if that debt will ultimately keep AMZN from realizing it's on-paper potential.
Looking Ahead
Having experienced both euphoria and despair within such a short time frame, what more could internet investors expect? Answer: Balance. That may be the one thing that's been largely absent from this sector. And it could well emerge as an important theme over the rest of 2000, and hopefully, beyond. Here's how the balance theme may unfold in connection with some key issues.
--Cash Burn: Analysts had been looking at cash burn all along, and the public tuned into the issue in the spring. Unfortunately, the topic was popularized with more hype than analysis, but that's faded and investors now seem to be approaching the topic in a constructive manner. It's important to be aware of liquidity and the extent to which companies continue to use up their cash. And investors also understand the need to temper simplistic ratios (cash divided by quarterly use of cash) with projections of diminishing cash needs as well as additional funding opportunities. Still, emotion is an odd thing. Watch out for a bad spell in the internet sector whenever a well-known name bites the dust. But over time, such reactions should diminish, as the market gets increasingly comfortable with the fact that failures for some are normal and don't spell failure for all.
--The Holiday Season: Long term, I like B2C e-commerce (see below). But for now, I prefer the sidelines. All retailing is under pressure as investors worry about higher interest rates and a slowing economy. And when it comes to retail, investors, even under the best of conditions, tend to get a bit antsy as expectations get tossed about regarding the seasonally important holiday season. With e-tailers still having much to prove, jitters surrounding these stocks are likely to be far more extreme than what we're already seeing in the brick-and-mortar world.
--After The Holidays: Adopting a longer term perspective, I'd say rumors of the death of e-tailing are greatly exaggerated. (See 6/7/00 Cyber Corner). As we move into the second half, start looking closely at weakening commerce stocks and try to identify long-term keepers that might be available at bargain prices early in 2001. Also, pay close attention to brick-and-mortar chains, some of which may show signs of success in gaining a toehold into cyberspace. Look at the numbers, and surf the sites aggressively.
--Content: As discussed in Cyber Corner articles on 6/14/00 and 6/21/00, our love affair with internet infrastructure is going to look extremely silly if all we wind up with is faster downloading of empty web pages because all the content providers fare as poorly as so many now expect. Regardless of what numbers anyone might dredge up now, bank on the fact that over the long term, it's going to be about content. The two referenced articles review many issues that still need to be resolved in the years ahead. So we don't yet have all the answers. But with content stocks so far out of favor, this is a good time to start taking a hard look at this sector. And at least now, you have the luxury of doing that without worrying the stocks will run away from you if you don't buy in the next ten minutes.
--Infrastructure: If we've learned nothing else in the first half of 2000, we should have at least come to understand how easily that which is loved today can be hated tomorrow. Infrastructure is important long term, since we know our ability to deliver internet is going to have to become far, far better than it is at present. But getting from here to there isn't always a straight line. DSL investors may not be factoring this into their willingness to buy shares, but DSL customers are having little trouble figuring out that it's far easier for the marketers to talk about and sell DSL than it is for the operating folks to actually deliver the service. Cable broadband remains alive and well and wireless is just getting started. None of these issues are permanently earth shattering, but they may not mesh smoothly with the all-is-perfect bullishness so many now apply to infrastructure.
--Consolidation: It's still too early to tell if the America Online (AOL) Time Warner (TWX) merger will happen. Regardless, start thinking about consolidation. I'm not sure when we'll see it, but the sector seems ripe as there are too many companies with strong, but narrow, capabilities that could benefit from being part of a broader portfolio of products/services. Even before we're ready to start identifying merger candidates, there is one thing to think about right now. Look for opportunities that may arise if stocks are unduly pummeled by announced mergers. Many consolidation benefits are the sort that can't easily be measured by the numbers analysts use to formulate projections. If such situations arise, look for the two-plus-two-equals-five type of story and don't worry if EPS is going to be diluted for a few quarters.
--Forecasting: In yesterday's article, I expressed concern about the tendency of analysts to drastically overestimate their ability to forecast earnings, especially in a slowing economy. Those concerns are magnified when we turn to internet. Expect surprises, many of which will be unfavorable, when second quarter results are reported, and probably even more in the third quarter. You may find attractive opportunities in companies that are perfectly fine but whose stocks were hammered because of unrealistic expectations regarding the psychic abilities of analysts.
--Valuation Methods: So far, most investors have been valuing internet stocks based on multiples of sales. That sort of thing is OK for the very early stages, but we really can't rely only on that forever. We're still a long way off from being able to use P/E. But expect the market to shift toward some in-between ratio in the not-too-distant future. Other emerging industries compare share prices to EBITDA. And by the way, try not to focus on gross profits. Different ways of classifying costs as overhead or direct can make it hard to compare one company's gross margin with that of another. You're more likely to get apples-to-apples comparisons with operating margins.
--Valuation Levels: I saved the "best" for last. Even after the so-called internet crash, valuation remains an Achilles heel for this sector and overlays every other issue that's been discussed. In the past, if investors loved an internet company, they just bought the stock. But sooner or later, we have to seriously think about how much we're paying for however bright a future we may be buying into. Look at it this way. Who wouldn't pay $5,000 for a new top-of-the-line Mercedes? Who would pay $5 million for it? Most internet stocks ought not be owned at or near current prices unless you believe (1) the existing business can and probably will exceed analyst projections by substantial amounts and/or (2) the companies will evolve into a much broader business, with greater profit potential, than we now see. I'm not just saying this for the sake of saying it. Analysts are far more limited than most investors realize in their ability to forecast generally, and these limitations are much more pronounced when we turn to emerging technologies and industries. And companies really do evolve. Yahoo! (YHOO), for example, is much more than the search engine it was when it started.
So what's the bottom line? Should you buy internet stocks or avoid them? There is no single correct answer that works for every investor. That's because the forecasting uncertainties and valuation issues are so extreme as to defy any sort of conventional analysis. As a result, a go or no-go decision here is deeply intertwined with the financial resources and goals of each individual investor as well as his/her individual risk/return preferences.
But there's one thing that can be definitively stated. The easy-money era in internet is gone so it's important that whatever decision you make be based on calm consideration of the kinds of issues discussed above. Even if you can't always have all the answers, it'll be very helpful if you're least looking at the right questions.<<<
multex.marketguide.com ***Membership required.
|
