Another Interesting Read:
WHAT PRICE INTERNET STOCKS? (May 21, 1998)
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THEY LAUGHED over at Excite (XCIT) when Zapata (ZAP), a Houston firm whose major business is fish protein products, offered to acquire the Internet-directory company for $72 a share in a deal valued at $1.7 billion. Excite executives instantly rejected the bid, issuing a press release titled: "Excite Declines to Acquire Food Processing Company."
Laugh all you want at Zapata's offer -- an $11 a share premium over Excite's current price of 61 -- but it does raise a very serious question: How do you put a price tag on an Internet company? How do you operate in a market where what passes for value would make Ben Graham spin in his grave? It isn't difficult to imagine what the father of value investing would say about stocks such as Excite, Yahoo! (YHOO), Lycos (LCOS), and now schmaltz-marketer K-Tel Communications (KTEL).
Graham would no doubt want to know why, when a brilliant bellwether stock such as Lucent Technologies (LU) is considered expensive at a recent price of 72 and a forward P/E of 44, is Excite a must-have at a price of 61, with forward earnings of, um, negative fifty-seven cents? Some analysts now counsel not to pay attention to current valuations, or simply to "go with the winner."
With the Internet index of 55 companies tracked by Hambrecht & Quist having nearly tripled in the past year, and with talk of the Internet serving as infrastructure for nearly everything from shopping to sex and telephone calls, there's certainly a temptation to throw one's hands up in the air.
Don't do it. You can intelligently value Internet stocks -- though you may not want to go near any of them once you do. One way is to project earnings as far into the future as necessary, pick a decent multiple, say, 45, and discount that backward a bit to get a current value.
By that logic, Andrea Williams, who tracks Excite for Volpe Brown, says that not only was the offer far too low, but that Zapata itself brings no "synergy" to the deal. How much higher should it have been? Williams arrives at an 88 target for next year by taking EPS figures for fiscal year 2000 -- two years out, in other words -- and putting a 50 to 60 P/E multiple on that, then discounting it back 25%.
It's a model that works, for the moment, but already Williams has adjusted her metrics to account for the unpredictability of the Web. In its recently announced deal with Netscape (NSCP), Excite disclosed it will have an extra $31 million charge in the near future as a cost of doing business. While the deal will boost revenue, Williams says, it will also depress earnings in the near term.
To reflect the uncertainty in the stock represented by that sudden swing in earnings outlook, she has essentially abandoned her previous model, which focused on multiples of revenue, and is instead asking how much the company is worth as a multiple of earnings. It's a "somewhat more conservative" valuation method, Williams writes in a recent report, meant to reflect the significant execution challenges facing the company.
In cases where there is little "visibility," meaning ability to track earnings, analysts may simply multiply expected revenue not too far out. For Amazon.com (AMZN), for example, analyst Steve Horen of NationsBanc Montgomery Securities, has a 94 price target for next April. He gets that by multiplying projected revenue of $648 million for fiscal year 1999, or two years out, though Amazon's losses are expected to be almost double last year's $27 million by that time. Horen says Amazon is worth a premium to other Internet stocks based on future products, such as a recently launched music distribution business.
Some say a reasonable valuation for a profitable company like America Online (AOL) provides another metric, basically the value per subscriber, similar to the way wireless cellular phone operators value their real estate. Take the value per subscriber for the category leader, the thinking goes, and use that as your benchmark for all others in a group.
But Williams of Volpe Brown warns about leaping to conclusions in determining the value of any of the chips on the table. "You can certainly look at the revenues brought in by page views or hits for companies like Yahoo," says Williams. "But I don't think anyone's come up with a valuation metric for that yet."
The problem is, Internet companies seem to change their business plans faster than chat room participants switch identities. Netscape, for example, started out as a software company. Now, it plans to derive an increasing portion of its earnings through advertising banners on its Web site, which it plans to turn into an Internet portal to compete with Yahoo, Excite and the like.
Roger McNamee, an investor with technology investment firm Integral Capital Partners, argues that the risk/reward ratio for Internet stocks may be out of balance in the current market. "People excuse these valuations with the explanation that this is nothing more than public venture capital," he says. "Unfortunately, at these valuation levels, this is like shooting yourself in the head and calling it target practice."
The typical venture investment, according to McNamee, combines three risk factors, namely market risk (i.e., the market the company is targeting with its products); technology risk; and execution risk, or the company's ability to successfully carry out its business plan. In a public company, only execution risk should remain, with the other two factors having been proven. However, the Internet stocks carry many of the same troubling issues as startup companies, with business models changing rapidly. McNamee argues that for the amount of risk carried by some public companies, a comparable investment on the private side would be valued much lower.
The flight to AOL as a "quality" stock because it actually has revenue one can track, and the hesitancy of shrewd investors such as McNamee, raises another peculiar question for the Internet crew, namely who exactly is buying these issues? You would think that few mutual fund managers would be brave enough to hold shares of these sky-high P/E stocks.
But according to CDA/Spectrum, of the 45 million Yahoo! shares outstanding as of the latest quarter, a total of 101 major institutions owned 11 million shares collectively, about 10% of that held by domestic mutual funds. As for Lycos, 67 institutional investors owned roughly half of the 15 million shares outstanding, with about a quarter of that held by funds.
We doubt seriously if the majority of these institutional shareholders bought in when these companies were trading at mere fractions of what they are now. Investors such as McNamee point out that the incredible runup in these stocks has taken place under ideal market conditions -- almost zero inflation, low interest rates and solid economic growth.
"If interest rates rise, people will be much less willing to invest in 'concepts' [such as Internet stocks]," says McNamee. "And if the fundamentals for the large cap stocks decline, then the average market cap of tech stocks will decline, and it will be really hard for anything to perform well in that environment."
Perhaps Excite will rue the day when it laughed off Zapata's offer. But there is one more thing to keep in mind: The prices for many of these stocks are based on optimistic projections of the Internet's growth rate. And like all momentum stocks, the Internet group will probably tank at the first sign of trouble. That said, up until now at least, the growth of the Internet has exceeded even the most optimistic expectations.
-- By Tiernan Ray Source: SMART MONEY |
