Net Values: Will The Next Great Stock Be Found In Cyberspace? How To Separate Today's Highfliers From Tomorrow's Flameouts
{scroll down, thread, the best part is in the middle of the aticle]
This story appears in the August issue of SmartMoney
magazine.
By Tiernan Ray, Nellie S. Huang and David B.
Lipschultz
What's the latest hot Internet stock -- the stock that's
being touted on the cyberspace chat boards, the stock
that is going to tear up its competitors, the stock that's
going to make its investors rich? A year ago it was At
Home, a company that provides Internet services
through cable-TV modems. The stock, which went
public at $10.50 in July 1997, has climbed 387 percent
since then. Six months ago it was DoubleClick, which
creates ads for online advertisers. That stock went
public in February at $17 and shot up to $41 -- a 141
percent gain -- in two months. Then just a few weeks
ago CNET announced a $32 million deal with NBC, as
its stock hit yet another new high -- up 95 percent from
just a year ago.
It's hard not to watch all this and wonder if you're
missing the boat if you don't take all your savings and let
it ride on, say, Yahoo! (up 400 percent in the past 12
months). After all, as you've probably heard too many
times already, if you had just been prescient enough to
have put $10,000 into a stock like Dell Computer back
in 1990, you'd have nearly $4 million in your pocket
right now.
But that begs the question -- at least for a rational
investor -- of how you value these Internet stocks. How
do you decide if today's highflier is actually going to turn
out to be tomorrow's flameout? (After all, five years ago
you might well have put $10,000 in the 3DO Co., which
makes multimedia entertainment software for the
Internet, and been left with nothing but bitter memories:
The stock has dropped 88 percent since its initial public
offering.) This is, when all is said and done, a
maddeningly tough sector to measure - - a collection of
stocks that seem to go out of their way to defy
conventional analysis.
Let's take Amazon.com, that pioneer of e-commerce. It
has recently experienced a 236 percent runup in its
stock. How would traditional research -- like examining
its price/earnings ratio -- value this company? Well,
Amazon.com trades at around $99, a lofty price for a
company expected to lose $1.15 a share in its 1998
fiscal year and 61 cents in 1999. But P/E is an unfairly
rigid measure of such a young company's potential, you
say, so let's try price/sales (Amazon.com's is a
stratospheric 24.5, compared with other booksellers'
ratios of 1) or price/book value (182) or even price/cash
(the company doesn't have any cash, but it does carry a
debt/capital ratio of 79.5).
Okay. Let's cast aside these traditional -- some might
say moribund -- measures and try to value these Internet
stocks the way the experts do. Take, for instance,
Morgan Stanley's Mary Meeker, probably the sector's
most influential analyst right now. Meeker generally
values a company based on revenue minus expenses
projected out to the year 2001. With those numbers,
she runs a series of complex calculations that determine
at what level a stock should be trading. Based on that
analysis, Meeker has been bullish on Amazon.com of
late, but now says, "I felt a lot more comfortable talking
about Amazon a few months ago" -- when it was 30
points lower.
Then there is Keith Benjamin, who puts a different
methodology to work at the San Francisco brokerage
firm BancAmerica Robertson Stephens. He looks
principally at how many people are turning to the given
business and how that feeds into earnings. With
Amazon.com he estimates that over 8 million people will
be using the site by the year 2001, contributing to
revenue of $120 per user and net income of over $7 per
user. Taking these figures, he then projects an earnings
number for the year 2001, discounting expected
expenses. Assuming that earnings should trade at a
multiple of 50, he then comes up with a current price
target based on those numbers. Given all this, he figures,
Amazon.com should be trading at $44, 52 percent
lower than its current price.
And then, of course, there is the very real possibility that
this bookselling phenomenon is just a sitting duck, with
Barnes & Noble -- a company with 1,011 stores, $2.8
billion in revenue and 27 years of success under
Chairman Leonard Riggio -- vowing to blow
Amazon.com off the Net one day soon.
With risks like these on the Internet, is it any wonder
that Warren Buffett just bought an insurance company?
Buffett may be steering clear of the Internet right now,
but plenty of mutual fund managers have been diving
right in. Legg Mason's William Miller is buying America
Online -- a stock recently trading at 106 times 1999
earnings. So is Mike DiCarlo at John Hancock Special
Equities, Warren Lammert at Janus Mercury and Jim
McCall at PBHG Large Cap Growth. Meanwhile, Gus
Sauter, the index-fund maven at Vanguard, is buying
Yahoo!
But these fund managers all have good reason to buy
these kinds of stocks, no matter how overvalued they
may seem to the rest of us. For managers in an
increasingly competitive fund world, it's almost worse to
miss out on buying the "next great stock" than to have
gambled and lost. Their shareholders are typically willing
to let them take these kinds of risks because the ultimate
payout could be so great.
And we agree. But what works for a fund manager may
not work for you. Yes, there is money to be made on
the Internet by individual investors. Yes, many of these
stocks look tempting. But if you are going to gamble on
this sector -- and by gamble, we mean taking $10,000
or so, not your entire retirement stash -- we think the
best course to follow is one that lets you work the odds
in your favor.
How to do that? Well, we believe there are three
strategies worth pursuing in the Internet sector:
1. Buy a front-runner that still looks good on a valuation
basis.
2. Buy a beaten-down company with upside potential.
3. Buy an undiscovered stock.
Can you find such stocks right now? We took a close
look at more than four dozen Internet companies in four
broad areas - - software, infrastructure, the media and
e-commerce -- and came up with four picks that look
promising to us, including one that somewhat stretches
the definition of an Internet stock and yet seems uniquely
poised to benefit from the continuing growth of
cyberspace.
FOLLOW THE LEADER WorldCom
When it comes to overall market leaders, perhaps no
Internet company appeals to us more than Cisco
Systems, an $86 billion maker of networking equipment
for the Net. We have recommended this stock twice in
the past two years: first in September 1996 ("Sifting
Through the Debris"), at a split- adjusted price of
$32.95, and then in October 1997 ("Ten Stocks for the
Year 2000 and Beyond"), when we stated that Cisco,
then trading at $51.92, could well become the next Intel
or Microsoft -- a blue-chip stock with explosive
earnings growth. While we still think there is
considerable promise in this stock, at a little over $83
right now, it's a bit expensive to recommend --
particularly as a value play.
Thus we cast our net a little wider in looking for an
industry leader to put some money on. You might not
think of the telecommunications market as a field for
Internet investing, but the Internet is a global
communications network -- the reach of which is
unprecedented in scale and unbounded in the way that it
will transform work and play. That consumers can pay
bills online through a service such as CheckFree or
Intuit, a practice no one would have imagined possible
only a few years ago, is due to this network,
undergirded by telephone carriers that have invested in
making the transport of data from Web site to desktop
PC more reliable. In other words, none of this would be
happening without the phone companies that build and
maintain the Internet.
WorldCom (WCOM; $47.59. All stock prices as of
June 26) is our pick for the carrier that best understands
how to sell the Internet as a service to businesses and
the consumer. Bernard J. Ebbers has already made
several magazine covers with a string of more than 50
acquisitions since he founded WorldCom 15 years ago.
But Ebbers now has a very different task before him.
Integrating the UUNet division of WorldCom, one of the
organizations that best understands the promise of the
Internet, with MCI Communications, a blue-chip service
and sales operation for which WorldCom is paying
roughly $37 billion, is a daunting task. Ebbers must do
this at a time when the old Baby Bells, especially SBC
Communications, and AT&T are learning to be more
entrepreneurial and more aggressive.
But Ebbers has a good handle on what will propel
growth, with a strong focus on the business services that
will most likely be a key driver of the Internet carrier
business. Companies are replacing expensive "leased
line" data-networking facilities with so-called virtual
private networks built from relatively inexpensive
Internet connections. Earlier this year Ebbers acquired
two prime data-networking firms: the network services
part of CompuServe as well as ANS Communications,
an important early player in the Internet's construction.
And Ebbers has made key investments in competitive
local exchange carriers, startup phone companies that
will give him a beachhead in local markets.
SmartMoney: Net Values: Will The Next Great -2- But
it's the UUNet network that really goes to the heart of
what WorldCom is doing. Even before WorldCom
picked up UUNet in 1996, when it acquired MFS
Communications, UUNet was already the largest
Internet service provider in the world. From the start,
WorldCom's goal was to build its own global network,
controlling costs and boosting the bottom line. What
UUNet accomplished, and what Ebbers built at
WorldCom, adds up to a very rich strategic asset that's
going to be hard for competitors to duplicate.
What's more, Ebbers is taking that powerful fiber
network overseas, to European and Asian markets that
represent a tremendous potential upside for voice and
data services. Governments around the world are
unburdening themselves of their monopoly telecom
providers, and that has spurred a race to provide
competitive services in what is estimated to be a $700
billion global market for telecommunications. And
WorldCom is cheap relative to its brethren. Qwest
Communications is a fascinating example of the great
public- works project that is the Internet: It's laying
hundreds of miles of fiber-optic cable crisscrossing the
country. Qwest is pricier on both an earnings and
sales-multiple basis: about 7.7 times sales on a recent
price of about $33, while the company is expected to
lose 17 cents a share this year on further expansion of its
network. At a recent price of around $47, WorldCom
trades at about 6.1 times sales and 53 times this year's
projected earnings.
We wouldn't wait for the integration to be completed at
WorldCom to put money on this stock. Though earnings
models are tenuous at this stage, WorldCom is expected
to bring in $1.97 in 1999 per-share earnings and $2.78
in 2000. In Internet terms, that's great upside. As analyst
William Vogel at Montgomery Securities says, "If you're
going to be investing in the Internet, you want to go with
the company that's going to be the battalion leader, the
arms dealer to everyone. And that's WorldCom."
BET ON AN UNDERDOG Netscape
Lately it's been difficult to tell just what's going on with
the company that started the Internet craze, but there is
long-term value in this stock if you're willing to sit
through its soap opera. Having been chased out of the
browser business by Microsoft, Netscape (NSCP;
$27.19) has been licking its wounds since the beginning
of this year as it made the transition to a new revenue
model.
The damage so far has been serious, but it may also be
near an end. For the fiscal year ending this October,
analysts expect a loss of 64 cents a share. The company
was forced to change its fiscal-year reporting schedule
after losing 22 cents a share in the fourth quarter and
taking restructuring charges in January to recover from
Microsoft's attack. Now, however, the company has
declared itself a portal site, akin to Yahoo!, Infoseek,
Excite and other content-oriented Internet companies. It
continues to sell advertisers premium space on its Web
site, as well as prominent positions on its browser, which
it is now giving away. A number of analysts bumped up
their recommendations on the company in June, citing a
potential windfall from Netscape's portal business. For
example, Steve Sigmond of Dain Rauscher Wessels
foresees $125 million in revenue from Netscape's
Netcenter site in 1998 and $198 million next year. The
hope among some investors is that the industry pioneer
might be picked up at a substantial premium by a media
company that wants Netscape's real estate, the same
way CNET and Infoseek received hefty premiums from
NBC and Disney, respectively, for controlling interests
in their online properties.
But if Netscape does get bought, it'll be a surprise. It's
hard to imagine the company's brand meaning much to
most big media companies. Rather than planning on a
fire sale, then, you'd better evaluate Netscape as a going
software concern. The task won't be easy: Netscape's
software revenue for the most recent quarter dropped
year over year, from $89 million in the first quarter of
1997 to $77 million in the April quarter of this year.
Among smaller information-technology shops, its
software is considered bloated and unwieldy, with many
IT managers preferring simpler, more reliable software
such as Apache.
But Netscape has had some wins lately, like the $20
million deal it signed with Citibank back in May.
Citibank is using Netscape's suite of server software as
the horsepower for a new Web site that will give
consumers a range of online banking services. Deals like
this mark an important transition for Netscape. Whereas
once the company sought to compete in the market for
so-called groupware, head-on against Microsoft and
IBM's Lotus division, Netscape is now positioning itself
as a builder of infrastructure for a variety of large online
business ventures.
In addition, Netscape has not fully given up the browser
business. The company is planning another free release
soon and the 5.0 version of Navigator is promised by
year's end. Both versions will help keep surfers coming
back to Netscape's home page, and it's also possible
Netscape will sell add-ons and enhancements to its
browser in the future, given that the company has a
prime shot at being a major software-distribution hub.
With technology leadership and a clear commitment to
sticking it out for the long haul, not to mention a superior
sales channel in its well-trafficked Web site, Netscape
has tremendous potential that's not reflected in its
beaten-down stock.
GO UNDISCOVERED Broadvision or Iona
Leaving aside Netscape, Broadvision (BVSN; $22.06)
has perhaps the greatest potential of becoming a
powerful supplier of so-called enterprise software, the
technology that companies depend on to run their
businesses, such as Oracle's database products.
Broadvision founder and CEO Pehong Chen was one of
the first entrepreneurs to use the now oft-repeated term
"extranet" to describe how businesses can transform the
way they work together by harnessing the Internet. But
Broadvision has been fighting an uphill battle, both to
convince the world of Chen's vision and to move
forward in a crowded market of similar Web software
vendors. Over the past two years the company has
duked it out with a variety of players who had
competing products of one sort or another: Open
Market, Connect and even Steve Jobs's old company,
NeXT Software.
But Chen's company remains the best-positioned of the
bunch, says Bill Burnham, vice president of electronic
commerce at Deutsche Bank, who follows the company.
Broadvision's One-to- One system is a kind of engine
that allows companies to create personalized Web sites
through which to sell targeted goods and services.
Moreover, Chen is really in the business of selling
applications-programs that help structure the way
companies sell over the Net, and the way they manage
relationships with partners and with employees on
internal networks. That kind of practical edge is unique
to Broadvision and stems directly from Chen's original
belief that the Net would change the way companies do
business.
How far can it go? Broadvision executives say they
expect to bring in $50 million in revenue this year, and
feel confident they're about to register their first
profitable quarter. Hambrecht & Quist's Dan Rimer,
who expects the company to post $71.5 million in
revenue next year, says Broadvision is just rolling out its
sales and marketing push to corporate America. That
suggests that the company's rate of new- customer
acquisition, which it pres ent ly pegs at 20 to 30 a
month, could bump up in the future.
As for our second pick here, it's rare to see an
entrepreneurial spirit emerge from corporate welfare.
But it seems Europe's dole has given birth to a high-tech
company every bit as competitive as a Silicon Valley
startup. The founders of Iona Technologies (IONAY;
$36.88) credit the lack of venture funding in their native
Ireland and a government- funded software project at
Trinity College, Dublin, in the 1980s with getting Iona
listed on the Nasdaq as a profitable concern. Last year
the company raised $160 million in a public offering and
turned in a respectable 38 cents of profit per share, with
expectations of 61 cents per share this year and 95
cents in 1999.
Iona's being forced to subsist for many years after its
1991 founding as an independent consulting business,
without hope of venture money, may be what has set the
company apart from other middleware companies. A
discipline whose mere mention puts most investors to
sleep, middleware (the link between software programs
running on different computer systems) has led to few if
any tremendously successful companies. Most
middleware outfits labor in obscurity, building a nice
cottage business but rarely achieving notoriety or
substantial sales growth.
But Iona is riding the wave of an industry standard that
has gained momentum in the past two years. It's called
Corba, and many believe it will tie together the Web
sites of the world and play a key role in Net commerce.
Iona has rapidly turned out multiple variations of Corba
since its inception in 1991, under the appealing rubric
"Orbix." Companies use the technology to link Web
software across a variety of operating systems, including
Microsoft's Windows NT and UNIX.
With revenue of $17 million in the first quarter, up 93
percent from a year ago, Iona is still small, and there's
no guarantee it will grow to be as huge as companies
like Oracle. But Marshall Senk of Banc America
Robertson Stephens predicts revenue of $83 million this
year and $123 million next year, a 60 percent annual
growth rate.
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