BW ONLINE DAILY BRIEFING
INVESTING Q&A June 28, 1999
Merrill Lynch's Henry Blodget on Where Net Stocks Are Headed
The Net and E-commerce analyst suggests investing with caution -- and holding on for the ride
Some 10 to 20 large successful Internet companies will be created over the long-term, predicts Henry Blodget, Merrill Lynch senior analyst for Internet and E-commerce stocks. However, the majority of Net companies are likely to be acquired, or to fail.
That's why Blodget advises long-term investors to hedge their bets and own a basket of Internet stocks rather than just one or two. CMGI, which operates kind of like a venture capital fund for Internet firms, is a good choice for those looking to own a number of Internet companies while only buying one stock, Blodget advises. And there are already some Internet "blue chips" to choose from, including America Online, Yahoo, and Amazon.com, that he thinks will survive.
Blodget also discussed ways to measure the growth of Internet usage, whether an Internet company can be successful using an advertising-only model, and his favorite Internet and E-commerce stock picks -- all in a chat hosted by Business Week Online on America Online on June 24. Here is an edited version of Blodget's responses to questions from the audience and from Business Week Online moderator Jack Dierdorff.
Q: Are there any signs of a slowdown in the growth of Internet usage, or are we still at a breakneck expansion pace? Also, What's your favorite method for measuring Internet usage?
A: Relative to most industries, we are still growing at a breakneck pace. However, on a percentage basis the growth rate is definitely starting to slow in the business-to-consumer space. We still expect that there will be tremendous growth over the next five years, but we are no longer growing at 100% year-over-year in terms of number of people on line.
We think that you can measure traffic growth in three separate ways, each of which is valuable in a different way. You can look at the number of people online, the average time spent per person online, or page views. As broadband develops it is likely that time will become more important than it is now. Right now, page views are more important.
Q: Is there such a thing as blue-chip Internet stocks?
A: On a relative basis, yes. These stocks are still incredibly volatile, very risky, and extremely expensive. But, there is no question that companies like America Online, Yahoo, and likely Amazon.com have real businesses that should be around for a long time. Therefore, we would regard stocks like these as the blue chips of the Internet.
Q: How profitable will Amazon be when music companies and book publishers get their own Internet sites for retail sales?
A: We don't think that many music labels or book publishers will be very successful selling music and books directly. Therefore, we do not view them as a threat to Amazon's profitability. How profitable Amazon can become is still very much an open question. Our guess is that if the company continues to successfully develop a global electronic commerce franchise with a number one or number two market position in each product category, the company will produce net margins in the area of 5% to 10%. This is obviously very difficult to prove, however, and it is a long way in the future.
Q: Why don't you think music companies and book publishers will do a good job selling their products directly to consumers over the Net?
A: The number one criterion for consumers when choosing a particular online retailing site is selection, not price. We believe that very few consumers know which music label or which publisher makes a particular record or book. We therefore think that consumers would find it very inconvenient to search multiple publishing or record label sites to find the book or record they were looking for. We think that online retailers like Amazon, which aggregate millions of titles from thousands of publishers, add considerable value to the consumer as well as to the publishers. Thus they occupy a valuable space in the distribution chain.
Also, publishers and record labels are very dependent on their existing distribution channels both online and offline. The moment they begin to sell product directly at lower prices than can be found at their distributors, they create severe channel conflict. Book and music retailers will get irritated because they will feel as though they are being cut out of the distribution process. This is something that very few publishers or record labels can afford to do. As a result, we think it is unlikely that publishers and labels will sell their products at lower prices than a consumer could find in a book or record store.
Q: What do you think of DoubleClick now that CMGI is going after AltaVista?
A: We think that DoubleClick has a viable business with or without AltaVista. There is no question that the company is currently dependent on AltaVista for a significant percentage of its revenues (40%). But, long-term we believe the company will do well regardless. Also, it is not clear that AltaVista would stop using DoubleClick if it were to be acquired by CMGI. DoubleClick has one of the most powerful sales forces in the industry and Alta Vista would almost certainly lose revenue if it were to switch.
Q: How do you like CMGI?
A: We think CMGI is a good way to play the growth of the Internet for two reasons. One, it allows investors to buy a portfolio of investments while buying only one stock. Investors are also able to buy that portfolio at private market value, which is obviously much cheaper than public market value. However the performance of CMGI as a stock is almost directly correlated to the performance of the Internet sector in general and the Internet IPO market in particular. As a result, CMGI tends to be more volatile than an already unbelievably volatile sector. So if you buy it, hang on to your hat.
Q: Is Wit Capital ahead of its time?
A: Right now the financial services industry, including the investment banking industry, is going through tremendous change. As this happens old firms are breaking apart and new ones are being formed. We think that Wit Capital has some competitive advantage because it is so focused on the Internet and has access to some Internet distribution. We also think it is a good time to form a new investment bank, and therefore we imagine that Wit will probably do well whether or not its Internet strategy is successful.
Q: What do you think of content aggregators like InfoSpace?
A: The Internet ultimately is about the rapid and efficient distribution of information. We think it makes more sense to have one or two major content aggregators that serve hundreds of different distribution points rather than having hundreds of different content aggregators that have to create and maintain the same commodity like information. Therefore, we think that InfoSpace has a good business model.
Q: What is your opinion of the Dutch auction method of IPOs? It seems like a great idea, but the Salon.com IPO didn't exactly inspire confidence in the model. What's the future there?
A: In general, the Internet is allowing the proliferation of many new pricing mechanisms across multiple industries. We are not surprised to see this in the investment industry. We think that the Dutch auction model probably favors the issuer more than the investor, and because it is not optimal for either the issuer or the investor we are not sure how successful it will be.
We think the current pricing mechanism for IPOs in the capital markets is actually very good because it allows the issuer and the investors to effectively negotiate a price for the securities. When the model works well, both the issuer and the investor are pleased with the outcome of the transaction. Therefore, although we expect to see more innovative pricing mechanisms, such as the Dutch auction, used in this industry we would not be surprised if the current model remains the primary one.
With regard to Salon, we would not judge the Dutch auction model by the success of this particular IPO, which may have simply been brought to market at a bad time.
Q: Can you please comment on the proposition that the Internet's effects on society will be revolutionary, but as an investment very few will be financially successful?
A: We think the Internet will ultimately be as important in changing the world economy as the industrial revolution. In the process, we think it will create at least 10 to 20 large successful companies over the long-term. Without question, however, the majority of companies are likely to get acquired or fail. Most markets are like this, although the Internet market obviously is much larger and more diverse than others.
Q: Do you think a Web company can be successful using an advertising-only business model? Will Web advertising ever be as compelling to advertisers as TV or print ads?
A: We think that advertising on the Internet will always be very different from television or print advertising. We think it will be complimentary to these media, and therefore we think it will likely find a place in many company marketing budgets.
With regard to the advertising-only business model, we think that a few large companies such as Yahoo and America Online will continue to do very well while generating primarily advertising revenue (in this we obviously exclude AOL's subscription revenue). We also think that some small, targeted companies can probably survive on an advertising model. That said, however, there is no question that commerce is an extraordinarily large opportunity and ultimately we think that most companies will try to use a hybrid advertising and commerce model. We think that even commerce companies will often have advertising revenue as well as commerce revenue (for example, BUY.COM).
Q: What do you think of the impact of day trading on Net stocks and the market as a whole?
A: I don't think of it as either good or bad, but merely as change. And, it is clearly causing significant change in the way stocks trade, especially in the Internet sector. When we have a severe bear market we expect that much of the enthusiasm and gambling-like behavior of many day traders will diminish, and therefore that the impact of day trading on the overall market will lessen. However, as it is in other industries, the Internet is allowing a much larger segment of the population to go "direct" (in this case, to trade on their own). We expect that change in the market place will likely be permanent.
Q: To sum up, can you quickly name your top Net and E-commerce favorites?
A: Our recommendations are very much intended as long-term investments rather than near-term stock picks (unfortunately we can't change our ratings every few weeks based on short-term price movements). In this context, the stocks we are comfortable owning for the long-term include industry leaders such as AOL, Yahoo, eBay, Amazon, Inktomi, AtHome, DoubleClick, and others.
Our general recommendation for long-term investors is that they own a basket of these stocks rather than concentrating the investment in one name. We think it is highly likely that one or more of these companies will fail, although we don't know which ones. We also believe that because of the extreme valuations and volatility of Internet stocks, even the most aggressive investors should invest only a small percentage of their total portfolio in the sector. The risks are too great otherwise. |
