Merrill's Cohen's last report there I believe:
Investment Highlights:
* Internet stocks last week staged a remarkable and difficult to explain rally,
with the three largest (market-capitalization) names - AOL, Yahoo! and
Amazon.com - reaching new all-time highs.
* We are now concerned that they have become driven almost entirely by
momentum and short-term trading considerations.
* Given recent levels of volatility, we would suggest that investors need for
the moment to view almost all public Internet stocks as trading-oriented (as
opposed to investment-oriented) vehicles.
* At the same time, we continue to believe that there exist companies with
hugely compelling business models which take fundamental advantage of
the Internet?s unique structure.
* Our overall outlook for the growth of Internet connectivity and commerce
remains extremely enthusiastic.
Fundamental Highlights:
* Our advice to investors is to focus on those public companies which have
demonstrated an ability to generate profitability and which trade at
valuations which bear at least some resemblance to their likely future
operating results (we continue to use a relative valuation methodology using
price-to-forward revenue multiples regressed against prospective operating
margins).
* We include AOL, Lycos, and 24/7 Media (each of which we maintain
Buy/Buy ratings on in the category of reasonably-priced companies well-positioned
to successfully transition to the next Internet operating model
(i.e. broadband)
Comment
United States
Internet Software & Svcs
23 November 1998
Jonathan Cohen
First Vice President
Tonia Pankopf
Assistant Vice President
Internet
Software & Services
Comments on Recent Internet Stock Price Moves
Reason for Report: Industry Update
Merrill Lynch & Co.
Global Securities Research & Economics Group
Global Fundamental Equity Research Department
RC#30232705
Industry
Internet Software & Services ? 23 November 1998
2
Internet stocks last week staged a remarkable and difficult
to explain rally, with the three largest (market-capitalization)
names ? AOL, Yahoo! and Amazon.com
? reaching new all-time highs. We note that those three
companies now have a combined market cap of
approximately $66.0 billion. Moreover, the recent rally
has not been confined to the large-caps: a simple average
(equally-weighted) of the share prices of 18 of the most
visible Internet stocks shows a 30-day gain of
approximately 76.5%.
The question has clearly become: What Next? Valuations
across the Internet space have always been enormously
volatile. We are now concerned that they have become
driven almost entirely by momentum and short-term
trading considerations. On that basis, we feel compelled to
caution investors against viewing any Internet stock in the
same context as they would other investments.
Specifically, and given recent levels of volatility, we
would suggest that investors need for the moment to view
almost all public Internet stocks as trading-oriented (as
opposed to investment-oriented) vehicles.
At the same time, we continue to believe that there exist
companies with hugely compelling business models which
take fundamental advantage of the Internet?s unique
structure. We think that the propagation of Internet
connectivity, and the benefits which will accrue from it
will span a 15-20 year event horizon. Given the profound
benefits of a ubiquitous global data network (most of
which have yet to even be conceived ), it seems reasonable
to expect that the Internet as a medium for investment
should remain at the forefront for at least the next 5-10
years. Our advice to investors is to focus on those public
companies which have demonstrated an ability to generate
profitability and which trade at valuations which bear at
least some resemblance to their likely future operating
results. Into that category we would place America
Online, Lycos and 24/7 Media (each of which we maintain
Buy/Buy ratings on).
Addressing the broader issue of valuations across the
Internet space, we believe that there exists a severe
imbalance between the supply of and the demand for
public Internet stocks. We expect that that imbalance will
be at least partially addressed during the first half of
calendar 1999. With the benefit of an open window for
Internet IPOs, and with a substantial backlog of companies
eager (and overeager) to access the public equity market,
the number of public companies will probably go from
about 20 now to closer to 30 fairly soon (we note that we
define ?Internet companies? more rigorously than many
others do).
In terms of the ultimate success or failure of individual
companies within this space, we continue to take a
relatively conservative outlook. We believe that the
various component enterprises across the Internet
(including companies engaged in commerce, content
creation and distribution, community sites and Internet-based
functionality) still look very much like early-stage
operating businesses: they are only just beginning to be
sufficiently mature where there individual strengths can be
evaluated. We continue to focus intently on the ability of
Internet companies to generate a meaningful return on
their invested capital. We expect that those companies
which are unable to meet that basic requirement will see
the violent erosion of their market values concurrent with
that realization by the market.
In fact, the broad-based destruction of Internet equity
valuations has occurred once before: from December 1995
through December 1996, most of the first-generation
Internet companies lost at least 60% of their market values.
Significantly, that period corresponded with disappointing
operating results from both connectivity providers and
Internet software companies. It is worth noting that the
current generation of public Internet companies are
focused primarily on building either proprietary content
(occasionally original, but more frequently aggregated) or
online consumer traffic upon which advertising revenues
can be generated. Furthermore, while stand-alone ISPs,
Internet Software companies, Portals, Internet Content
companies, etc. have each been affected by the equity
market?s changing sense of Internet fashion over the past 2
years, there have only been two major fundamental trends
during the life cycle of public Internet companies:
- Stage 1: Text only. Leader ? U.S. Government.
Consumer Access ? None.
- Stage 2: Text only. Leaders ? U.S. Government
and Academia. Consumer Access ? None.
- Stage 3: Text with graphics. Leaders ? AOL,
Prodigy and CompuServe. Consumer Access ?
Limited.
- Stage 4: Graphics with very limited video and
sound, communication (e-mail)-centric. Leaders
? AOL and Netscape. Consumer Access ?
Becoming more common in U.S.
- Stage 5 (Present): Limited (improved) video and
sound, commerce, text- and image-based
communication, community, content,
entertainment, computational (early-stage), etc.
Leaders ? AOL and Yahoo!. Consumer Access
? The leading reason for new PC sales.
- Stages 6/7/8: Full-motion video and high-quality
(16-bit red book or better) sound. Ubiquitous
consumer and corporate connectivity with high-bandwidth
(over 1-meg/sec.).
Our point here is that while things like aggregation and
disintermediation are mechanisms capable of generating
substantial results (and financial returns) over some period
of time, their practitioners tend to be dislocated by shifts in
either technology or market conditions. Our specific
worry is that the next several stages of the Internet?s
inevitable maturation will produce such a violent
Internet Software & Services ? 23 November 1998
3
redistribution of equity valuations that investors focused
on companies which rely on the existing Internet model
may abandon the space for some time.
With regard to Internet commerce and Amazon.com
(which wears the mantle of Internet commerce with the
least modesty and is the single company which we regard
as most egregiously overvalued within the Internet
universe), we have thus far been very unsuccessful in
predicting the recent movement of the stock price. Over
the past 30 days, the stock as increased in value by more
than 50%. At the same time, the stock seems to be almost
empirically mispriced. We continue to believe that
Amazon.com enjoys almost no significant competitive
advantage in a market characterized by razor-thin
operating margins. The company?s success in generating
revenues has come at the cost of very great operating
losses which we expect to continue for a substantial period
of time. While other Internet companies are at almost
perpetual risk from shifts to the technological and
competitive landscape, Amazon.com seems to have left
itself with no high ground on which to retreat.
It seems almost universally acknowledged that Internet
stocks are, broadly-speaking, overvalued (in some cases
grossly so). The question has now become: What event or
series of events will cause investors to reevaluate the
prospects of Internet stocks and bring valuations down to
more reasonable levels. We believe that the next stage of
the network?s development (including the more universal
deployment of broadband connectivity, the propagation of
device-based Internet solutions and the availability of
much richer functionality at the consumer level) will
trigger that reevaluation over the next 18 months. During
the interim, we continue to advise investors to focus on
those public companies best-positioned to successfully
transition to the next model (AOL is the most obvious
example) and to concentrate on relative valuations using
price-to-forward revenue multiples regressed against
prospective operating margins. Those valuation
calculations are available from us on a daily basis.
[AOL, LCOS, TFSM] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years.
[AMZN, TFSM, YHOO] The securities of the company are not listed but trade over-the-counter in the United States. In the US, retail sales and/or distribution of this report may be made only in states where these securities are
exempt from registration or have been qualified for sale. MLPF&S or its affiliates usually make a market in the securities of this company.
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 -Reduce,
5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend.
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