Have Net Investors Lost Their Minds?
Unruffled by the Internet stock craze, our three top analysts name online equities you'd be nuts to buy now--and one you'd be nuts not to.
Nelson D. Schwartz
Let's see if we got this straight: You sell compilations of oldies on CD via an 800 number on late-night TV, and your stock languishes around $6. Then you announce you will sell the same CDs on the Internet, and your stock is suddenly worth $65. That, it seems, is the market's judgment on K-tel International, a humble music retailer that added $220 million in market value simply by uttering the word "Internet." Call us crazy, but isn't that a sign that things are getting a tad overheated in the market for Internet stocks?
Now, certainly no one would deny that the Internet is a big deal or that it will one day make some shareholders very rich. But you have to wonder whether they will be the same shareholders now buying K-tel at 206 times earnings, Yahoo at 257 times, or AOL at 176.
That's why we decided to turn for advice to three of Wall Street's sharpest analysts: Henry Blodget, a onetime investment banker who now tracks Internet and new-media stocks for CIBC Oppenheimer; Jonathan Cohen, a top-ranked stock picker who recently joined Merrill Lynch after stints at Smith Barney and UBS Securities; and Brian Oakes, a former network engineer who came to Wall Street 12 years ago and now analyzes Internet and publishing companies for Lehman Brothers. Keep in mind that even the stocks all three like still carry a high degree of risk. We started with a question that anyone watching Internet stocks couldn't help but wonder right now:
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Are we in the middle of a bubble?
Oakes: I don't really think we're in a bubble, but that's the question you have to ask when you see stocks like K-tel go to $65 overnight. No one even realized K-tel was there, and now every other company that wants to get its stock price up creates a division it calls Internet.
Blodget: I would say "waves" is a better term than "bubbles." In this sector you've seen several surges followed by pullbacks. I think there are fundamental differences between Internet stocks--between, say, a Netscape and a Yahoo. Technology is a winner-take-all business. Media is not. Netscape was a technology company that got into trouble because it failed to have the best technology. Yahoo is not tech based, so it's likely you won't have the same sort of correction that Netscape had.
Cohen: If the question is, will we see some Internet stocks come down in price dramatically, the answer is clearly yes.
Oakes: There are going to be winners and losers, and history tells us the losers will see their share prices cut in half or worse.
Blodget: But if you are a growth investor and not invested in this sector, you really could be missing the biggest thing since the PC or the telephone. It's almost imperative to put some money to work.
Are most people looking at these stocks in a rational way?
Cohen: I don't think so. There is an enormous amount of emotionalism attached to the buying and selling of Internet stocks.
Oakes: Jonathan is right. All the valuation work in the world isn't going to help you if the emotion on a stock has turned negative. So once you do all your valuation work, you still have to step back and ask yourself what the expectations are for this company over the next 12 to 18 months.
Blodget: You can expect these stocks to be very volatile, but the fact that they are expensive does not mean by itself that they have to come down. If the fundamentals deteriorate or the competitive landscape changes, however, the high valuations will exacerbate the correction.
Speaking of volatile, what is going on with K-tel?
Oakes: It's music, and music is hot on the Internet.
Blodget: You have CDnow and N2K, so people look at music as the next hot area. So they saw K-tel and thought, "Here's another music name; great, let's go after music." And K-tel actually is a real company. It has roughly $75 million in revenue. It hasn't been growing spectacularly, but that's more than can be said for some online commerce companies that have gone public.
Oakes: But a lot of K-tel's revenue is traditional, not Internet related. I've seen a lot of traditional businesses that have been around 20 or 30 years create an Internet subsidiary just to try to get that Internet multiple.
Let's talk about another company that's been on fire lately--Yahoo.
Blodget: The bullish case is that Yahoo is an Internet media company that can tap the $150 billion advertising pie as well as the direct-marketing segment, worth another $150 billion. We firmly believe that brand is the single most important factor on the Internet, and Yahoo has one of the top three Internet brands.
Along with?
Blodget: Along with AOL and Netscape. This is a field that could double annually and grow into a multibillion-dollar business in the next several years. Even if you believe that, Yahoo is still extremely expensive. But Yahoo is one of the only names that many investors will consider buying. Our take is that Yahoo was expensive at $30 and was still expensive at $70. But as long as the company continues to beat expectations, the stock will go up. Obviously, Yahoo runs the risk of a major correction if it disappoints.
Then, is the argument for Yahoo that people will buy it at a higher and higher price until it stops going up?
Cohen: No, I think the argument is better than that. Yahoo is the strongest player among Internet search engines. The issue for us has been valuation, which is why we have a long-term buy on Yahoo but a neutral in the intermediate term. We have put a more aggressive intermediate-term rating on Lycos, which is trading at about a quarter of Yahoo's valuation.
Oakes: No one has ever questioned Yahoo's capabilities or management. But at some point, you've got to step back and ask yourself, how much of this good news is already factored into the stock price?
Blodget: Yahoo is up 12 times from last year's price, so obviously a lot of the near-term run is out of the stock. But if you say Yahoo is too expensive, you have to consider what happens if it doesn't pull back to a price where you can be comfortable getting back in. Do you think anything is going to kill it? If not, then stay in for a while longer.
All three of you have buy ratings on AOL--are you truly confident about this famously volatile company?
Cohen: We are, absolutely. AOL is both the single strongest player and one of the least expensive. That's an easy thing to overlook, given how strong the stock has been recently. In fact, AOL is enormously compelling even at these levels.
Oakes: I agree. AOL is trading between $1,100 and $1,300 per subscriber, while investors in cable stocks pay $2,000 to $2,500. I see a similar business model developing, but with AOL having higher margins and much greater free cash flow.
Blodget: I also think AOL is an enormously powerful brand, but I'd suggest AOL's business model has more evolving to do. AOL will see continuing erosion of its gross margins because usage of the service is going up faster than it can handle. However, there are many ways they can address that, including the obvious: increasing the monthly service charge.
Let's talk about Infoseek.
Blodget: We have the equivalent of a long-term buy on Infoseek. We think the Internet is big enough to support multiple players. We just don't think it's big enough to support multiple huge players. We really see Infoseek as being in a different competitive position from Yahoo, AOL, or potentially Netscape. Instead, Infoseek may evolve into a specialist focusing on a particular segment of the market.
Jonathan, you've got a neutral on Infoseek.
Cohen: Infoseek is certainly a viable, legitimate competitor, but it has had an enormous run-up. Less than a year ago, the shares were about $4.50, and recently they traded as high as $40.
Fair enough. What about Excite?
Oakes: We think Excite has as good an opportunity as anyone to be a clear No. 2, and its valuation was at such a compelling discount to Yahoo's that we put an outperform rating on the stock.
Blodget: We actually have a hold on Excite. We downgraded it at $91 a couple of weeks ago because we thought there was a bubble. When a stock has run up 100% in two weeks, anything that can be perceived as negative could bring it down. We decided at $91 we'd had enough. In our mind, Excite is a higher-risk, higher-reward opportunity. The company is clearly rolling the dice to become No. 2 after Yahoo.
Cohen: We're enthusiastic about Excite's operating prospects. The company will continue to grow strongly. But given the volatility in Excite shares, we're fairly conservative, at least in the near term.
If Internet commerce does take off as you all predict, what businesses do you think will end up as road kill on the information superhighway?
Blodget: Everything from travel agents to telephone books. There are so many businesses here that could be threatened by the Internet.
Oakes: I follow a publicly traded sector that's always said to be threatened by the Internet--newspapers. I think that has been blown out of proportion. To date, they don't see any impact. It may be different for booksellers. Amazon has just captured the Internet marketplace. In fact, the whole retail industry could be threatened by an Amazon.
Cohen: Speaking of Amazon, I think Barnes & Noble has done a very good job responding to Amazon's threat. They put together a very strong Web presence.
If you have two favorites, especially for individual investors, what would they be?
Oakes: Well, if I look at my Internet coverage, it's got to be AOL, as No. 1, and Excite as No. 2.
Cohen: AOL and Lycos.
Blodget: AOL and Yahoo.
Any final words of advice?
Cohen: I think that investors should tread carefully in this segment. That doesn't mean don't participate, but exercise even greater discretion than you normally would when investing in equities.
Blodget: I agree. Invest with extreme care.
Oakes: We've had people call us just looking for Internet stocks, not even sure what the names were. They'd say, "Just tell me an Internet name, because I need to play the Internet. I need to buy it. I need to own it." I think if there is any rule of thumb, it's to stick to the industry leaders. That should be a less risky investment than picking up a company that someone on the elevator told you has an Internet business.
Issue date: June 8, 1998
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