AOL and 'Pretty Boy' made TSC today.
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Commentary Features: *New* Christopher Byron: The Internet Stocks Go Off Line
By Christopher Byron
Special to TheStreet.com
9/10/98 12:53 PM ET
(Editor's note: In our continuing effort to expand our roster of contributors, we introduce Christopher Byron, the tart-tongued commentator who writes for several outlets, including our editorial ally, the New York Observer. Byron has developed a reputation as a tough-nosed watcher of the investing world. Each Thursday we will bring you his Back of the Envelope column, which also appears in the Observer. If you have comments, questions or feedback, feel free to email me at dkansas@thestreet.com. As always, the opinions of our contributors are theirs and do not necessarily reflect a view endorsed by TheStreet.com.)
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The real story in this convulsion isn't whether the 30 stocks that make up the Dow are collectively worth 19 times current earnings, in contrast to, say, the 14 times earnings at which the group has traded, on average, over the past 70 years.
There's a lesson to be drawn from the wild stock market ride that has carried the broad market averages all over the place in recent days: Internet stocks stink.
As everyone not in institutional confinement now knows, it's been a wild time indeed, with the 30 stocks of the Dow Jones industrials dropping 1063 points, or 12.3% of their value, in just four trading days -- one of them the sickening 512-point drop on Aug. 31 -- then recovering all of that, plus another 475 points, in the five trading days thereafter.
Yet the real story in this convulsion isn't about P/E ratios. The real story here is what investors have at last begun to realize regarding the real worth of many of the junky initial public offerings in the Internet sector: basically nuttin'.
This is something that many officers, directors and other insider investors in the sector have known for quite some time now, and as we'll see in a minute, many began bailing out of this overheated group in the weeks leading up to the current collapse, registering an astounding $594 million worth of insider stock for sale since May. First, however, a bit of perspective on the market's harsh judgment about the financial strength and staying power of the companies themselves.
We've been flogging this horse here at Back of the Envelope for well over a year now, arguing to multitudes of the deaf that Wall Street's Internet initial public offering deal machine -- basically just a fee-generating racket dominated by a handful of investment firms with well-cultivated ties to some dim-bulb mutual fund managers -- was a train wreck waiting to happen. Now it's happened.
For evidence we need look no further than our own aptly named New York Observer Internet Suckers' Index, which tracks the market performance of some 31 stocks in the cybersector -- nearly all of them IPOs that came to market with eye-popping hype (and preposterous valuations) in the last two years. We started this index last winter as the speculative bubble in Internet stocks began to grow, and we've been adding new stocks to it ever since to maintain as comprehensive a picture as possible of what's actually been going on in this fast-changing sector.
And here's what the picture shows regarding the events of the last month -- with particular emphasis on the last week of August: While the broad market averages, as reflected in the Dow industrials, have slumped 14.8% from the Dow's all-time high of 9337.97 on July 17, the Observer's Internet Suckers' Index has crashed by 29.6%, barely recovering at all on Sept. 8, when the Dow spurted 380 points, or 5%. In fact, the Suckers' Index rose by exactly nothing that day.
But don't fret, because what we're seeing here, folks, isn't bad news at all. It's actually good news: evidence that the wildly overinflated Internet sector -- financed recklessly and haphazardly by fee-obsessed Wall Street investment banks -- has returned to earth with a thud. This isn't panic selling, it's a forced downward revaluation of prices as investors once again begin doing what they should have been doing all along: looking for actual value in what they're purchasing before handing over their money.
Necessarily, the carnage has been severe. America Online (AOL:NYSE) is by far the largest company in the sector, with nearly $2.3 billion in revenue and $65 million in earnings over the last 12 months, and -- until recently -- a berserk valuation of 129 times estimated 1999 earnings of 99 cents per share. This for a company with a long and well-documented history of managing its earnings through accounting gimmicks ranging from capitalizing marketing costs instead of expensing them, to trying to expense the purchase price of acquisitions as "in-process research and development" when the costs should be capitalized instead.
As a result of the former abuse, the company announced in October 1996 that it would take a charge of $385 million, totally wiping out all profits the company had made since its founding more than a decade earlier. Now AOL is quarreling with the SEC over whether to capitalize or to expense in-process research and development costs, and as a result has not yet released full financials for the April-June 1998 period. In any case, the rout in Internet stocks has carried AOL from a high of 140 1/2 on July 21 to 95 1/4 on Sept. 8. That's a 32% drop in barely six weeks -- the steepest such drop for the stock, in so brief a period, in the company's history -- wiping out nearly $12 billion in value from the portfolios of those who held shares in the company.
One such holder was -- and is -- AOL's chief executive, Steve Case, a business-world pretty boy who likes to bask in his fame in an aw-shucks sort of way, posing for Gap (GPS:NYSE) khaki ads when the spirit moves him. The slide knocked $99.6 million off the more than 2.2 million shares of AOL that Mr. Case held at the start of the year.
But don't cry for Pretty Boy. According to company filings with the SEC, between January and the end of August Mr. Case sold just about 1 million of those shares on the open market, pocketing what looks to have been somewhere around $81.2 million in the process. According to an SEC filing on May 29, $33.7 million of the haul came in May alone, by which time AOL's share price had already climbed to more than double its January level. All together, AOL insiders registered to sell a stunning $191.7 million during the May-August period.
In a similar spirit, consider theblood that's been shed in the current rout by holders of Amazon.com (AMZN:Nasdaq). This company went public in May 1997 at a split-adjusted price of about 10 and soared to a peak of 143 3/4 on July 7 on nothing but hype, hope and games-playing by day-traders. By that time, of course, it was obvious that investors were making a big mistake. The run-up was being artificially fueled by day-traders who were buying, selling and then repurchasing the same shares over and over again each day, creating the appearance of demand.
In the nine weeks since then, Amazon.com's price has also returned to earth, dropping by 36% to a Sept. 8 closing price of 92 1/4. In the process, nearly $2.6 billion of illusory shareholder value went up in smoke. Who got hurt? Not the corporate insiders, officers and early investors like Amazon.com director Tom Alberg, who filed papers with the SEC on Aug. 6 to sell 30,000 shares of Amazon.com for $3.13 million. Between May 1 and Aug. 18, 16 such individuals filed papers to sell $65.7 million of their stock in the company. Some vote of confidence!
Did these cut-and-run artistes maybe think that, at an average price of 88 during the period, Amazon.com might have gotten just a tad ahead of itself? My analysis of a recent announcement of me-too IPO by Barnes & Noble (BKS:NYSE) suggested that Amazon.com is probably worth somewhere around 65.
Reasonable people might quarrel over whether 65 or 92 1/4 is the fairer price, but with Amazon.com having now retreated decisively from its nosebleed level of 143 1/2, at least we can agree that the price is finally returning to a defensible level.
The list goes on and on. There's Yahoo! (YHOO:Nasdaq), the directory company -- down by 18.5% to 84 5/8 since July 7, even as insiders have filed bailout papers since June 1 to the tune of $27 million. Or consider CNet (CNWK:Nasdaq), a Web site operator: down by 40% from its peak of 74 1/2 on July 23. Bailout honor roll? More than $32.5 million in insider stock sale registrations since May, including an $8 million planned sale by Chairman and Chief Executive Halsey Minor on July 29. Or what about CDNow (CDNW:Nasdaq), which sells music CDs over the Internet? This pipsqueak operation, which logged a mere $33 million in 1997 sales while erupting in a volcanic $27 million worth of losses, crashed from a high of 25 5/8 on July 21 to a Sept. 8 closing price of 9 7/8 -- a sickening 62% slide that wiped out $257 million of the company's market value in little more than a month. Meanwhile, company insiders headed for the exits, registering to sell $7.6 million of stock, representing 5.23% of all the shares outstanding.
This could go on all day, but there's really only one matter left to discuss: Who's to blame for starting all this tulip-time waltzing in the first place? For an answer, look no further than the gang on Wall Street. By slapping "high-risk" warnings on their deals, white-shoe firms like Goldman Sachs and Morgan Stanley Dean Witter -- both of which plainly should have known better -- have felt justified in cranking out worthless deals that never should have left the portfolios of the venture capital firms that dreamed them up. But out the deals have come, like the march of buckets and broomsticks in Fantasia, and now they're all struggling to stay afloat in a business where the profits are scarce and where capital may soon be growing scarce, too.
These investment firms are playing a huge and cynical game. They know better than anyone that companies like GeoCities (GCTY:Nasdaq) (which Goldman Sachs took public earlier this month at $17 per share) and Broadcast.com (BCST:Nasdaq) (which Morgan Stanley helped underwrite back in July) are really nothing but financial junk deals with no hope of ever standing on their own as self-sustaining enterprises. Indeed, the registration statements for both IPOs say as much flat-out, warning investors that neither company has any expectation of earning any "net income for the foreseeable future."
These deals are being brought to market not because they make financial sense, but because the firms get to rake in fees by exploiting the phony demand for such IPOs that have been ginned up by day traders. All of which explains how Morgan Stanley and its co-underwriters bagged $3.6 million in fees for raising a mere $33.9 million on behalf of Broadcast.com, which came to market on July 27 at 15, jumped within a week to 63, then keeled over. On Sept. 2, it was selling back at less than 42 -- a slide that had wiped out 9.5 times more value than was invested in the company by IPO shareholders in the first place.
Ah, this whole thing is making me sick. These deals stink. And at the end of August, the market finally began to smell the rot.
Christopher Byron tracks the financial markets for several outlets, including the New York Observer. He appreciates your feedback at cbscoop@aol.com.
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