Valuation Watch
Their Own Rules
Weíve long since resigned ourselves to the reality (you can determine if itís a sad reality or happy reality
by looking at your portfolio) that the Internet sector plays by its own rules, and they most decidedly are
not Ben Grahamís rules. Though the Internet stocks have long tended to polarize opinions about whether
or not this sector is real or merely a mania whose time will come (and go), the needle has moved even
further over the last two weeks toward mania. And with Internet stock valuations becoming grist for a
cover of the latest issue of Business Week (can anyone else hear the bell ring of a top?), we know this
must be the case.
Our favorite quote to this end has got to be Roger McNameeís (a buy-sider at Integral Capital ), who was
quoted in the WSJ earlier this week: "We are past the point in the cycle where people are kidding
themselves.î We find it hard to argue with such common sense, though we would hasten to add that there
are sometimes yawning gaps between the speculation on certain Internet stocks and other, more efficient,
ones. As weíve tried to point out, the has been little (read: no) discrimination between the wheat and the
chaff in this growing corner of the market. So what now?
Our approach, especially at times like these, is a pragmatic one; we have kept our ratings intact (because
the market may change its view on the value of a firmís operations doesnít mean the operations
themselves have changed) and our price targets unchanged until we get fundamentally new information to
plug into our valuation models. Though we harbored something of a yen for a Ph.D. in economics in
another life (alas, we were shot down for a summer internship with the New York Federal Reserve bank),
we wonít pretend to know more than Nobel prize winners in economics by coming up with our own
valuation methodologies for these Internet stocks to justify a higher price target. After all, Miller-
Modigliani entity valuation approaches still hold plenty of water and when all is said and done, cash flow
or earnings (as a proxy for cash flow) are what ultimately count. As analysts, our job is to be better at
predicting what those earnings and cash flow levels could be, not coming up with new and ingenious
ways of valuing those earnings or cash flow streams.
That said, we share in the growing frustration of right-minded people quoted in the WSJ this week that
"trading in an irrational way, totally into momentum, without any allegiance to any kind of rational
investment philosophy, can't be good for the public and it can't be good for the market structure." This
frustration is embodied in our Internet Investing First Principle that, as vehicles for determining the entity
valuation of these companies, Internet stocks are extremely inefficient. Small floats, shorts positions, and,
as the excellent write-up in Thursdayís WSJ pointed out, Internet day traders are expected culprits (see
page C1 of Thursdayís WSJ at www.wsj.com).
News this week that several Wall Street firms had increased the margin requirements for a host of
Internet stocks sent some of the names into a tailspin. Waterhouse Securities, Ameritrade, Salomon Smith
Barney, U.S. Clearing Corp., (which clears trades for 350 brokerage firms) all increased margin
requirements for this universe of stocks, in an obvious attempt to make the market for these names more
efficient. Of course, this may or may not help much, since the switching costs of moving from, say
Ameritrade (who has stricter margin requirements) to E*Trade (which has not yet taken any action with
respect to Internet stock margin requirements) is artificially low. Weíll see if these firmsí efforts are
enough to inject some more reason into the trading patterns of these stocks.
Something will probably end this cycle of blind buying, though the universal human susceptibility to
pattern recognition suggests that it may still be some time before that happens. That said, we hope we
continue to make the point that the Internet is real, despite the very unreal trading in some of the stocks
that lay claim to the name, and that institutional investors should remain committed to understanding (if
not owning) the quality companies in this space.
Froth Watch?
For the last several weeks, weíve been toying with the notion of creating a new section in The Internet
capitalist called Froth Watch, the purpose of which is to highlight what we believe to be excellent
indicators of the indiscriminate nature of the shareholder value allocation that the market has been
practicing. This past weekís ìcorrectionî in the Internet stocks (or at least in many of them), seems to
have brought down the pressure in the bubble a bit, so weíll not institute Froth Watch it this edition,
preferring to save it for a rainy day. Having said that, weíd like to share some of the examples that would
have made it into the section this week:
Onsale (ONSL), the online auction house who ostensibly competes against Ebay had several amazing
runs over the last few days (both up and down). Our favorite reason, as quoted by a sell-side analyst, for a
few of the ìupî days (post Thanksgiving) when it went from $28 to $100: ìIt got discovered."
Cyberian Outpost (COOL), the online retailer of computers and peripherals, had its shares leap 34% last
Monday, spurred on in part by a new ad campaign and the unveiling of its new Web site.
Blue Fly (BFLY), a brand-name clothing and accessories retailer, had its shares jump 50% (to $22) after
the online retailer announced that it had reached an agreement with Yahoo! Inc. (YHOO) to launch a co-
branded version of Bluefly's online outlet store on Yahoo!ís Shopping channel. At the beginning of
November, Blue Flyís shares had been at $4; they stand at $12 as of today.
The Calendar: Week of 12/07 & 12/14
Excite/MatchLogic analyst meeting, Denver, CO.; 12/7
SG Cowen Internet Dinner with AOL - NYC; 12/8 (please call your SG Cowen institutional sales person
for an invitation)
The Internet Capitalist Manifesto
Why ìCapitalistî? The Internet is interesting and hip. Itís also popular and cool. Unfortunately,
recognition of these facts wouldnít have necessarily made you much money over the last few years.
Indeed, an investment strategy based on these gleanings would have left you with a portfolio of Java,
VRML, and ìpushî technology vendors. And though each of these might have created shareholder value
on the margins, none would have compensated you for the risk inherent in Internet investing or for the
opportunity cost of not being more fully invested in more profitable Internet themes. Our goal, then, with
ìThe Internet Capitalistî is to identify and profit from the dislocations that the Internet has created for
businesses and consumers alike. We start by asking three basic questions: Which companies have
identified the revenue opportunities created by the Internetís growth as a consumer and business
medium? Which have the skill sets and management breadth to execute against these opportunities? and
Which have business models that will create substantial shareholder value over time? Our answers to
these questions should help you capture the arc of our thinking in this industry as it evolves from a
network for academics into a medium for the masses.
Why ìCompanionî? We hope this piece asks as many questions as it answers, and generates as much
debate as it satisfies (which we plan to include). Coupled with a user friendly layout, we want ìThe
Internet Capitalistì to stimulate and ease the investment decision. The mental framework with which we
parse Internet investments is defined broadly and driven by a few relatively simple themes. Within this
framework, however, there are multiple paths to generating superior, above-market returns. ìThe Internet
Capitalistî is our attempt to illustrate those paths on an ongoing basis, determine the commonality among
them, and suggest how shareholder value will be impacted and where it will flow. And though youíll find
us to be bullish on the Internet sector generally, our expectations for these stocks are tempered by three
realities. First, that the market remains relatively inefficient for these securities, which makes taking a
substantial ownership position both difficult and costly. Second, valuation levels leave little to no room
for errors of execution or strategy. Third, profits (or cash flow) matter; progress toward meaningful
profitability is a necessary condition for an increase in shareholder value. With those caveats, we still
believe investors can achieve superior returns based on a patient, disciplined, long term strategy toward
investing in this sector. We hope ìThe Internet Capitalistî becomes an indispensable tool toward that end. |
