Internet Stocks Are No Longer A Sideshow to the Real Market
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
For most of the year, the feverish trading in hot Internet-related stocks
was a sideshow to the real market.
Not any more.
The imminent addition of America Online to the Standard & Poor's
500-stock index, the rise to "supercapitalization" status of Cisco Systems
and the boost Internet exposure has delivered to stocks like Federal
Express's parent, FDX, and Sotheby's Holdings all illustrate how
Internet-driven valuations are spreading.
Although only a tiny part of the blue-chip
index is affected so far, these trends highlight
the extreme interpretations being placed on
the stock market's record valuations: Either it
is a new era of technology-driven growth, or it
is a bubble.
Cisco Systems represents the debate. At $150 billion, the company, the
dominant supplier of Internet networking gear, has the 10th-largest
capitalization in the S&P 500. With its stock price at 100 times trailing
reported earnings, it's also one of the most expensive.
But last Monday, Donaldson Lufkin & Jenrette analyst Stephen Koffler
raised his price target on Cisco to $120 (it closed Thursday at 94 3/16 on
Nasdaq) without raising his earnings estimates.
"On the face of it, we certainly agree the stock is in uncharted valuation
territory," Mr. Koffler wrote. But, he argued, "As an Internet stock, Cisco
is cheap!"
In an interview, Mr. Koffler says the Internet changes valuation standards
because it's "a pivotal point of change in the economy. The Internet is
driving price deflation by turning the world into this big global auction. At
the same time, it's driving tremendous gains in productivity. It's hard to find
other times in history where that's been true."
Mr. Koffler says online booksellers and car dealers merit higher valuations
than bookstores and car dealerships because "that's the way things are
moving." And Cisco deserves its valuation because besides its reliable
profit growth and strong market position, "the Internet would come to a
screeching halt if all of a sudden Cisco decided to go on strike for a
week."
This sort of talk alarms William Meehan, chief market analyst at Cantor
Fitzgerald. "It tells me there's an asset bubble on Wall Street. We've run
out of rationalizations for current levels so the next step is to project
earnings far, far ahead with commensurate price targets and justify it with
newfound ties to the Internet and how it's all going to be wonderful."
Christine Callies, chief investment strategist at Credit Suisse First Boston,
says the "conviction that certain exceptional companies shouldn't have any
valuation ceilings" becomes more widespread and easier to defend "after
16 years of rising market valuations."
Thursday, the Dow Jones Industrial Average rose 15.96 points in a quiet,
shortened preholiday session to 9217.99, leaving it up 16.6% for the year.
The S&P 500 slipped 2.27 to 1226.27, leaving it up 26.4% for the year.
The S&P 500's gains this year have been concentrated in just a handful of
stocks, dominated by technology. Through Monday, Microsoft, Cisco,
Intel, Lucent Technologies and Dell Computer had contributed more than
one-quarter of the year's gain, according to Salomon Smith Barney.
To appreciate how much technology stocks have transformed the stock
market, consider that five years ago, none of those five except Intel were
even in the S&P 500 (Lucent was still part of AT&T). Now, their
collective value tops $900 billion -- about 10% of the entire S&P 500.
Given that their trailing its price/earnings ratios range from 38 to 150, they
have elevated the overall market's valuation.
S&P's decision that at the close of trading Thursday, AOL will replace
Venator Group, the former Woolworth Corp., in the S&P 500 pushes this
trend to a new level. Venator is bigger in the traditional economic sense:
Its revenue is two times larger than AOL's, and its work force is nine times
larger. But the forward-looking stock market has anointed AOL the
standard bearer of the Internet economy. Its six-fold appreciation this year
gives it a market value of $63 billion, ranking it ahead of about 460
existing S&P 500 components and about even with Walt Disney,
according to Merrill Lynch. Venator, which has changed from
department-store to specialty retailer, has a market value of less than $1
billion.
AOL is so large and its P/E ratio, at 244 times current fiscal-year earnings,
so high, that its addition will have a measurable, albeit small, impact on the
index's valuation. Based on Merrill Lynch estimates, it boosts the 1999
P/E of the S&P 500 to 27.71 from 27.55.
Internet valuations defy conventional explanations. But they are now being
used to value some conventional stocks.
On Tuesday, Merrill Lynch analyst Mark Miller boosted his rating on
auction house Sotheby's, arguing it "may be revalued as it develops a
strategy to expand its auction business through the Internet." To put a
value on Sotheby's online effort, Mr. Miller assumed in a year it could
equal that of online auctioneer uBid, which went public Dec. 4 at 15 and
closed Thursday at 121 5/8 on Nasdaq. With Sotheby's at 28, Mr. Miller
published a 12-to-18 month price target of $35. The stock promptly took
off, closing Thursday on the New York Stock Exchange at 38, up 4 1/2.
The point of such analysis "is not to pinpoint exactly how much [the online
business] is worth but whether ... it's an incremental opportunity that can
make the company stronger," says Mr. Miller. That said, the stock's leap
"makes me anxious more than anything because the company has not
developed the strategy yet. They're going to have to deliver something
here."
Far more staid companies are also playing up the Internet's potential
benefit to their growth. In presentations to Wall Street, banking giant Wells
Fargo has boasted that its online customer base has grown to 650,000
from 20,000 in 1994. While far outnumbered by Wells Fargo's 10 million
regular banking customers, online customers are less expensive to service,
do more business and stay with the bank longer, says Clyde Ostler, group
executive vice president. The bank is selling used cars from leases to
employees online, and hopes eventually to offer them to all online
customers.
Such potential appeals to shareholder Philip Miller, a value-oriented
manager for Nicholas Applegate Capital Management, who notes the
bank's P/E, while still modest by today's market standards, is higher than
its peer group's. "Looking down the road, [Wells's online business] is one
of the pieces that justifies the higher multiple." |
