Article 2 of 200
FORTUNE Investor
Net Stock Frenzy There are methods behind the price madness.
They're just a bit different.
Jeanne Lee
02/01/99
Fortune Magazine
Time Inc.
Page 148+
(Copyright 1999)
A new year; another wild burst of market enthusiasm for Internet stocks.
Suddenly, obscure companies in unlikely businesses (collectibles, fish meal)
are transformed into e-icons that investors are desperate to pile their money
into (eBay, Zapata)--at least for the moment. And stocks like Active Apparel
rise more than 1,000% in a day.
Many a skeptic will conclude that this is just another example of Wall Street
Madness, and they may turn out to be right. Some Net- stock buyers are
so-called momentum investors who jump on stocks that are already moving
up, creating a self-reinforcing upward spiral. They're not deep thinkers, as
evidenced by this recent plea posted on an e-commerce discussion thread:
"This is the spot to Post which stock you like and why. Please Start with the
symbol followed by a very very short reason why. Type Fast!"
And obviously the market is not holding Internet companies to the same
valuation standards as traditional brick-and-mortar businesses. The bizarre
comparisons are already familiar: five-year-old Amazon .com, for
example, with a market capitalization of $25 billion- -a level that Wal-Mart
took 27 years to reach. But back in the days before e-commerce, profits
were required before a stock rose; for today's Net companies, profits are the
exception rather than the rule. "We are trying to value companies without
any historical valuation rules or tools," says Morgan Stanley Dean Witter's
Mary Meeker.
So the Wall Street analysts who follow Net companies for a living have been
forced to improvise. The methods they're using to value Net stocks aren't
traditional and they're not precise--they can in fact produce wildly different
stock-price targets. But they're not crazy.
In mid-December two of the Street's leading Internet analysts faced off over
Amazon . Henry Blodget, at CIBC Oppenheimer, raised his price target
from $150 (which the stock had already passed) to $400. Meanwhile, Merrill
Lynch's Jonathan Cohen stuck resolutely with the "reduce" rating he'd
slapped on it in September.
A month later Blodget was looking pretty good, as Amazon blasted right
past the $400 level. (In mid-January the stock split three for one, and as
FORTUNE went to press the new shares were trading at $160.)
We asked Blodget to walk us through his methodology. He starts by looking
at the size of Amazon 's target market. Worldwide, the market for books,
music, and videos is around $100 billion. So how big a slice of that can the
company get? Blodget draws an analogy between Amazon , the leader in its
category, and Wal-Mart, the leader in discount retailing, which has a 10%
market share. Since Amazon is adding to its product mix, he thinks it's fair
to estimate that it could hit a 10% share in the next five years, which would
amount to $10 billion in revenues. Then, he asks, what could the company's
profit margin be? Traditional retailers typically achieve net margins of 1%
to 4%. But Blodget believes Amazon will be able to run leaner than
land-based types by paying less rent, keeping less inventory, and hiring
fewer employees. Its net margin, he assumes, could be more like Dell's--a
fatter 7%.
So, 7% of $10 billion is $700 million in net income. The last question is,
what price/earnings multiple will the market assign Amazon at that point?
P/Es normally range from ten or so for a slow- growth company to about 75
for one that's growing quickly. That means that a slow-growing Amazon
could have a $7 billion market cap, or $44 per share (post-split), while a
fast-growing Amazon could be worth $53 billion, or $332 per share. Using
these assumptions, Amazon 's current $25 billion market cap and $160
share price start to seem plausible.
Blodget admits that those assumptions are pretty loose and that putting faith
in a specific dollar figure is extremely problematic. "Sometimes," he jokes,
"it's helpful not to look at valuations too closely. Just blur your eyes and say,
'I see a big future for these stocks.'"
But Cohen, at Merrill Lynch, calls the stock "the single most expensive piece
of publicly traded equity, not only across the Internet space, but probably in
the history of the modern equity markets." He is unconvinced that Amazon
is capable of producing Dell- like profit margins or even that it has a
sustainable edge over competitors. "To my mind, there is a very real danger
that Amazon is unable to ever generate meaningful profitability," he says.
Even if the company achieves an operating margin of 5% to 7%--a less
daunting target than Blodget's net-margin assumption--Cohen reasons that
the stock should sell at two to four times 1999 estimated revenues, which
leads him to conclude that during the next 12 to 18 months, AMZN will fall
below $50 ($17, post-split). We'll check back with Blodget and Cohen next
year.
America Online is another young, highflying Net stock that many analysts
still enthusiastically recommend (Cohen among them). Again, the big
unknowns are how large its profits will be, and how much to pay for that
profitability.
One AOL bull--Lise Buyer of Credit Suisse First Boston--gamely offers
clients her multi-columned "Do-It-Yourself AOL Valuation Chart." Certain
parameters are fixed: For example, AOL gets around $22 a month from each
customer for access, which Buyer estimates costs the company $14 a month
to provide. She assigns a multiple of 11 times operating income, a figure in
line with the cable industry's. Many more factors are variable: How quickly
will the customer base grow? How much revenue--in addition to the access
fee-- will the company collect per customer from advertising and e-
commerce? How many months will the average subscriber stay? In one
scenario Buyer assumes AOL will grow to 17 million customers from the
current 15.5 million by the end of the year, the average customer will bring
in an extra $4.20 a month in addition to fees, and he will remain a subscriber
for 60 months. That gives a target price of $148, close to where the stock has
recently traded. But make a couple of little changes--20 million subscribers,
$5 in extras, and 70-month subscriptions--and the target price jumps to $224.
These valiant efforts to quantify Net-stock uncertainties all lead to the same
conclusion, a maxim of investing theory: In a newborn industry, analysis
can't get you very far. At this point, picking Net stocks is more a bet than an
investment--but a bet that can pay off big.
{BOX}
INSIDE: Lycos, loved at last... News flash: Stocks rise when analysts tout
them... WorldCom's CEO has some planes to sell... Greenberg hates splits...
Carolyn Geer on "refinancing" your estate... Why Serwer thinks the
Redskins are cool... and more
{BOX}
BUZZWORDS
--Rodney Dangerfield valuation: A stock with such a low price/earnings ratio
that it just can't get no respect.
--Float management: How investment bankers try to ensure that an IPO's
float (the number of shares available to outside investors) is less than demand
so the shares will trade up after the first day.
--Breakage: How much you push a stock up in the process of buying a
quantity of shares (and down when you sell).
--Bubble.com: Internet stocks in general.
{BOX}
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COLOR PHOTO: PHOTOGRAPHS BY ANNE KATRINE SENSTAD Jonathan
Cohen Merrill Lynch Amazon : $50 No, he didn't hurt his hand duking it out
with Blodget. But his forecast is hurting. {Jonathan Cohen} COLOR PHOTO:
PHOTOGRAPHS BY ANNE KATRINE SENSTAD Henry Blodget CIBC
Oppenheimer Amazon : $400 He can think of lots of reasons that it's so high.
So far, he's sitting pretty. {Henry Blodget} COLOR PHOTO: TIMOTHY
ARCHIBALD Lise Buyer has AOL all figured out. |
