Article - Fund managers shouldn't miss Net
By Richard Hefter
Last Update: 3:34 PM ET Apr 6, 1999 Courtesy of MicroCap1000.com
BOCA RATON, Fla. (CBS.MW) -- Piper Jaffray's Steve Franco spoke with CBS.MarketWatch.com about institutional interest in Internet value stocks, opportunities in online financial services and why fund managers won't get “AOL'd” again.
As senior research analyst at U.S. Bancorp Piper Jaffray specializing in e-commerce, Steve Franco has been conducting research on Internet-related topics since the Internet's inception in early 1994. That experience that gives him a unique perspective on the development of successful business models in this highly dynamic marketplace.
What is driving the Internet sector currently?
Franco: A couple of factors. One is there's a lot of new issues in the pipeline, a lot of new business models, and in some cases some larger companies like Barnes & Noble (BKS) and DLJ (DLJ) are starting to spin out Internet divisions.
Another reason, probably even more important, is that institutions decided when they came back from Christmas vacation in January that they had to own Internet stocks.
Why?
Franco: Otherwise, they were going to continue to get trounced by their benchmark indexes, particularly as a stock like AOL (AOL) got added to the S&P 500 ($SPX). If you were a fund manager that got measured against the S&P and did not own AOL in 1998, odds are you got absolutely creamed compared to the S&P.
So a lot of these fund managers are starting to say, “I don't want to get AOL'd again. Maybe I want to own Yahoo (YHOO) or Amazon (AMZN)…” which are probably the next companies that are going to be added to an index like the S&P. Also, managers don't want to just meet the benchmarks, they want to beat them, and so they're looking deeper and deeper to seek returns necessary in order to keep pace, and Internet stocks have proven time and time again to be the best place to look for home-run returns over the last 12 months.
What is your outlook for this coming earnings season?
Franco: The risk in the Internet space right now is that a lot of online retailers, in particular, had an extremely strong December quarter, buoyed in part by the strong holiday season. Particularly for larger ones like Amazon, they've got a really big revenue base that needs to grow looking forward to Q1. So there's a risk that the law of large numbers plus seasonality will start to catch up with some of these guys.
On the other hand, Internet stocks are starting to segment where the retailers will trade together but not necessarily in lockstep with other Internet stocks like online brokers which don't have the same seasonality concerns.
What Internet sectors do you like at the moment?
Franco: I've had a bias toward the online financial services sector. It's a highly fragmented market, which suggests opportunity for a company to develop a meaningful online business in a relatively short period of time somewhat insulated from the existing competition in the off-line world.
Why the fragmentation?
Franco: There's a significant amount of channel conflict that it keeps the incumbent players somewhat at bay at least for a period of time. Merrill Lynch is a great example. They've been toying around with online trading for two- plus years now and are just now rolling out a product. They've got a tremendous channel conflict issue, as they don't want to alienate their brokers -- who are making the company tons of money in commissions -- by offering online trading which you can basically do without a broker.
As a result, companies like E-Trade (EGRP) and Ameritrade (AMTD) have been able to get a two-year start.
What does this mean for the investor?
Franco: With online brokerage as a financial service product proving to be a model that works, I think we're going to see something similar in the online mortgage space, the online insurance space, the online real estate space, and the online credit card space. The characteristics of the brokerage industry are very similar to these other products in terms of degree of fragmentation and channel conflict, which lends toward successful business models.
Also, these are products that typically start at healthy gross margins, north of 40 percent, compared to Amazon, with starting gross margins in the mid 20s, so there's an opportunity to build a profitable model more quickly.
Any companies in these spaces that come to mind?
Franco: In the mortgage space, E-Loan just filed. In the credit card space there's one obvious company I can't talk about because we're involved in the underwriting. In online insurance InsWeb is the leader. And in the realtor space, Realtor.com is probably the leader, but the market's still pretty wide open.
What trends do see creating investment opportunities in the Internet arena?
Franco: Yes. Computer Literacy (FATB) sets up online bookstores on company Intranets, providing a centralized place for employees to shop for their technical books, which also centralizes the expensing and reporting. This is a business-to-business e-commerce model that is emerging as its own sub-category within the overall market. Lots of market research firms have done studies showing that business-to-business is ultimately going to be a much bigger space than business to consumer, even though it will probably take longer to develop.
We've got a handful of public companies that fit into that category, and there's probably going to be a bunch more coming public in the next 12 months.
Can investors still find value in Internet stocks?
Franco: In some cases, yes. There are some smaller companies that have been either ignored or orphaned by the Street that are starting to have more of an Internet or electronic commerce story to them but aren't getting the recognition for this.
What are some examples?
Franco: Finet (FNHC) is one. It's in the online mortgage space, and has been overlooked as they went public the quick and dirty way - they reversed merged into a shell -- without official Wall Street sponsorship. But they are likely to get a pretty good pop once E-Loan and some of these other companies go public, because there's going to be recognition that Finet is a play that's already been in the space for a awhile -- that they've got a longer history of reported earnings and that they're a legitimate company.
Egghead (EGGS) is another one that falls into that orphaned-by-Wall Street category. They were a physical software vendor and had a period where they were hemorrhaging losses. A lot of Wall Street analysts dropped them, and the company basically went through two years with no coverage. But they turned the company around, sold off all their real estate and got into the online business. Now it's a very different story, and in doing their secondary they've attracted new Wall Street coverage.
What other stocks do you like?
Franco: I don't want to tip my hand to future coverage, so there's a couple of names I'll refrain from talking about. But a company that's not in the MicroCap space that I really like a lot is CheckFree (CKFR). They're an outsource provider of online banking and bill payment services, which they provide to 23 of the top 25 banks in the country. They basically have a lock on the market, somewhere around a 75 to 80 percent market share, and this is a market that's probably about 5 percent penetrated, with penetration expected to grow to 20 to 25 percent over the next five to six years |
