– 25 May 1999
2
n Possible reasons for the recent weakness.
Typical quarterly trading pattern. The stocks usually
trade off after the major companies report earnings in the
first month of the quarter. They are usually weakest in the
second month of the quarter, and then strongest in the
third.
Summer is seasonally weak with regard to online usage
and commerce dollars. The three main value drivers for
the consumer-focused internet companies are 1) usage, 2)
advertising dollars, and 3) commerce dollars. Usage,
measured by number of people online, time online, and
pageviews, tends to be weaker in the summer than the
winter, and as a result, we do not expect to see especially
strong growth in pageviews or new online subscribers in
the June quarter. Advertising revenue is strongest in Q2
and Q4 and relatively weak in Q1 and Q3; consequently,
we expect to see strong sequential revenue growth at the
leading content companies. Commerce dollars are
seasonally weak in Q2. At this stage of the industry's
development, of course, “seasonality” should be
manifested only as slower growth, rather than sequential
declines (which is why some of the earnings reports last
quarter concerned us).
Concerns/questions/issues surrounding fundamentals of
three industry bellwethers. The three leading bellwethers
in the internet industry are AOL, Yahoo!, and
Amazon.com. In the last several months, new issues and
concerns have developed around each of them (aside from
the age-old questions about valuation). Despite laying out
a coherent broadband strategy, AOL has yet to calm
investor fears that it will somehow be shut out of cable
access—and the recently announced merger of AT&T and
MediaOne added fuel to this concern. Yahoo! had another
spectacular quarter in its core business, but will soon close
the two largest acquisitions in its history (Geocities and
Broadcast.com)—leading to concerns that it will not be
able to smoothly integrate them. Amazon.com's
sequential revenue growth slowed significantly in Q1 and
the company massively increased its investment spending,
more than doubling expected losses in the next few
quarters. Although we are essentially comfortable with the
fundamentals of all three businesses, it is clear that the risk
profile associated with each has increased.
Possible speedbump in April traffic rating report. The
April Media Metrix numbers showed a small sequential
decline in the estimated number of monthly internet
users—the first such decline we've seen (with the
exception of last November, when the company changed
its methodology). Although the estimates are extrapolated
from a small sample and one month does not make a trend,
it seemed relevant to note that internet usage won't grow
sequentially forever (and that when it stops growing, only
the stocks of companies that are gaining market share are
likely to continue appreciating). Please see our April Web
Ratings analysis.
Chock-full IPO pipeline, with many deals, and
substantial recent follow-on offerings. At a stage of
industry development in which in which it is hard to make
precise valuation arguments, prices are determined largely
by supply and demand. With so much new supply hitting
the market, it is possible that investor demand for internet
shares on the open market is much closer to being
satisfied—especially when the only sure-thing in the sector
right now is buying IPOs.
Rising interest rates. Tough as it is to be precise about
valuation, one thing is certain: the internet stocks are
discounting decades of future earnings. When interest
rates go up, discount rates must go up with them, which
leads to lower present values.
n Outlook
The third month of the quarter is usually the best for the
internet stocks—and Q2 advertising revenue should be
strong. The internet stocks usually peak just before
Yahoo! reports earnings and then hit bottom in the second
month of the quarter. Q2 should be a strong quarter for
advertising revenue, and we still expect that excitement
about the results of the leading companies will drive the
stocks higher next month.
Summer features light usage, light advertising, and light
commerce. Once we get through July and August,
however, the 1999 holiday season will be only a few
months away. If you thought last year's online holiday
shopping was impressive, just wait until AOL's 17 million
subscribers and Amazon.com's 8 million customers have
at it this year.
Recommendation. We would continue to hold a basket of
the leading stocks, including AOL (AOL; D-1-1-9; $119
*), Yahoo! (YHOO; D-2-1-9; $137 7/8), and, in smaller
size, Amazon.com (AMZN; D-2-1-9; $117 *). We expect
to continue to see significant volatility in the sector
through the summer, but expect the stocks to trend higher
by the end of the year.
[AOL] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years.
[YHOO, AMZN] The securities of the company are not listed but trade over-the-counter in the United States. In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt
from registration or have been qualified for sale. MLPF&S or its affiliates usually make a market in the securities of this company.
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 -Reduce,
5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend.
Copyright 1999 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). This report has been issued and approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is
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