– 3 June 1999
2
Review of factors likely behind 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 concerns
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 is working on 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 dubious-quality deals,
and enormous recent follow-on offerings. There are—get
this—90 internet-related deals in the pipeline for an aggregate
of approximately $8 billion. 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—
especially with some of it of such dubious quality—it is
possible that investor demand for internet shares on the open
market is much closer to being satisfied. Moreover, signs that
the only sure-thing in the sector--buying IPOs—is also
starting to weaken appeared last week, when several of the
new deals approached or broke deal prices.
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.
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.
After the quarter reporting period, we would expect to see
another pullback—but by that time the 1999 holiday season
will be less than six months away. 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.
Risks. These stocks are extremely expensive and wildly
volatile and it appears as if they have no near-term valuation
“floors.” This means that the leaders could easily pull back
another 50% or more from current levels (we don't think they
will, but it is clearly possible) and the laggards much more.
As always, we would limit our exposure to the sector to a
small percentage of a balanced portfolio (5%?).
[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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