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Wins yet worries for Internet stocks

Overvaluation and recession concerns challenge the sector.

February 11, 2008|Walter Hamilton | Times Staff Writer

NEW YORK — When shares of Yahoo Inc. soared 48% on the first day of this month, it felt like a flashback to the late 1990s when Internet stocks routinely defied gravity.

But this was far from dot-com euphoria. Rather, Yahoo was propelled by a takeover bid from Microsoft Corp. that reflected the Web icon's recent stumbles as much as its perceived opportunities, underscoring the peril as well as the promise of Net stocks these days.

The Internet sector has matured greatly in the years since the dot-com bust. Google Inc., EBay Inc. and Inc. have solidified their positions, while less likely survivors such as Inc. and EarthLink Inc. managed to escape ruin in the dot-com shakeout. And since the crash, enthusiasm over ever-rising Internet use has translated into generally sterling stock performance.

But those strong gains have renewed fears that Net stocks are overvalued. And despite some hopes to the contrary, analysts say, the sector is unlikely to be immune this year to the recession that many have predicted. Meanwhile, Yahoo's struggles show that the vast changes still roiling the Internet marketplace -- relegating the once-dominant company to second-tier status behind Google -- make it hard for investors to pick long-term winners.

Perhaps the biggest difference between the Net sector now and during the dot-com era is that today far more companies make money -- and far fewer exist on just a hope and a prayer.

"Now they're real companies," said Jeff Tyler, a portfolio manager at mutual fund group American Century. "You can apply real-life logic to them."

However, critics say the resurgence in the Net sector in recent years also left the valuations of many of its stocks overstretched.

After being pummeled starting in early 2000, an index of Internet stocks more than quadrupled from its low in October 2002 to its high five years later compared with a mere doubling of the more broad-based Standard & Poor's 500 index during the same period.

Despite a pullback in prices in the last four months, the Internet sector's average price/earnings ratio -- a measure of how expensive a stock is relative to its earnings per share -- is about 36. By comparison, the average price/earnings ratio of the companies in the S&P 500 is about 18.

The valuation concerns became especially strong late last year when investors briefly were enchanted with the notion that large tech stocks would be able to withstand the economic turmoil lashing most other sectors. For example, Amazon's price/earnings ratio exceeded 100 in December and still tops 60 despite a recent sell-off.

"While a lot has changed, a lot hasn't changed," said Fred Hickey, who writes the High-Tech Strategist newsletter from Nashua, N.H. "Valuations are still wild."

And because a wild valuation often reflects the potential for wild growth, any news that throws doubt on a buoyant scenario for growth can send a stock, especially a smaller one, plunging.

Shares of Travelzoo Inc., an online travel site, for example, skidded 32% on Wednesday after the company's profit fell short of analysts' estimates because of wider losses in Europe and Asia. The stock is down 73% since its peak in April.

More immediately, some experts say, Internet stocks could be particularly vulnerable to an economic downturn.

Though technology is often viewed as a growth industry that can expand even in a soft economy, many Internet companies are dependent on cyclical consumer spending, experts say.

"A lot of the large names are funded by advertising [and] a lot of the other large names are retailers," said Stuart O'Gorman, co-manager of the Henderson Global Technology mutual fund in Edinburgh, Scotland. "So obviously if we do have a really hard landing, and it looks like it'll be consumer-led, then these stocks will suffer."

O'Gorman has been following through on his analysis by selling Internet stocks in recent weeks.

He hasn't been alone. Since hitting its peak Oct. 12, the Interactive Week Internet index is down 21% (compared with a 15% drop in the S&P 500).

Cisco Systems Inc., which sells much of the networking equipment that makes the Internet run, last week released lower-than-expected sales projections, blaming cautious corporate spending in the U.S. and Europe. Cisco shares are down about 30% since the company warned in November of weakening demand among major customers.

The question for investors is whether share prices have fallen enough to become compelling.

Beyond the short-term worries, however, the challenge is picking the right companies in an ever-changing Internet marketplace where the basic problem remains how to translate heavy consumer usage into ever-rising profits.

Google has struck gold, but others have been unable to replicate its success.

Yahoo was once considered a Goliath in the online advertising and search-engine markets. But the company has stumbled badly in recent years, steadily losing market share to the more innovative Google and failing to capitalize on Internet trends such as social networking.

Even mighty Google isn't immune to setbacks. Its fourth-quarter earnings were shy of analyst estimates -- the second time in three quarters that's happened -- and its share price has sunk 30% from its November peak (but is still six times what investors paid in Google's August 2004 initial public offering).

"Five or 10 years ago it was all just getting traffic and then figuring out how to monetize it," said Kevin Landis, chief investment officer of tech-focused Firsthand Funds in San Jose. "Now it's been demonstrated that monetizing that traffic is not so easy. And Yahoo is the absolute poster child of that."


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