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Special Report

A Little Tussle Over Internet Stocks

Internet stocks have been creamed over the past several weeks. Though they've bounced back a little from their lows, stocks such as Amazon AMZN, TSCM, and Ebay EBAY, have dropped by half or more. And instead of soaring on opening day, many new Net shares are languishing at their offering prices.

Is it time to go bargain hunting? Pat Dorsey, Morningstar's technology analyst, says yes. He even admits to recently buying America Online AOL after its stock fell more than 40%. "Sure, AOL's expensive--but what do you expect from a company growing so fast? After the sell-off, it was worth it."

But just as the Civil War set brother against brother, now the Internet pits coworker against coworker, with the battle line running down a row of cubicles. Taking aim at Dorsey and the bulls is Morningstar Stocks Editor Haywood Kelly, a man who's never paid more then 20 times earnings for a stock and who looks both ways before crossing the street.

Kelly--The Case Against
Let's start with the obvious. Just because many Internet stocks have fallen doesn't mean they're suddenly contrarian investments. Far from it. Because they ran up so fast early in the year, most have simply fallen back to where they were in February. They were egregiously expensive then, and they're egregiously expensive now.

First Problem--Returns on Capital
Internet firms are generating super sales growth, but they're also tearing through capital like so much monopoly money. And there's been little return on that capital to date. In Morningstar's online-retail and online-information industries, the average return on assets is negative 30%. In other words, for every $1 in assets these firms have collected from shareholders and creditors, they're losing 30 cents of it each year.

That's why Internet firms all earn such miserable Morningstar grades for profitability--Ds and Fs in most cases. Besides issuing new stock to raise capital, companies like Amazon have turned to debt markets to conjure up cash. Yet Amazon's losses continue to widen. Only a handful of Internet firms--AOL, Ebay, and Yahoo YHOO among them--have shown they can scrape up a positive return on assets.

Internet companies risk doing what Japanese companies did in the 1980s: Issue billions of dollars of capital for no other reason than that it's readily available, regardless of the return earned on the money. A company can grow as fast as it wants, but without a high return on capital, it's destroying shareholder wealth. Earning a good return won't be easy, particularly for firms in industries with low barriers to entry. Online retail is a great example. Bookseller Amazon is growing like gangbusters, but it's spending oodles of cash on advertising and acquisitions to maintain its lead over rivals. If it doesn't spend that money, it's dead. (My favorite recent issuers of capital? Online flower sellers.)

The Internet has taken competition to a new level. Every year, business schools graduate more budding Internet entrepreneurs, each ready to be funded by a host of eager venture capitalists. Who's to say what Amazon, PCLN, or Yahoo will look like five years from now? Against whom will they be competing? What about firms like or Edgar Online EDGR, which face competition from literally hundreds of financial Web sites?

Second Problem--Valuation
As optimistic as the market is, Internet companies must eventually produce not a decent return on capital, but an excellent one. You must make some truly heroic assumptions about growth and profitability to justify current prices. AOL trades for 154 times forecasted 2000 earnings. Yahoo trades for 273 times. Those are steep multiples, so you'd better be darn sure profits will ramp up in future years.

Take AOL. The company is generating about $800 million in annual free cash flow, or $1.20 per share. Depending on how fast you think those free cash flows will grow, you can get a fair value for the firm of anywhere between $50 and $200 per share, compared with a current stock price of about $94. (See the bullish section of this article for more on how we came up with these estimates). Even that $50 estimate assumes the company can maintain a 20% growth rate five years from now, so it's hardly a doomsday scenario. It just goes to show what incredible risk you're taking on in betting on any of these stocks. Remember, too, that AOL is the cream of the crop--the blue chip of Internet stocks.

Dorsey--The Case For
First of all, let's be fair: Talking about "Internet stocks" as if they were some amorphous, undifferentiated mass is silly. A company like AOL (market cap: $104 billion) has about as much relation to a tiny outfit like Log On America LOAX (market cap: $153 million) as your local grocery chain does to Wal-Mart WMT.

Instead of tarring the industry with the same brush, look at Internet companies on their individual merits (or lack thereof)--like you would firms in any other industry. Believe it or not, some Internet firms are profitable and sport reasonable valuations given their enormous growth rates. Many of them also boast business models and cost structures that are tough to replicate in the offline world.

What to Avoid
Theoretically, Internet companies like bookseller Amazon and broker E-Trade EGRP have big advantages over competitors like Barnes & Noble BKS or Merrill Lynch MER, because they don't have to build stores, pay rents, or pay salespeople. So, they should have lower costs and higher profits.

Here's the catch: Running a top-notch Web site is expensive--ultrareliable computer equipment isn't cheap, and you can hire four or five bookstore clerks for the same salary as a single experienced programmer. Moreover, firms such as E-Trade and Amazon offer commodity-like products and services that are easily replicated, so rivals can force them to compete on price alone. If I want to buy 100 shares of General Electric GE, or the latest Stephen King novel, it doesn't make much difference what company performs the transaction for me. In the end, I wind up with the same stock or the same book. Since I'm getting the same product, I buy from whoever has the lowest price, which is great for me, but not so hot for the firm trying to make a buck.

What to Look For
Internet firms of a different sort are better long-term bets. In particular, companies that benefit from the "network effect" (their services become more valuable the more users they attract) are very attractive because it's easy for these firms to maintain their leadership.

Online auctioneer Ebay, for example, has more than 10 times the business of its closest competitors. With more items for sale on its site and more bidders, it's easier to get a better price (or find what you want) on Ebay than on other auction sites, which makes it relatively easy for Ebay to stay ahead of rivals that want to muscle in on its turf.

Portal site Yahoo, which is second in popularity only to AOL, is in a similarly enviable position. The more users Yahoo has, the more attractive it is for content providers to use as a distribution channel. The added content attracts even more users, and Yahoo's popularity feeds on itself. Then there's AOL itself, the granddaddy of Internet stocks. Perhaps the biggest reason AOL adds 8,000 members each day is that almost five out of 10 Americans who access the Internet do so through AOL. With such a huge community of members, AOL can virtually assure prospective users they'll find something they like (or someone they know) within its network.

Valuations--Growth Like This Ain't Cheap
Of course, even Internet companies with attractive business models may well have stocks that are priced too high. In some cases, though, it turns out that apparently crazy valuations may be justified, given how fast these companies are growing. Just for fun, we estimated the value of America Online's stock under three different growth scenarios using a type of analysis known as discounted cash flow. (For more on discounted cash flow, click here.) Here's what we came up with: