Back From The Dead Internet stocks are soaring again. Is this nuts or not?
By Aravind Adiga

(MONEY Magazine) – If you were teaching Investing 101, here's the first thing you would probably warn your students: Never, ever, go near an Internet stock. Between April 2000 and October 2001, the Morgan Stanley Internet index dived 91%, a swoon that wiped out billions in shareholder wealth and guaranteed that millions of investors would suffer a lifelong aversion to the mere sound of the word dotcom.

Amazingly, though, some of last year's top performers were Net stocks. Global Sports shot up 261%, Expedia rocketed 325% and Overture Services surged 385%. The Morgan Stanley index has gained 30% since October vs. a 6% rise for Standard & Poor's 500-stock index. And once-wrathful investors have softened so much that Internet IPOs are now being ventured again: Online payment firm PayPal went public on Feb. 15, and the stock jumped 55% that day.

Have investors gone nuts? Or is there a rational argument for gritting your teeth, wiping away your tears and buying Internet stocks once again?

Survival of the fittest

In the aftermath of dotcom mania, scores of onetime high fliers like Pets.com and Webvan crashed out of business. The players that survived this carnage tended to have real earnings and strong balance sheets--attributes that seemed quaint at the height of the New Economy. "A lot of really experimental business models are gone," says Robert Lloyd, co-manager of AIM Global Telecommunications & Technology fund, which recently held stocks like eBay and PeopleSoft. What remains, he says, are companies with "viable business models."

Now that the "who cares about earnings?" days have passed, a burgeoning cadre of Internet firms are posting profits even in the midst of a recession--instead of frantically spending investors' cash merely to build market share and generate hype. Intuit, which helps companies manage their finances online, earned $120 million in the fourth quarter of 2001. Even Amazon.com, long soaked in red, may have turned a corner, eking out a first-ever profit of $5 million in the fourth quarter of 2001.

There are other signs that the sector may finally be coming of age. Ask Larry Haverty, a portfolio manager at State Street Research, why he wants to own an Internet stock like Expedia and he almost yells out, "I like cash!" Expedia boasts $238 million of cash on hand and no debt, and its operating cash flow is growing more than 100% a year. Gushes Haverty: "There aren't too many businesses that can do that."

The dream lives on

The bulls insist that the recent recovery is just the beginning of a renaissance in Net stocks. After all, the Internet revolution is still in its infancy, says Mitch Rubin, manager of Baron iOpportunity fund, which itself is just two years old. Two million Americans start using the Web each month, according to a study by the Department of Commerce, and online retailing continues to boom. Last year e-commerce sales hit an estimated $33 billion, up 19% from 2000.

Of course, many investors who were burned when the Internet craze flamed out are loath to play with fire again. "But that to me is the opportunity," says State Street's Haverty, a contrarian who also holds nontech stocks like Viacom. In recent years, he argues, investors' perception of the Internet has swung from one extreme to the other: First it was meant to change the world, and now it's viewed as a financial fiasco. "The reality is somewhere in between," says Haverty.

Amid such skepticism, the believers argue that it's now possible to buy viable Internet firms at sane prices. Take Overture (over), which operates a widely used online search service. If you use the Internet to shop for books or tickets, compare prices or bid, there's a strong chance you're doing so using Overture's search engine. For example, go to www.yahoo.com and type in "airline tickets." Among the first names you will retrieve--identified as "Sponsor Matches"--will be three Overture clients. (Overture pays Yahoo for the privilege of highlighting its clients' services this way.) If you click on the clients' names and visit their websites, these companies will pay Overture a fee that averages 23[cents] a click.

Clients value this service because it boosts their odds of being noticed by online shoppers. And Overture's "pay for performance" model reassures clients that they won't have to pay unless you actually view what they're hawking on their website. While flakier business models have imploded, this one seems to be gaining traction. "It's probably the worst year for advertising and marketing in 20 years," says Baron's Rubin, "yet Overture grew its revenues 180% last year" to $288 million.

More important, Overture isn't merely growing revenue--a feat many Internet has-beens achieved before running out of cash and dying. Last year, Overture reported earnings of $20 million, and it's financially strong, with $139 million in cash and no debt. This combination has attracted some distinctly hype-averse investors, including the Brandywine fund, which re- cently owned 57,000 shares.

After its heady climb last year, Overture's stock has shed 26% in 2002, partly on news that online portal Google will launch a rival pay-for-performance search service. "The volatility is ridiculous for a business that's executed that well," says Rubin, who recently had 4.7% of his fund's assets in Overture. He argues that panicky investors have underestimated the value of Overture's alliances with online portals like MSN and AOL, as well as its network of 53,000 advertisers. Meanwhile, the stock trades at 29 times earnings, which strikes him as less than crazy for a company growing at such a rapid clip.

Another Internet company with an apparently solid business model is Hotel Reservations Network (room), which sells discounted rooms through its own website and a network of 23,000 affiliated sites run by firms like Travelocity, Expedia and Northwest Airlines. Even though the travel industry was hit hard by Sept. 11, Hotel Reservations Network has continued to grow quickly, with sales rising 63% last year to $536 million. (The company generated profits of $13 million for the year.) Yet CEO David Litman says his firm still sells only 1% to 3% of the hotel rooms in most of its markets, leaving it ample scope for growth.

State Street's Haverty, who used the company's website earlier this year to book a discounted room in Manhattan, likes the fact that "they get paid before they deliver the service." As a result, the firm generates "an awful lot of free cash flow." Like Overture, Hotel Reservations Network is also financially sound. It has no debt and is sitting on $219 million in cash, offering at least some assurance that this is one Internet company that will survive.

--ARAVIND ADIGA