Markets take another turn with tech

The world's top five internet stocks are now worth more than all of India's public companies put together. Warning bells should be ringing for investors, says James Ferguson

Mary says the boom is back "Internet boom is under way, says Morgan Stanley's Meeker." No, that's not a dusty old quote dug up from last century's archives, but a recent headline in The Wall Street Journal. The article quotes Mary Meeker - "one-time queen of the internet" as Simon English puts it in The Daily Telegraph - as saying: "The enthusiasm was well placed; it just got ahead of itself in many respects."

Along with Henry Blodget, Jack Grubman and Frank Quattrone, Mary was a prominent analyst in the dotcom era, touting tech stocks for Wall Street while her employer made billions from selling shares to the public. But after the bubble burst, angry investors got angrier and looked around for someone to blame other than themselves. So the Wall Street companies bravely handed them a few heads, and then the regulators and the prosecutors saw a chance to get their names in the paper. And when it was all over, and Blodget and Grubman had gone, Meeker was for some reason still standing. But, it seems, none the wiser for it. According to her, the tech boom is back, and it's going to be bigger and better than ever. Speaking in the royal "we", she maintains: "As we have said for a long time, from a wealth creation standpoint, we believe we lived through a boomlet, followed by a bust, followed (now) by a boom." A boomlet?!

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So why is the venerable WSJ paying attention to this nonsensical stuff now, a full four years on from the collapse of the last internet bubble? The main reason is that shares in search-engine firm Google have doubled since its August listing price of $85, even though that figure was a near 40% discount on the original proposal, and it has taken the whole US internet sector up with it. After Google reported better-than-expected third-quarter earnings earlier this month, a flood of Wall Street analysts raised their price targets for the firm, encouraging investors to buy more shares. Only one of the 22 analysts covering the stock now thinks, publicly, that it is a "Sell". And Meeker raised her own target price by another 27% this month, claiming that even this 'could prove conservative'' in future. Perhaps it will. Or perhaps it will prove to be wildly over-optimistic. "Because [Google] is such a young company," says Heath Terry of Credit Suisse First Boston to Saul Hansell in The New York Times, "it doesn't take a whole lot of changes in assumption to get a really different value.'' For example, if he increased by 1% the estimate of Google's annual revenue growth rate in his model, he would get a price target of $233, which is 32% or $6.2 billion above his current figure. The fact is that, since Google's value is dependent on investors' assumptions of how big it will grow, unexpected good growth in even one quarter "can have a big impact on its share price".

Lucky coincidence

Google made a profit of $52m during the last three months - some 35% ahead of Wall Street estimates - in its first earnings period since flotation. That was double its profits for the previous year, on revenue that soared from $393m to $805m. Cynics may wonder at the timing of such auspicious numbers given that only 19.6 million shares were issued to the public at the firm's IPO and that the next three months will see another 250 million shares emerge from their lock-ups. This includes the 16.6 million shares that the three principals have already announced their plans to sell. Even the non-cynics among us will agree that the company has notoriously poor financial disclosure. But, it appears, this doesn't include Prudential's Mark Rowen, who cites these "blowout" results as justification for a 12 to 18-month price target of $200. He refers to the valuation as "quite reasonable, compared with those of other growth companies".

Will they ever learn?

Not everyone can be quite so sanguine, particularly as the likes of Rowen seem to be repeating the same mistake that they made during the dotcom days: looking only at relative valuations. "So, simply because the market has risen, the boom is back?" asks an incredulous James Montier, head of Global Equity Strategy at Dresdner Kleinwort Wasserstein. "The psychological evidence shows it is incredibly hard for people to learn but, surely, investors must have learnt something from the experience of the bubble years. No investor who has even the vaguest respect for any concept of valuation could go near [these] stocks."

Montier cites a p/e ratio of 222 times for Google, which looks outrageous but does include the costs associated with its recent listing. Most analysts ignore such one-off items. JP Morgan, for example, which rates Google "outperform" after "excellent 3Q results", reckons the p/e ratio is only about 67 times their earnings forecast, which will fall next year 53 times. Although that's still pretty high, it doesn't look so bad if you consider Montier has calculated p/e ratios of 93 times for e-Bay and 126 times for Yahoo.

The reason these stocks command such high multiples from today's market is that they're still considered to be in the high-growth stage. Google's sales (net revenues) will double this year to about $2 billion. Given that the firm's operating profit margins are a whopping 56%, you can see why few analysts feel brave enough, or stupid enough, to stand in the way of the "buy" consensus. They know that every time there's a strong quarter, all their peers will be out revising up their long-term earnings forecasts, and that could prove rather awkward. Many doom-mongers lost their jobs during the dotcom bubble for being out of step with the market, and very few got them back when the crash finally proved them right.

The good times never lastGoogle's operating-profit margins may be 56%, but they're on their way down. Note that they were 68% at the start of 2003, according to JP Morgan, but were pushed down as the business expanded and the domestic market has gone ex-growth. More worrying, such flashy profitability attracts predators. Microsoft entered the fray this month with its very own search engine, for example. Even if Google is spared Netscape's fate - the original internet browser lost supremacy to Microsoft - margins will have to fall. Consider the games market: although Microsoft's X-Box may not have been all that successful in its own right, it forced Sony to turn the highly profitable PlayStation 2 into a loss-leader, supporting its game software sales.

An insider explains

If margins cannot be expanded, the only way for valuations to be justified is for sales to keep defying belief. Google's price-to-sales ratio (PSR) is 24 times. James Montier reckons Yahoo is on 15.5 times sales and e-Bay 23 times.But when companies mature, they trade on a mere one to two times sales, which gives you an idea of how much growth is still needed to justify these stock prices. Scott McNealy, CEO of Sun Microsystems, explained the absurdity of this kind of valuation best in BusinessWeek, back in April 2002: "Two years ago, we were selling at ten times revenues when we were at $64. At ten times revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes, with zero research and development for the next ten years, I can maintain the current revenue-run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?"

As Montier sums it up: "A tech insider tells you that ten times sales is insane, yet the WSJ cites internet stocks trading on 15 times as evidence of an internet boom." John Mauldin, who wrote a US market caveat in last week's MoneyWeek, reminds us: "In the early 1990s, after-tax profits were less than 5% of revenues." Now, however, after tax cuts, 50-year low rates and fiscal stimulation, "the S&P 500 has profits of 9.2% of revenues - in short, it doesn't get much better than this". And Google depends on revenues from advertising, which is sensitive to the business cycle. When the profit cycle turns down, stocks on 24 times earnings are going to be hit hard, never mind those on 24 times sales. Perhaps that explains why Google founders Larry Page and Sergey Brin have decided to sell 20% - about $1.2 billion each - of their stock?

It's not the boom that's back, it's the bubble. Mary Meeker is very wrong.