Magazine

The Net


Technology investors can spend ages boning up on the newest gadgets to spot the next Microsoft Corp. (MSFT). Or they can ride the biggest trend in tech: the migration of consumers' time and money to the Internet. It should have years to run, it's spreading in earnest outside the U.S., and it's beginning to produce the next generation of giants.

Indeed, this second-wave Internet boom, which began in 2002 amid the ashes of the tech bust, is showing signs of accelerating. Consumer e-commerce in the U.S. is expected to grow nearly 30% this year, to $144 billion, though it is still just 5.4% of retail sales, according to Shop.org, the online arm of the National Retail Federation. And U.S. Internet advertising, which claims about 6% of total ad spending, was up 39% in the first quarter, compared with a year earlier. Such growth explains why Internet HOLDRs (HHH), an exchange-traded fund dominated by shares of eBay (EBAY), Yahoo! (YHOO), Amazon.com AMZN), and Time Warner (TWX), is up 20% this year while NASDAQ -- populated by lots of non-Internet tech outfits -- has been flat.

In Asia, investing in Net companies appears to be just warming up. Four Chinese Internet companies have gone public in the U.S. since December, and two more are in the pipeline. Already, all six make money, boosted by a Chinese Internet audience that is now 80 million strong and set to hit 153 million by 2006, exceeding the number of Net surfers in the U.S.

Despite complaints that the rapid rise is just Bubble Redux, Net stocks are no longer as pricey as they once were. Most big ones trade at price-to-earnings multiples of 25 to 40, but at the same time their profits are growing quickly. Pro forma earnings of 50 leading Web companies could grow 40% this year and 39% in 2005, figures Piper Jaffray Cos. (PJC) analyst Safa Rashtchy. "There is still room for [their] profit margins to expand; the growth is sustainable for several years," he adds.

Among e-commerce stocks, Amazon is not an obvious short-term bet because many analysts are leery of its strategy to boost demand by cutting prices and profit margins. But the company's guidance looks conservative: After boosting sales 36% last year and 41% in the first quarter, Amazon says full-year 2004 sales will rise only 22%, to 31%. Unless Christmas is lousy -- not likely with the economy so strong -- it's on track to beat its forecast for both sales and operating earnings.

If books are hot on the Net, movies may be even hotter. Shares of Netflix Inc., the online DVD-rental store, look pricey at about 60 times earnings. But it has racked up 2 million customers, double a year ago, and analysts expect 50% annual earnings growth through 2008. So far, competition from Wal-Mart Stores Inc. (WMT) hasn't slowed Netflix, partly because it offers 40% more movies. A bigger risk: that DVDs will be superseded by online movie rentals. That won't become a megatrend, though, until a critical mass of consumers upgrade their TVs, and Netflix itself is moving into digital downloads.

In Asia, U.S. investors can keep things simple by betting on a Web business they know well -- online travel. In China, Shanghai-based Ctrip.com International (CTRP) is the leader. Chinese travelers often lack credit cards, but Ctrip simply bills the hotel for the stay instead. The company's stock trades at 40 times Rashtchy's estimate of $12.7 million in profits this year under generally accepted accounting principles. He says earnings will hit $18.4 million next year. That's one reason Rakuten Inc., which runs a Web travel agency serving Japan, agreed to pay a premium for a 22% stake on June 14.

E-commerce is the most obvious way to play the Net, but software and equipment companies offer good alternatives. Security-software companies have been getting a big run from the creep of viruses and other dangers. That gives companies such as Symantec Corp. (SYMC) and Digital River Inc. (DRIV) a big push. Equipment companies, though, can be tough for individual investors to figure out as the Internet is continually upgraded to meet demand for broadband and wireless connections. That's why an exchange-traded fund called the Broadband HOLDR (HHH) is a smart pick for small investors. More than 90% of its holdings are in 10 stocks, led by Qualcomm (QCOM) (33%) and Motorola (MOT) (22%). The idea is that the fund lets investors bet on the Internet being upgraded without having to pick individual winners. And Motorola's and Qualcomm's p-e's of 34 and 26, respectively, make the fund look reasonably priced considering that most gearmakers' earnings are just beginning to rebound.

With the Internet building a full head of steam, the big investment picture for high tech is clearer than it has been for several years. For investors who can stomach the risk, the Web can be worth their while.

By Timothy J. Mullaney in New York


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