Since 2002, our BusinessWeek Web 20 -- a selection of established and profitable Internet companies designed to show how ordinary investors can play Net stocks without undue risk -- has performed superbly. The model portfolio rolled up a 71% gain in its first year and followed with a 24% rise in the six months ended in March. Then came the second-quarter earnings season, and half of our picks got whacked. Since Mar. 1, we're down 6%. Ouch.
We're chastened, but still believers. Forrester Research (FORR) recently raised its forecast of U.S. e-commerce growth, saying last year's $114 billion market will double by 2007. Jupiter Research says U.S. Web ad sales will jump from $6.6 billion in 2003 to $13.8 billion in 2007. As tough as July's selloff was, our Web 20 is still performing as well as the market. Its recent loss basically matched the 4.8% dip in the Standard & Poor's 500-stock index, and clobbered NASDAQ's 10.7% drop. (You can follow the month-to-month fortunes of the Web 20 -- formerly called the BW Real World Internet Index -- by going to www.businessweek.com/web20.)
To maintain a high level of performance, twice a year we review the list of stocks, scratching disappointing (or acquired) players and adding up-and-comers. This time, we've axed the University of Phoenix Online (UOPX), which was acquired by majority owner Apollo Group Aug. 27, along with online ad-services company DoubleClick (DCLK), Web-conferencing software leader WebEx Communications (WEBX), e-tailer 1-800-Flowers (FLWS), Internet service provider United Online (UNTD), and Digital Insight (DGIN), which makes software for online banking sites.
With all the controversy over Google's (GOOG) valuation in its August IPO, we paused to consider whether to include the search-engine giant on our list. Even at recent stock prices of around $102 a share, we think it's a good long-term bet. Google trades at 31 times its 2005 earnings, after factoring out noncash charges for stock options. Skeptics argue that Google needs to be cheaper than elite Web players Yahoo! and eBay. It is: Its 2005 price-earnings ratio is about half of Yahoo's and 40% lower than eBay's. Standard & Poor's (MHP) analyst Scott Kessler figures Google cash flow can grow nearly 80% a year through 2009. That may be high, but it leaves wiggle room.
Type the word diamonds into the Google box and the first name that pops up (under sponsored links) is another of our Web 20 additions, e-tailer Blue Nile (NILE). The Seattle-based online jeweler peddles diamond rings for up to 35% less than brick-and-mortar jewelry chains and needs only a small warehouse to sell as much bling-bling as 116 stores. Operating margins are nearly twice the jewelry-industry average, at about 9% versus 5%, and management focuses on profits, not growth at all costs. "It's how we survived," CEO Mark Vadon says.
Analysts expect Blue Nile's profits to grow 33% next year. The stock, first offered to the public in May, is pricey at 50 times 2004 estimated earnings, but Forrester says the U.S. online jewelry and luxury-goods market will nearly double, to $5.3 billion, by 2007. That gives Blue Nile, with $129 million in 2003 sales, room to grow.
Flowers is a more established e-tailing category than jewelry, thanks in large part to 1-800-Flowers. Still, we're removing it from our list in favor of an emerging competitor, Provide Commerce (PRVD), which runs Proflowers.com. These two might look like Frick and Frack, but they're not. 1-800 sells mostly through local stores that handle delivery. Provide deals with growers who ship directly to customers overnight. Analysts say Provide will earn $10 million in the June, 2005 fiscal year, up from around $8.5 million in 2004.
Recently, outsourcing tech work to India has surpassed even e-tailing in generating buzz. Few Indian outsourcing companies have better prospects than Bangalore-based Infosys Technologies (INFY). Earnings are expected to grow 28% a year for five years, enough to justify its p-e of 35. We like the 2.5% dividend, too.
We added Double-Click (DCLK) last March to bet on the resurgence of the U.S. online-ad market, but it posted a weak second quarter, cut second-half earnings projections, and saw its stock fall 50%. A better choice: aQuantive (AQNT), a Seattle agency with lines of business DoubleClick lacks. "We're probably more of a proxy for online advertising," than DoubleClick is, says aQuantive CEO Brian McAndrews. AQuantive's Razorfish unit is a leader in writing and producing online ads.
It has also moved faster toward business models that let it charge premium rates when ads lead directly to a sale. Analysts say aQuantive earnings will be up 26% next year, to $20 million, after rising 41% this year.
Finally, we are betting on e-finance by restoring IndyMac Bancorp (NDE), an original Web 20 member we dropped last summer. The Pasadena (Calif.) mortgage bank has won kudos for a Web-linked broker network that has made it highly efficient. We thought the waning refinancing boom would kill profits. Instead, they're expected to rise 24%, to $212 million. With interest rates rising more slowly than expected, analysts think earnings will grow 19% next year. Plus, it pays a 3.8% dividend.
At an average of 36 times 2004 earnings, the Web 20 stocks are more than twice as expensive as the S&P 500. Still, Net-industry earnings should grow four times faster than S&P profits next year. In that light, they don't look so pricey.
By Tim Mullaney