Another tech-stocks bubble?

Buttonwood

Jul 22nd 2005
From The Economist Global Agenda

Internet firms are all the rage again. Another triumph of hope over experience?

MARKETS like these need heroes, and Google is the closest thing they’ve got. With most share prices stuck in the mud until recently, Google’s has shot up by 60% this year alone, nearly quadrupling since the firm went public last August.

Why? Investors with more dollars than sense are desperate to find something promising juicy returns. Google is too new to have burned buyers in the last dotcom downturn. And it has a plausible tale to tell. To hear the techie analysts sell it, prospects for online sales and advertising, especially the sort of paid keyword-search business that Google has perfected, are virtually limitless.

Yahoo!, Google’s rival in the search business, was the first of the big four internet firms to report second-quarter results. On Tuesday the firm announced revenues, net of commission to marketing partners, that were 44% higher than the same quarter a year earlier. Profit grew more than sixfold but most of it came from the sale of an unidentified investment (could it be Yahoo!’s shares in Google?). Investors reacted by “taking profits”—ie, dumping Yahoo! shares in after-hours trading.

The 53% increase in second-quarter profits and 40% rise in revenues reported on Wednesday by eBay, an online auction house, were better received. The figures exceeded expectations and eased worries that eBay's precipitous growth might be fizzling out.

To keep its share price above the $300 mark that it first achieved last month, Google needed to trump its two rivals when it announced its results on Thursday July 21st. On the face of it, they were pretty good: second-quarter profits more than quadrupled to $343m, on almost doubled revenues of $1.38 billion. Google's shares duly closed at a new record of just under $314 on Nasdaq. However, they then plunged below the $300 mark in after-hours trading, on worries that Google's rise may be running out of steam. The firm's chief executive, Eric Schmidt, admitted that revenue growth may not be so impressive in the current quarter.

The last of the four internet giants, Amazon, an online retailer, reveals its results next week. All have their fans. But it is Google that produces the acid burn. Now, Buttonwood likes a hero as much as the next hackette (and confesses to watching “The Last of the Mohicans”, ostensibly with her daughters, at least once every six months). She has approached the internet yarn with a fresh eye, determined to let bygone busts be bygone. And valuations are, in fact, better founded than many of them used to be.

But around 50 times next year's expected profits is still quite a leap of faith. At the levels seen in recent days, the price of Google's traded shares implies that it is the world's most valuable media company, with a market cap comfortably in excess of Time Warner's $76 billion—even though the latter had $42 billion in sales last year to Google’s $3.2 billion. True, Time Warner‘s business is increasing at a snail’s pace compared with Google’s. But putting so high a price on future growth only makes sense if all’s for the best in this best of all possible worlds. And it isn’t. There are a lot of unknowns, plus some knowable storm clouds rolling in.

The arguments for these high valuations (and Yahoo!, at around 60 times expected profits is right up there too) all boil down to one: the growth in internet firms’ business reflects a secular shift that is broadly impervious to economic cycles and has a long way to run.

More people are gaining access to the internet, and specifically to broadband, to which about a third of American households, for example, are now hooked up. They spend more time—and money—online than dial-up peons. Sales on the internet grew by almost a quarter last year, and have been doing so at a similar clip since 2001. Even so they account for only a small fraction of American retail sales.

Meanwhile, on the marketing side a big gap has opened up between the proportion of their media time that people spend online (almost 35% in America, on figures from Forrester Research, an independent firm) and the percentage of ad spending devoted to the internet (about 6%). That void cries out to be filled. Internet advertising in America grew to about $12 billion in 2004 as a bouncing economy boosted all advertising and firms warmed to the web.
Forrester expects it to increase by some 23% in 2005 and then to taper off to single-digit growth by 2010. Search-engine marketing, Google’s speciality, will see the fastest growth.

Add in abroad, where the business is growing twice as fast as in America, and the picture is rosier still. About half of the revenues of eBay and Amazon, along with two-fifths of Google’s and more than a quarter of Yahoo!’s, come from outside the United States. Mike Mahaney, an analyst at Smith Barney, reckons that if these patterns continue, and neither Google nor Yahoo! loses market share, their revenues should keep growing for quite a while at 25-30% annually. His estimate that Google’s shares will hit $360 in 12 months’ time is on the high side but it looks less outlandish all the time.

Now for the cold water. The internet’s growth is slowing markedly: most people in industrialised countries have access now, so just adding users is not the source of growth that it was. Broadband is increasing the value of the net as an advertising medium. But the growth rate of broadband connection is slowing too–not just in America but most places.

Another negative—who knows yet how important it will prove—is that a bit of a backlash against the net is setting in along with viruses and other malware, points out Fred Hickey, the editor of High-Tech Strategist, a newsletter. Independent research firms have found that people are increasingly unwilling to give their details online: Gartner found that of the roughly 30% of a survey sample who bank online, three-quarters were logging in less frequently than before, and nearly 14% of them had stopped paying bills online; Financial Insights found that 18% of internet users had stopped shopping online for fear of identity fraud; Jupiter Research found that even online dating is down, at least in America.

Then there is competition. Barriers to entry in internet businesses are low, as Amazon’s slipping market share testifies. Yahoo! is trying to improve its search system to challenge Google in paid search ads, and Microsoft has entered the game too. And as Google, sensibly, also expands from its original business, it is running into higher costs and hostility. Its move into video search, especially, has ruffled the feathers of those providers whose content it blithely skimmed without asking first.

A bigger risk to Google even than competition is that of an economic downturn. For the more internet businesses grow, increasing their share of the wider market, the more cyclical they become, and this is something that its share price fails totally to reflect. America’s economy refuses to lie down, for the moment, but there are plenty of reasons to think it will. When it does, internet business will dwindle too, and the shooting-star stocks with it. After all, it has happened before.

At the end of the day, most people buy Google less from some rational assessment of the future of the internet than because they think “they can’t not be in it. There’s nothing else out there when the price is rising so fast,” says Fred Hickey.

Paul Desmond, the president of Lowry’s Reports, has a theory about this. Lowry’s is an old investor-advisory firm that has tracked supply and demand in individual firms’ shares for almost 70 years and is big on the cyclical ebb and flow of investor sentiment. Investors move from complete abandonment of the stockmarket at a major market bottom like March 2003, then gradually through a period of increasing confidence until they get to a point where greed really sets in, he says. When they start focusing on a relatively small number of get-rich-quick stocks, it is a sign that the bull market is about to turn. There is incredible buying strength behind Google right now, according to Mr Desmond. The bull is not nearly on its knees yet, but “we’re seeing a warm-up of that with Google,” he says. You have been warned.

Send comments on this article to Buttonwood (Please state whether you are happy for your comments to be published)

Read more Buttonwood columns at www.economist.com/buttonwood

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.