Inktomi Is Pricey for a Company That Has Hit the Reset Button

For the first time in years, pointing out simple valuation inconsistencies seems to work. So let's shine the bright light on a former Internet-industry highflier, Inktomi(INKT Quote), whose shares have plummeted along with those of nearly every other stock of its ilk.

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Cabot Microelectronics Goldman Sachs

The short form is that the formerly press-release profitable company trades for about 286 times expected pro forma earnings for calendar 2001. (Profits in press releases exclude all sorts of icky charges to earnings; profitable companies are the ones that show black ink according to GAAP, or generally accepted accounting principles.)

Despite its projected year-over-year revenue growth having slowed to a relatively anemic 16%, the company is worth about $1.5 billion, or nearly five times expected revenues of $311 million. Fans of the company argue that a near-term price-to-earnings valuation doesn't work for Inktomi because it already has demonstrated it can be profitable. That's a fine argument, until you consider that it rang up those profits largely from telecommunications carriers whose best days may be behind them and at a time when capital essentially was free. The point is that Inktomi -- like so many companies serving the dormant Internet industry -- essentially is starting over. Is there any reason to believe, again, that future earnings justify a lofty valuation today?

Inktomi makes software that helps users speed up the traffic on their Web sites. Telecommunications carriers plop Inktomi's software down on top of Sun Microsystems' (SUNW Quote) servers so that Web sites sent to users will load more quickly. Inktomi also supplies Web content companies, including America Online-Time Warner, with search-engine software.

The Foster City, Calif., company was one of those stunning Internet successes. Founded in 1996 and taken public in 1998, the stock rose from a split-adjusted offering price of $4.50 to as high as $241.50 in early 2000. Sales grew quickly as well, from $6.3 million in the quarter ending June 1998, its first as a public company, to $80.5 million in the quarter that ended in December. That zenith also happened in the quarter Inktomi first missed Wall Street's expectations and essentially reset its business plan. The stock closed Thursday at $11.44, up 1%.

But as business for overly optimistic telecom carriers has imploded, so, too, has Inktomi's outlook. Inktomi had hoped to have December-quarter revenue of about $90 million. Now, after last month's sale of a unit that produced $5 million in revenue in the past quarter, it's expecting sales this quarter of between $63 million and $67 million, and analysts have given up on Inktomi's earning a quarterly profit again until the quarter that ends in September. Meantime, the company is pushing into the market to sell software to corporations running their own networks and for wireless applications. The so-called enterprise market is one tough place to be focusing at the moment. The wireless market is a crowded field.

And yet, Wall Street remains relatively upbeat. Bear Stearns analyst Robert Fagin, who rated the stock attractive at $17.50, notes that "the company was profitable, so the business model was proven." Similarly, First Union Securities analyst Christopher Russ (a hero to this column for being the only guy who'd badmouth VeriSign at $150-plus) notes that Inktomi "has a high gross margin. So when the revenue reaccelerates it should become profitable again." He rates the shares a buy.

The bottom line: Too many shoulds, coulds and ifs. For now, Inktomi's business is stalled, its end markets are changing, its historical customer base is shellshocked -- and it's worth a billion and a half dollars.

Make no mistake, Inktomi's situation isn't unique. Sure, its stock is down 95% from its high, but that's not unusual. The question is whether its shares are cheap.

Chief Financial Officer Jerry Kennelly is philosophical on the subject. "It's not a simple topic," he says. "There was a strong market last year, and we got to profitability several quarters earlier than expected. We think we have something the world really wants. We expect things to return."

Kennelly says Inktomi expects in coming years to get between 20% and 40% of its revenues from enterprise customers; up to 95% of past revenues have come from carriers. He also suggests that with the stock price so thoroughly shellacked, Inktomi is like a "fresh IPO" but with plenty of cash, 1,000 employees and a history of profitability.

Cash it has, though a little more than a third of the $311 million in liquid investments is reserved for collateral on a sweetheart deal Inktomi struck to assure itself of cheap headquarters space. The value of its investments in equities has dwindled from $127 million in September to $52 million at year-end.

As for those employees, Inktomi is pioneering a novel form of incentive compensation. By a deadline of last Wednesday, Inktomi's employees were able to turn in their existing stock options in exchange for a promise to receive an equal number of new options in six months. This allows Inktomi to get around requirements to record repriced options as a noncash compensation expense. Of course, it also turns Inktomites into bears on their own stock in the near term.

"Now they can all stop worrying about the stock price as a daily concern and about how hopelessly underwater their options are," says Kennelly, who calls the "shareholder friendly" move something of a "six-month put" on Inktomi's stock.

Don't feel too sorry for Inktomi employees. First, Kennelly says the company has no plans to lay off workers. Also, they received another slug of low-priced options in December.

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Come to think of it, the six-month time frame probably isn't a bad idea for investors as well as employee-investors. Inktomi performed well in its youth. Its stock likely has at least half a year more of adolescence before it grows up again.

Update: Cabot Microelectronics Shaves Some Value

The investor love affair with chemicals maker Cabot Microelectronics (CCMP Quote) ended this week. Stock in the maker of chemical mechanical planarization slurries, a brew used to etch and flatten silicon wafers during chip production, has fallen 27% so far this week, taking into account a late rally Thursday that left it up 31 cents, or less than 1%, for the day. A profile here Monday suggested that Cabot's value was far too high, considering that the stock had climbed 26% in three weeks even as the bottom was falling out of the semiconductor market.

One firm that hasn't believed the Cabot valuation is Fechtor Detwiler in Boston, which alerted clients last week that a Philips chip plant in San Antonio, Texas, had lowered its monthly wafer starts, a measure of chip production, by 88%. A slowdown in wafer starts anywhere isn't good for makers of slurries, of which Cabot is a leader. Another factor in Cabot's drop undoubtedly was the guess Monday by Salomon Smith Barney's Jonathan Joseph that Intel(INTC Quote) -- a 15% customer of Cabot's -- would spend as little as $5.5 billion on capital expenditures this year, compared with the $7.5 billion it had forecast. In a speech to Intel partners on Tuesday, Intel CEO Craig Barrett reiterated Intel's intentions to spend the full amount.

As Cabot's stock has fallen, rumors swirled that the company would back off its previous guidance of 50%-plus year-over-year increases in revenue and earnings. The company didn't return a phone call Thursday seeking comment.

Clarification: Goldman Didn't Call the Bottom -- Honest

Goldman Sachs hardware analyst Laura Conigliaro phoned Wednesday to protest good-naturedly her technology team's treatment in this space that day.

As a refresher, Goldman on Tuesday lowered its earnings estimates for all sorts of companies and generally told its clients it wasn't at all clear when the climate would improve. Conigliaro even acknowledged a bit of "subjectivity" in a meager list of clean-as-a-whistle companies that hadn't yet shown weakness. What she meant by that, says Conigliaro, a Wall Street veteran who has seen tech-stock cycles before, was that analysts should make sure companies on the list "don't have any hair that's about to appear." In other words, just because there'd been no hiccups wasn't reason enough for being included on the list. Whether or not the companies are banking clients of Goldman's wasn't a factor, she says.

Clean as a Whistle? Ten of Goldman's 11 hairless Nazz favorites have had an unsteady week
Company Name	Ticker	2/26 close	3/1 close	% change
BEA Systems	(symbol Quote)BEAS	45.75	38.92	-14.9
Check Point Software	(symbol Quote)CHKP	80.88	71.31	-11.8
Comverse Technology	(symbol Quote)CMVT	81.94	76.52	-6.6
Concord EFS	(symbol Quote)CEFT	47.19	43.75	-7.3
eBay	(symbol Quote)EBAY	45.38	37.25	-17.9
Micromuse	(symbol Quote)MUSE	49.44	45.92	-7.1
NDS	(symbol Quote)NNDS	47.5	46.63	-1.8
Paychex	(symbol Quote)PAYX	42.88	39.44	-8
Siebel Systems	(symbol Quote)SEBL	48.56	44.63	-8.1
Synopsys	(symbol Quote)SNPS	57.63	53.81	-6.6
Veritas Software	(symbol Quote)VRTS	68.94	70.69	2.5
Avg. decline: 8%
U.S.-listed Nasdaq stocks in Goldman's 2/27/01 "Clean as a Whistle" stocks

"It is so bad out there," says Conigliaro. "It really feels very bad. I talk to a lot of end users, and they already were pulling in their spending. Now they're looking at pulling it in even more."

The market so far agrees with Conigliaro's pessimism. Never mind the stock plunge of all the companies whose earnings estimates Goldman cut Tuesday. Despite the late rally Thursday, shares of the 11 U.S.-listed Nasdaq companies on Goldman's clean-as-a-whistle list ended the three days of trading down an average of 8%, compared with a 5.4% decline for the Nasdaq Composite Index. And remember, those were the good ones.