Internet

Return to Article

In Search of That Google-Like Glimmer

Kevin Kelleher

Admit it. You passed on Google at $85. You bought the stock -- or at least thought very, very hard about it -- as it neared $200, again as it passed $250, yet again as it broke above $300 and, defying even your more exuberant logic a mere six months before, when it shot above $400.

Along the way, you dabbled in Yahoo! and maybe some other Internet names like eBay or InterActiveCorp because it became clear that 2005 was the year at least a handful of these stocks got back some of the magic they had in that late, great year of 1999.

Now that Google is actually in a position to break through $500 -- an infinitely more unthinkable barrier than $400 was last summer -- research analysts are hustling out to lay down the barricades demarking reality from fantasy. No, they insist, thou shalt not buy Google at $425. Thou shalt smite Yahoo! if it rears its head above $40. There will be gnashing of teeth if thou wert foolish enough to buy eBay at $47.But such warnings are only partly useful unless you know where to put the money you just cashed out.

So where do you invest now? Although speculative trading may have ignited a bout of mini-mania in the Internet's biggest names, some investors say that has left the door open for opportunities to pick up some of the less celebrated names in tech.

"The market still hasn't recovered for a lot of small and mid-sized tech companies," says Alex Slusky, a managing partner at Vector Capital, a buyout firm specializing in forgotten and sometimes distressed Internet and software companies. "Growth is fleeting. High-growth companies have a tendency to disappoint. I'd rather own Oracle at $12 than Google at $420."

Vector and other buyout funds were presented with an unusually large number of undervalued tech companies in the darkest days of 2002 and 2003. "Those were uniquely good years for taking companies private," says Slusky. "But 2005 and 2006 will still be much better than average."

In the past year alone, Vector has added to its portfolio a few companies with names familiar to longtime tech investors. In July, it bought WinZip, the ever-present PC-file compression software, with the aim of leveraging its vast user base into stronger revenue. Since then, WinZip has signed a distribution deal with Google and integrated the program with Microsoft Outlook.

Last month, the firm paid $200 million for Register.com, which sought its fortune in the domain-registration niche and still holds on to a million small-business and individual customers. Corel, the maker of WordPerfect word processing program that Vector bought in 2003, is reportedly close to filing for another public listing. (Vector wouldn't comment on a potential IPO for Corel.)

None of these companies are a Google. These aren't even companies Google gives much more than a nostalgic afterthought to. They aren't the hot shots of the recently revived Internet sector. And that's the whole idea.

Of course, a buyout firm seeks to become the sole investor in a company. But the things it watches for are of interest to investors seeking a more sober approach to tech stocks: a strong customer base, a low price-to-earnings ratio, growing cash flows and a willingness to bring rigor into their operations.

Vector believes it's found a good candidate in Register.com, which has an opportunity to offer its customers more Internet services. Its cash flow from operating activities stood at $1.9 million on June 30 (the most recent figure before its buyout), up from about $100,000 one quarter earlier.

And although the firm won't say which other stocks are in its sights, a stock screen can help unearth some good candidates: Disk-drive maker Western Digital(WDC) trades at 0.84 times sales despite a 40% stock rise this year. Not only did the firm recently raise guidance, but it upped its cash flow from operations to $461 million in its most recent quarter from $190 million in the previous quarter.

Another longtime Internet name is Earthlink(ELNK), which has a steady customer base even after years of consolidation in the ISP market. Earthlink has seen steady growth in its cash flow from operations while trading at 1.15 times sales.

It's a little trickier for a buyout firm to capitalize on such opportunities. Earlier this year, when Register.com was trading just above $6, Vector approached the company about a buyout. Register.com passed, but after RCM Acquisition, which had tried to buy Register.com two years earlier for $4.95 a share, made a $7.10-a-share bid, Register.com went back to Vector.

Vector made an $8.10-a-share bid but lowered it to $7.81 after it received an important reminder of why undervalued stocks can be undervalued: Not only were there credit card penalties that Register.com was responsible for because of "high rates of refunds to customers," but Visa and MasterCard cracked down on the company because it didn't adhere to data-security standards. There was also an "employment-related lawsuit" filed in 2005 that Register.com hinted at in its filings with the Securities and Exchange Commission without offering details.

Not exactly the stuff of glamour. But in a volatile tech market, where glamour can fade quickly and take a good chunk of market value with it, there's wisdom in running with underdogs whose potential to surprise is on the upside.

"All stocks regress to the mean over time -- it's a very powerful investment thesis," says Slusky. "If everyone's expecting 100% growth rates from you and competitors are lining up you're more likely to regress down to the mean. I'd rather find companies below the mean so that they'll regress up."