Tech Outlook: Net Stocks, as Always, Ride on Valuation Trends

Outlook by sector:

PCs

B2B

Optical networking

Wireless

Venture capital

When you talk about Internet stocks, you have to talk about valuations first. And Internet-stock valuations are known to follow a logic all their own.

First, there was the well-chronicled run-up that led to the likes of Henry Blodget becoming a household name.

Next, with little warning, came a months-long rout that eventually led the aforementioned analyst to courageously downgrade a bunch of Net stocks already trading in the single digits.

Now most Internet stocks stand in a deep hole with, seemingly, little prospect of digging their way out.

So, forecasting what's coming in the next, say, five months becomes a tall task. But Wall Streeters aren't deterred, and a number of observers expect this summer's drought to lift in the fall, leading to a solid rally. Along the lines of valuation, they say, one of the key questions will be whether the merger of America Online (AOL Quote) and Time Warner (TWX Quote) is completed, and how the market treats the combined entity. Also key: how widely broadband Net access spreads.

Stands to Reason

Internet stocks will likely rally in the fall, says Mike Wallace, analyst at UBS Warburg, though not as sharply as last year. That last part, at least, seems like a mortal lock: From the end of July through the end of September, TheStreet.com Internet Sector index shot up 119%; it has since fallen 37%.

Wallace sees the Time Warner-AOL deal as one of the major issues hanging over consumer Internet stocks. After AOL completes its acquisition -- they're aiming for late October -- the valuation bar for AOL Time Warner will affect how other Net companies are priced, says Wallace.

America Off Track AOL shares fall after Time Warner agreement

Source: BigCharts

It has already had an effect: The partners' declining share prices since their early-January agreement presaged the general collapse of Net stocks. If AOL can regain its footing, lesser Net stocks should find the going a bit easier.

Other Questions

Another variable likely to affect investor attitudes toward the Internet sector is the number of high-speed connections to homes, as measured by the number of home subscribers to the Excite@Home (ATHM Quote) broadband service. The company, which had slower-than-expected growth of 300,000 new subscribers in the second quarter, says it will jump from 1.8 million subscribers midyear to three million by year's end.

"If @Home does end the year with three million subscribers, then all of a sudden that's something that people have to pay attention to," says Wallace. He has strong buys on AOL and Excite@Home; his firm hasn't done banking for either firm.

On the advertising front, regulatory and legislative concerns about consumer privacy have placed a damper on investor optimism toward the growth of Net advertising revenues. But that cloud over the industry seems to be dissipating. DoubleClick (DCLK Quote), for example, which has held off on an initiative to target advertising with the help of information collected about users' online habits, joined an online ad industry trade group recently in reaching an agreement with the FTC over guidelines for information collection. But ad budgets, cut back amid the new austerity among Net companies no longer rolling in easy money, don't appear to be returning until the fourth quarter, according to participants in the online advertising business.

So why a fall rally at all? Why not sooner, or later? "It's just one of those seasonal things," says Wallace. "When business gets stronger, stocks react." But they don't necessarily act the same as they did during earlier good times. "I don't expect the insanity we saw last year, for sure," says Wallace.