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The TSC Streetside Chat: e-harmon.com Fund Manager Steve Harmon

Whither Net stocks?

Last year, investors threw money at all things dot-com, tacitly agreeing to ignore tenuous business plans, nonexistent earnings and dwindling cash reserves. Net funds shot the lights out and no matter how big your portfolio's return, you felt like you'd missed the boat. Bonny days.

That was then, this is now.

Today, investors have accepted that many Net stocks won't be around in 10 years, and it shows. Since its peak on March 9, TheStreet.com Internet Sector index is down 33%. But if these stocks were overbought last year, are they oversold now?

Enter Steve Harmon. He's been writing about Net companies as an analyst since their infancy, way back in the mid-1990s. Now he's making the ambitious switch from media darling to fund manager with his new firm, e-harmon.com. His Internet fund, currently in subscription, will launch in less than 10 days. He's also slated to launch a fund that will track his own Net30 Index, a basket of the 30 largest Internet stocks ranked by revenue.

In this week's Streetside Chat he tells us how he plans to separate the wheat from the chaff in the sinking sector, where he sees opportunities and what stocks he plans to stay away from. He'll also weigh in on the proposed breakup of Microsoft (MSFT), how investors should play the software titan down the road.

Harmon spoke with TSC Personal Finance Editor David Landis, Deputy Personal Finance Editor Stephen Schurr, Technology Editor Jim Cole, Senior Writer Ian McDonald and Staff Reporter Ilana Polyak.


Ian McDonald: OK, Steve, we'll just get right to it. First off, obviously, there's been kind of a bloodletting in the Net sector recently. What slices of the Internet sector look good to you right now? Everything looks a lot cheaper than it was a while ago, but where are the values as far as you're concerned?

Steve Harmon: Well, I think the values are in the industrial Internet space. There's been a lot of acronym-tossing around in the media lately -- B2C, B2B wannaB2B and whatever -- whereas I tend to look beyond the buzzwords. I think the industrial application of the Net is really the next decade buildup, that whole space. What I mean is the unseen glue, the unseen software, the unseen hardware, the unseen services that are connecting existing corporations with their vendors, suppliers, manufacturers.

Ian McDonald: What are some of the companies there that you think are good opportunities right now?

Steve Harmon: Well, if you look at it, I think what's going to happen is your older technology companies with existing customers may move into the space pretty rapidly. In other words, IBM (IBM) is moving into the space, Microsoft will probably want to be there. Some of those, I think, will be the first ones to look at.

Second, in the pure Net play -- I think some of the names are known, like we know about Ariba (ARBA), we know about Commerce One (CMRC), we know about FreeMarkets (FMKT), we know about Broadvision (BVSN) -- beyond the initial group, you want to look a little bit outside the known players and say, well, who else could be in this group? Who else will migrate into this space?

And I think we'll probably see Intel (INTC) being a big player here, because of their whole shift to being a Net-sector company. I think we're going to see Sun Microsystems (SUNW) getting into this space. Sun doesn't really have a play there, today. What that means is they're probably going to have to acquire companies. You don't have time to build. It's cheaper, in fact, to buy, especially with prices depressed like they are.

I think they're going to need personalization companies, like Net Perceptions (NETP). They're going to need -- what's the company I'm thinking about? They're going to need some of the Ventros (VNTR) of the world, which was the spinout of Chemdex; I think they're going to need also some payment mechanism built into this ... I think we're going to see some consolidation in that area. There's a couple of start-ups that are not public, but with the market being depressed, they'll probably just be taken out by the larger players. PayPal.com is one of them. I also think we're going to see the telecom players realizing they're not in the telecom business, and realize they're in the service business, like AT&T (T) and WorldCom (WCOM) and the others. It's really going to get kind of busy in the consolidation and M&A space. I think that's going to be the next 12 months in terms of the value being realized in Internet stocks.

I don't think we're going to see huge runs in the stocks, based on internal growth, or based on any earnings. I think we're going to see runs based on expectations of consolidation.

Jim Cole: Are you a buyer of any stocks based on expected consolidation, specific stocks that you see as take-out targets?

Steve Harmon: What we do -- and we're just launching our mutual fund, so I don't want to give away the entire story -- is look at each sector that we've identified, seven sectors of the Net: hardware, software, commerce, infrastructure, etc., and we're looking at the top six companies in each category. And then we're evaluating the management teams, number one. The technology, concurrently, is equally important, and any existing market share that the firm may have in terms of the technology being used.

And there's really a chance to play sectors. I don't think you have to be right and pick the one horse out of the entire six or so that's going to be the winner. I think maybe a better approach is to take two or three, because what's going to happen is you're going to see the larger companies, for example, if Intel acquires one of them, IBM or Oracle (ORCL) or maybe Sun or even Softbank will have to acquire another. You may see the top three taken out in any space. To me, that's a better approach. It may not be 100% accurate in terms of all three being taken out, but I think there's room for more than one hunter in each category. And you know, if you miss the one you're going to buy, if you score one out of six, then you're going to miss all of the upside. But if you can hedge your bets a little bit, and take half the group in each sector, you've got the better approach.

Ian McDonald: The number has risen pretty quickly, and everybody really has a different angle. I mean, one fund has Merrill Lynch (MER) and Wal-Mart (WMT) in the top 10, another one is strictly dot-coms. How are you defining a Net stock?

Steve Harmon: First thing is, 51% or greater revenue must be derived from or because of the Internet. And the second litmus test is more informal: If the Internet never existed, would these companies exist? And, if the answer is yes, then they're not really Internet companies.

A lot of companies walking around with the Internet banner are really Internet-enabled. Most of their business is actually off the Internet; it's more about warehousing, shipping, manufacturing and doing other things, other than the Internet. For example, Amazon.com (AMZN) is really Internet-enabled. Now they can do things on the Net that you can't do offline, for sure. But you can sell books, video and music offline, and people have done so for decades. So, they're using the Net as an enabler to sell more of the stuff. So that's good, it's a great use of the technology, but means they're Internet-enabled.

Stephen Schurr: The first phase of the dot-com era was a bit of a shopping spree; you really didn't have to discriminate, necessarily, to make a profit on your holdings. But after the bloodletting, I don't know if that's necessarily the case. Are you going to try and set some parameters, whether it's a history of sustainable earnings or being in the top of their peer group?

Steve Harmon: Well, we use everything, we use all the metrics out there. We use discounted cash flow on our Web site , we have a thing, "Seven Keys to Value Creation." Really, those seven things are at the heart of what we're looking at all the time, for Internet companies. And they're consistently proving to weed out the weaker companies from the stronger. And even in the past, you could have done OK with the Internet sector bet years ago, but you'd have to have made a sector bet; you couldn't have done it if you had only gotten into individual stocks in '94, '95, '96, '97, '98 even '99, you could have lost money. It gets down to more of a qualitative process, not really quantitative. They're not coming at it with a P/E of this or a P/E of that, they're coming at it with evaluating management teams, if the technology can scale, who the investors are, if they have enough capital, who are their partners -- more of a quality exercise. In '94 when I started, you could have put money into Telescan, Net Manager, FTP Software, Quarterdeck and who else? CompuServe, Prodigy -- you would have lost money.

Stephen Schurr: At some point in time would those companies have met your seven measures?

Steve Harmon: Net Manager was actually the earliest one doing a comprehensive software suite that allowed you to get on the Net with a browser application, an FTP application -- you know, the whole suite -- and nascent server software. The problem was, they didn't have the marketing, they didn't have the management that understood how to scale quickly in the Net. And Netscape came along and blew 'em away.

So, the observation that you could have made money pretty much blindly with the Net in the last five years has been made many times. The reality is, it was not that easy to really get the better companies, and the only way to do it right was to be more diversified in the Net space. That's one reason why it makes more sense to take more of a mutual fund approach. Because with 400 stocks and 4,000 private companies that want to go public someday, it's more of a full-time job for an individual investor to keep track of this stuff. Even the daytraders can't keep track of it. They're just really trading ticker symbols. I think you have to have a comprehensive approach and almost become an investor, heaven forbid, rather than a speculator.

Ilana Polyak: Do you see more of a shakeout to come, or are we done with this? And if so, who are going to be the winners?

Steve Harmon: I think the consumer winners are becoming known. I think we're going to get back to the consumer Internet after this wave in more of a decisive way, but I think the shakeout will continue in the consumer space.

In the business space, the companies are still coming together, figuring out their markets and their customers and scaling up. I think a shakeout in that space will happen later. But they're very different. The media tends to group them together, like B2Bs business-to-business may not undergo the same sort of drop as a B2C business-to-consumer space. They're really very different areas, entirely. They have different dynamics. The consumer space is more driven virally, if you look at it.

In other words, consumers can spread the word about how to use Napster or whatever. That's very viral. In the business space, things tend not to be viral because companies are not going to just pick up and download a software and start using it company-wide, unless somebody in the company thought it was a cool idea. And even if it was the CEO, there's a whole process in adopting a software, standardizing it, making sure it's robust and reliable and then teaching the whole corporate system to use that software. That's different than somebody in their garage or at home just downloading Napster and suddenly sharing their music files all over the world.

David Landis: But isn't that how Linux started?

Steve Harmon: Linux started because the geeks running the computer systems in all these corporations were using it as a solution for their corporate needs. Linux grew virally, yes, but even so, it doesn't have a dominant market share in the network OS area. It's only about, what, 12% or something? So, yeah, Linux does have the viralness, but I think most of the viralness is really built into the developer end of it, because it's open-sourced and developers can add to it as they see fit. Corporations are using it because it's a real solution to a corporate need. It would be an example, probably, of a corporate viral sort of thing, but there are very few like that. I mean outside of Linux, I don't think you'd find many.

Jim Cole: A lot of people right now are talking about profitability. Is that an issue in terms of the companies you're going to be putting money into? Are you looking for companies with a clear path towards profitability?

Steve Harmon: We are looking for companies that are profitable or can become profitable.

Jim Cole: In what time frame?

Steve Harmon: Well, it ought to be within two to three years, you've got to see some profits. I don't care what space it is, if they come back four to five years, then I think I'd get a little concerned unless it's a huge, huge, huge opportunity. Even then, I would say two to three years would be the minimum in which I would like to see some indication of profits. Doesn't have to be huge, but it's just got to get above the waterline in two to three years.

Jim Cole: And what are you looking for in terms of getting there? Is it companies with strong sales growth or companies with shrinking expenses, or a combination of the two?

Steve Harmon: They have to be using the Internet for what it's good for, which is distribution and computing. People often use it for distribution, but they forget about the computing part. The computing part means commerce for doing stuff online, for getting it away from people having to answer telephones and process paperwork -- do things using software. That's computing.

Stephen Schurr: How concerned are you about valuations? There are some high valuations, even after this shakeout; are they going to scare you away from any stocks?

Steve Harmon: Valuations, you know, in certain companies are still high. But it's better today to be investing, I think, than it was a couple months ago. I see it as the best time since last November to be investing in this space.

A lot of them have been hammered down, and rightfully so. I think too many speculators were coming after the same stocks -- not maybe the same stocks, but the same sectors, and the individual investors got burned.

So, I think we are valuation-sensitive. In my prior life at Paul Kagan Associates, we did nothing but valuations for media and telecom companies. There's a couple of things that always apply. I'd say three relate to the value of companies. One is on their RGV -- real growth value -- and I think we're seeing a lot of that in the Net space. Another way is private market value, and the other one's the public market value. So really, the center of what we do is: Look at those three ways to value companies; figure out which company fits where. In certain situations, the take-out value of a company might be much higher than its trading value. It also helps to fundamentally look at the private companies, since we have a venture capital fund that we're investing in now -- $50 million -- and it allows us to apply the same valuation methodologies across the range.

Ian McDonald: What are some companies that have been really sold off very harshly that you think kind of deserve to stay down and shouldn't come back? Companies that really have some fundamental flaws you'd want to stay away from?

Steve Harmon: I think VerticalNet (VERT) is one of 'em. They're trying to build trading communities. The trouble with that idea is that most companies don't really like their engineers to be hanging out on Web sites. I don't understand the premise. If you want to be about trading communities, you've got to be in the software business, enable companies to link up with their suppliers and vendors. That to me is the way to do it, not to build Web sites based on content.

That's one of them. Let me think of another one ...

Stephen Schurr: The e-tailers?

Steve Harmon: Of course. I mean that, to me, is a goes-without-saying thing. I think e-tail gets back to what I mentioned at first, which is the idea of Internet-enabled. These are Internet-enabled businesses that don't really have the kind of margins that a pure Internet-centric company would have.

Ian McDonald: You mentioned you thought Microsoft was a laggard. Could you expand on that? What are your thoughts on Microsoft?

Steve Harmon: I don't know what's going on but they're forgetting about their own notion. Their notion is that OS is the platform, which is Windows. Now Windows is becoming less and less of a central piece to the open source, the open network idea. They don't have a platform that's ubiquitous. They don't have the standards. And they don't control enough of them to really be the centerpieces of the interactive revolution for the long haul.

The thing they should be working on is building and controlling the standards in the interactive media space, the interactive media commerce space. Standards for security, standards for wireless, standards for devices. They should be more worried about creating and owning the platform. They're fooling around with content and travel sites and all this other stuff, you know, even WebTV.

David Landis: Do you care to venture an estimate of the breakup value of Microsoft under the Justice Department scenario?

Steve Harmon: I don't think they're going to do it. But if they do, I would think, if I'm an investor, I'm going to want to own the networking side of Microsoft. The rest of it, they can have. I only want to own the networking side. That's the future. Networking is the future. The Internet is the operating system. So, Windows and the rest of that stuff doesn't matter.

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