Defying Gravity, Net-Equipment Makers Keep on Flying High

Many investors refuse to characterize the promising sector's recent success as a manic bubble, but some analysts think emotion is overtaking reason.
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SAN FRANCISCO -- Once again, psychology has defeated fundamentals where Internet stocks are concerned. The twist this time is that the frenzy is in the shares of Internet-equipment makers.

Starting in April, money managers and equity analysts decided that the builders of the Internet were safer bets than more recognizable e-commerce names such as

Amazon.com

(AMZN) - Get Report

and

eBay

(EBAY) - Get Report

. Equipment upstarts such as

Juniper Networks

(JNPR) - Get Report

and

Extreme Networks

(EXTR) - Get Report

would thrive in niches overlooked by industry leader

Cisco

(CSCO) - Get Report

, they reasoned.

That foresight has been more than amply rewarded. In recent weeks, prices have soared to levels that frustrate rational thought, thanks to a fight for scarce shares and a fear of being left out of another big Internet run. The surges have yet to come close to the furious rally that Amazon.com saw -- between February 1998 and April 1999, that stock rose 22-fold -- but the speed and strength of the Net-equipment stocks make analogies easy to draw. In fact, many of the equipment stocks have gone public since April, the month when Amazon and eBay peaked.

The analysts and investors are reluctant to call this a manic bubble, insisting these stocks do represent promising businesses. But analyst Martin Pyykkonen with

CIBC World Markets

, who is considering coverage of some start-ups in the sector next year, agrees that emotion is taking over. "People are saying, 'I don't want to miss the next winner.'" His firm has no banking ties to companies discussed.

Eight high-profile stocks in the sector -- including Juniper,

Foundry Networks

(FDRY)

and

Sycamore Networks

(SCMR)

-- have climbed an average 79% even after the close of their sizzling debuts, according to data from

Baseline

as of Wednesday. With a combined revenue of just $453 million in the past year, they together carry a market capitalization of $81.3 billion. Cisco, with revenue of $13.4 billion, is valued at $274.7 billion. Sycamore alone has swelled to $20.6 billion, more than eBay at $18.8 billion.

Like many of last year's e-commerce plays, some of the highest-flying equipment stocks are widely held by retail investors. Institutional investors have gotten their hands on fewer than 3.7 million of Juniper's 51.8 million outstanding shares, according to

Market Guide

. A Juniper official says the figures are "wrong" and might not account for a recent offering of 5 million shares, but declined to offer a more accurate figure. About 22.3 million Juniper shares trade publicly. "It's a big retail stock," says one trader who asked not to be named and whose firm makes a market in Juniper's stock.

Institutions have had more luck with Extreme and

Redback Networks

(RBAK)

. Institutions own 17% of Extreme's stock and 14% of Redback's. But these stocks have also caused pain for pros who are accustomed to making calculated buy and sell decisions.

Juniper is a good example. Its price tripled to 100 on its first day of trading June 25 and has tripled again since. Tuesday, Juniper Networks bolted 45 to a new high of 328 1/2 when the company disclosed plans to split each share into three shares, then eased 21 3/4 Wednesday. Sitting out that kind of surge is painful.

"I missed it," says Chris Bonavico, manager of the

TransAmerica Premier Aggressive Growth

and

Small Company

funds, although he believes in Juniper's business prospects. Another manager, Eric Efron with

USAA Aggressive Growth Fund

, laments taking early profits on Juniper. "These deals take on a life of their own, and if you're not there, your performance is going to suffer." So he's held onto Sycamore and Foundry, two more recent issues.

Equity analysts, always a bullish crowd, have been unable to get in front of this run-up as well. Juniper has shattered every price target on record with

First Call/Thomson Financial

, highlighting the irrelevance of analysts' sometimes farfetched efforts to "value" these stocks.

For example, when Juniper traded around 265 last week, Tom Erickson with

Dain Rauscher Wessels

wrote in a research note that the unproven start-up was worth $300 a share, or 80 times the revenue it will make next year. Peering into 2004, Erickson says Juniper will justify its valuation by posting revenue of $1.3 billion. But Erickson values Cisco -- a longtime performer -- at $100 per share, or roughly 18 times revenue expected in 2000. Erickson, whose firm has participated in deals with both companies, did not respond to a request for comment.

"I think there's a cognitive dissonance," says analyst Paul Sagawa with

Sanford C. Bernstein

. "The mania for start-ups seems to exist separately from the love of large broad-based companies." Sagawa, whose firm doesn't underwrite stock offerings, advises clients to stick with Cisco.

"It's hard to calibrate extreme enthusiasm," says Kevin Landis, manager with

Firsthand Funds

. Landis hasn't created a financial model for his Juniper investment. "It's a good thing, too, because the model would have been thrown out a few times."

Wall Street's faith marks a sharp turnaround from its skepticism in 1998 and early this year, when no high-profile Internet-equipment companies were going public. Extreme Networks ended the dry spell in April, offering shares for $17 each. During the roadshow, CEO Gordon Stitt was confronted repeatedly with the question: How can you possibly survive in a Cisco world?

In October, Extreme sold more shares for $77 apiece. Then, Stitt says, "That question never came up."