Yahoo! Slide Exposes 'Net Liabilities - TheStreet

Yahoo! Slide Exposes 'Net Liabilities

Still, backers say the lower level of hype this time around suggests greater staying power for Internet shares.
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The rewards of investing in Internet stocks are clear. But in the wake of Yahoo!'s (YHOO) second-quarter earnings announcement, the risks are starting to rear their heads, too.

Following Yahoo!'s

Wednesday evening report of revenue that beat expectations and earnings that matched them, shares in the Internet bellwether dropped more than 7%, dragging much of the rest of the tech market down for the ride.

Of course, Yahoo!'s slide may be little more than a case of traditional buy-on-the-rumor-and-sell-on-the-news behavior. But clearly the stutter-step in the stock's impressive run-up over the past few months has got investors wondering whether Net stock valuations can hold, or whether the market is simply rumbling toward a replay of its 2000 meltdown.

Certainly, the gains have been surprising among Internet stocks of all stripes. Before reporting its financials Wednesday evening, Yahoo!'s shares closed at $35.29, nearly four times their 52-week low set last September. Shares fell $2.69 to $32.60 on Thursday; other Internet leaders such as

Amazon.com

(AMZN) - Get Report

and

eBay

(EBAY) - Get Report

slipped 2%-3% Thursday.

Online advertising firm

aQuantive

(AQNT)

, which was below $3 a share in January, was trading at $11.35 on Thursday. The TheStreet.com Internet Index has more than doubled off of last October's lows.

At work, say buy-siders who follow the Internet closely, is a mix of improving fundamentals and momentum. Certainly, the chances for success of an average company in the publicly traded Internet universe are better than they were four years ago. But jumping on the bandwagon without taking a good look at the quality of the wheels hasn't gone out of style either.

Healthy Choice

Most of the sector's movement in the last six months has come because dot-com survivors have taken advantage of what is a healthy operating market for them, says Darren Chervitz, director of research for Jacob Asset Management, which runs the

(JAMFX) - Get Report

Jacob Internet fund. There's continuing improvement in online advertising, ecommerce activity, broadband usage and other measures. Meanwhile, relatively few companies survived the "intense and immediate" carnage of the dot-com shakeout, thanks to factors such as fortuitous money-raising before the funding window shut and cost-cutting speed. "For the players that are left, it's obviously a much healthier situation," says Chervitz.

While the thinning out of the population improves conditions for survivors, it also improves their scarcity value. "A lot of funds in the sector are all in the same stocks," says Chervitz. "It's a pretty small universe of companies to look at."

Chervitz acknowledges there's been a rush into Net stocks, but he says the enthusiasm is more justified this time around. The boom in Chinese Internet portal stocks "is clearly a case of momentum guys coming in the market." Yet, he says, "as crazy as the stocks have been acting, there's a basis behind it," because it's driven by growing usage of cellphones and the Internet in China, rather than by bubble-funded advertising expenditures of other net companies, as it was driven in the U.S. portal market. (Chervitz's firm owns shares in Chinese portals

Sina

(SINA) - Get Report

,

Sohu.com

(SOHU) - Get Report

and

NetEase.com

(NTES) - Get Report

.)

What would worry Chervitz, he says, is another historical replay: a boom in initial public offerings. "I would fear another round of craziness if new dot-coms are sprouting up," he says. I don't see it, so I don't fear it yet."

He also fears a consumer-led recession as opposed to a corporate-led one.

Reinflation Risk

Along with the survivors' growth and profitability, and the unlikelihood that new competitors will be financed, another buy-sider sees additional factors at work in the Internet run-up, which he says doesn't quite qualify as a reinflated bubble.

Unlike in 1999, the sell-side research community's expectations are in check, says the buysider, speaking on condition of anonymity. That means that Net companies, though far from cheap, are more likely to beat expectations than to miss them.

Additionally, says the buy-sider, the run-up stems from a liquidity issue. With interest rates down and bond prices up, investors are sinking money into the technology market. "There is a scarcity of profitable, growing technology and Internet companies, and we've now seen valuations get stretched," says the buy-sider.

But rather than ending in a quick deflation, says the buy-sider, the situation will more likely end up with individual stocks declining on news of missed expectations, or money rotating into other sectors. "It would be entirely unsurprising to see money shift out of technology," he says -- into cyclicals, for example, or Rust Belt manufacturers.

If, over the long run, Net valuations do top out or analysts inflate their expectations again, there's one key difference between 2003 and 1999, he says. This time around, the companies that people invest in "are probably going to be with us in three to five years' time."