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June 30, 1999

Wobbly Internet Stocks

By Stephen Lacey

The downward spiral in the price of Internet stocks is turning stomachs.

While broader market indexes are generally trending upwards after a 7-percent correction in May, the outlook for Internet stocks appears shaky, analysts say.

Some Internet laggards, they add, may have a difficult time recovering as rising interest rates contribute to the gloom.

"As a bull market matures, you tend to get larger corrections," said Robert Robbins, a market strategist at Atlanta-based Robinson- Humphrey Company. "With the Internet sector having been so blazingly hot, there was an obvious temptation to take some profits."

Since hitting an all-time high of 334.61 in mid-April, the Dow Jones Internet Composite of the sector's 40 largest companies was down roughly 30 percent early last month.

For the month of May, the index was down almost 16 percent. By comparison, the Standard & Poor's 500 shed just 48 points, or 3.5 percent, in the same period, off its all-time high of 1,375.98.

For less-seasoned Internet initial public offerings, the correction hit investor pocketbooks even harder. The stocks of the 73 Internet-related issuers this year are down almost 50 percent from their highs.

"The sell-off has been pretty much across the board," said Abhishek Gami, who tracks Internet stocks for Chicago-based William Blair & Co. "The only sector that hasn't seen as much of a decline has been security providers."

Spared

Providers of Internet security solutions - such as ISS Group (Nasdaq:ISSX) - have been spared. The market views the group more as enterprise software companies with solid operating fundamentals. Indeed, the most severely depressed stocks are those of companies boasting some of the largest operating losses.

The Outlook

Yet while the worst may be over for the S&P 500, Robbins and others are less certain about the outlook for the majority of Internet stocks. "This is not unusual in our minds," Gami said. "Smart investors will take this opportunity to purchase industry leaders like VerticalNet (Nasdaq:VERT), About.com (Nasdaq:BOUT) and DoubleClick (Nasdaq:DCLK)."

For companies that are second-tier or third-tier players in their industries, however, the recent pullback is less of a correction and more of a reevaluation.

"I don't think you'll see some of these stocks recover for some time," Gama added.

Here are the declines in the five hardest-hit stocks in the sector (and their closing prices late last month): consumer retailer Value America (Nasdaq: VUSA), down 73 percent, closing at $19 1/2; community-site operator iTurf (Nasdaq:TURF), down 74 percent, closing $16 7/8; subscription-management provider RoweCom (Nasdaq:ROWE), down 70 percent, closing $15 15/16; automobile-information provider AutoWeb (Nasdaq:AWEB) down 75.25 percent, closing $12 3/8; and Internet advertising software manufacturer WebTrends (Nasdaq:WEBT), down 57 percent, closing $36 3/16.

The Explanation

Rising interest rates are cited for the suddenly bearish sentiment, amidst a market reporting strong operating fundamentals. The rate hikes, in turn, are making investors more risk-averse.

With the Federal Reserve Board moving toward tightening rates, the yield on the 30-year U.S. Treasury is now hovering around 6 percent from 5.54 percent about two months ago.

"It looks like interest rates were the key factor," Gami said, commenting on the bearish mood. "Because Internet stocks have a higher beta [a measure of volatility], when the Fed started talking about the possibility of raising interest rates they were first to get hit."

While the operating fundamentals for some Internet companies have never been brighter, valuations have also run ahead of themselves.

"It's purely a valuation call," said Deutsche Banc Alex. Brown analyst Edward S. Caso Jr., after initiating coverage of Razorfish (Nasdaq:RAZF)with a market-perform rating. "Business is growing strongly. We would expect gross margins to improve over time."

Unlike retailers, who have leverageable business models, revenue growth for technology professional-service firms such as Razorfish and Proxicom (Nasdaq:PXCM) are limited. After hitting a high of $58 3/8 in second-day trading, Razorfish closed trading in late June at $26 3/4.

Stephen Lacey is managing editor of The IPO Reporter, a sister publication of Traders Magazine.