Internet companies quickly went from being Wall Street's darlings to being Wall Street's repeatedly kicked dogs. Biotechnology shares have been the new darlings the past 10 months. But how long will this love affair last before fickle investors demand meaningful earnings from most biotechs? It will probably last only as long as any infatuation.
"Internet businesses continue to go public at a record pace, with more than 60 initial public offerings (IPOs) behind us this year, and at least 80 more in the works. The many new offerings serve to dilute demand for Internet stocks by spreading the demand over the many options. In the past, an investor had few choices when investing in the online arena: America Online (NYSE: AOL), Yahoo! (Nasdaq: YHOO), Amazon.com (Nasdaq: AMZN). Now we have dozens of choices. Unfortunately, most of them are not attractive.
"Because the Rule Breaker holds a handful of online-based companies, many readers assume that we support anything Internet-related and believe in the valuations that we've been seeing across the board. I certainly don't agree with this. In fact, the more online-based companies to come public, the more I see situations that raise serious eyebrows.
"drkoop.com (Nasdaq: KOOP) recently came public with only $0.1 million in 1998 revenue and soared to over $500 million in total market value based on what sustainable business advantage and on what profitability model? It's now valued at $323 million, still very high in my opinion.... [It's now $1 per share, with a market cap of $34 million.]
"Salon.com (Nasdaq: SALN) will go public this week with a few million in revenue and a magazine-type business model, except it's online. How much would you pay for an offline venture of this size? Forty million dollars, or more than 20 times sales, is generous. Let's see what value Salon is given. [It was initially valued near $130 million. It's now $17 million.]
"[Consider] theglobe.com (Nasdaq: TGLO), MarketWatch.com (Nasdaq: MKTW), and TheStreet.com (Nasdaq: TSCM).... Is a site [TheStreet] with 36,000 subscribers paying $100 per year worth more than $1 billion? How about $735 million, the latest Street.com value? [It's now $77 million.]
"Then there is eToys (Nasdaq: ETYS). On its first day, it was valued at $7 billion, more than Toys "R" Us (NYSE: TOY), while achieving a tiny fraction of the toy leader's sales and none of the profits. I may sound Wise reciting that comparison, but the point is this: Would you even buy an offline toy retailer? If not, then what makes an online toy retailer that much more attractive that you'd pay such a monstrous premium for it? Do you want to invest in the business of toys at all? [eToys is valued at $435 million today -- still high in my opinion.]
"In sum, I don't believe in more than half of the online-based companies coming public, and I wouldn't invest in more than half a dozen of them right now -- if that -- and most of those that I would buy, this portfolio already owns. So, we are not supporters of 'everything Internet.' We believe only in the best businesses, and those are few and far between. When the Internet gold rush mentality ends (and who knows when that will be), we're going to have hundreds of recently public Internet-based businesses with valuations that could realistically contract for years. And we'll have the relatively few leaders that reward investors.
"I know that people are looking at new online-based businesses and thinking how large they may be after five years of hypergrowth, which the Internet promises to deliver to many. However, that doesn't mean that [you] can buy anything online-based at any price and hope to beat the market.... Calculate what you're paying for a stock as if you were buying the entire company. Would you pay $500 million for drkoop.com and its single-digit revenue? How about $7 billion for eToys?
"As more and more online-based companies come public, the attraction to every Internet-based IPO will subside after many of these companies report humdrum or even weak quarterly revenue.... The IPO market will become much more selective: The no-names will go unnoticed, as they used to be, while niche leaders with strong brands will be rewarded."
OK. Step back into October 2000. Now, last year we also wrote that we believed at least three-quarters of all new Internet companies would fail. It's just a fact: Most new businesses fail, online or not. But where are we going with this thought today?
Biotechnology stocks came into favor after Internet companies and they have risen sharply the past 10 months. The hype has been a few degrees cooler than it was with Internet companies, but there is still a great deal of excitement factored into most biotech stock prices. Sure, there is plenty of long-term promise at the best companies, but that promise will take years to reach fruition. Meanwhile, all of the second-tier and third-tier biotech companies with stocks that soared just because the whole sector soared will likely disappoint investors for many years after the excitement subsides.
Next year (2001) may be biotech's turn to take a back seat with investors. Why? Because, in the long run, all stocks are valued on earnings creation, and most biotech companies are several years away from creating meaningful earnings. Be forewarned that investors may choose to remember this fact next year, or the year after, and they may grow impatient -- as they did with Internet companies. Once they do, most biotech stock prices will contract for some time. In the long run, only the very best biotech companies will outperform. (Probably companies such as Amgen (Nasdaq: AMGN), MedImmune (Nasdaq: MEDI), Millennium Pharmaceuticals (Nasdaq: MLNM), and, we hope, riskier play Human Genome Sciences (Nasdaq: HGSI), among select others.) The other 90% of biotech stocks will lag.
P.S. On Wednesday, America Online reports quarterly results, and on Thursday, eBay (Nasdaq: EBAY) reports. AOL declined sharply today on fears that online advertising is slowing, the same fear that hit Yahoo! (Nasdaq: YHOO). AOL has about $2 billion in backlogged ad revenue, however, and most of its ad dollars are coming from blue-chip companies. Given its position, this fear will almost certainly fade in the long run in regard to AOL.