To start, we note that our evaluation of Internet stocks considers six distinct criteria. In order of importance, they are:
1. Company fundamentals: All else being equal, we are bullish on companies with accelerating revenue growth (or at least modest deceleration off of a high base), expanding margins, and high rates of free cash flow generation.
2. Industry fundamentals: All else being equal, we are bullish on industries with accelerating growth (or at least modest deceleration off of a high base), demonstrable pricing power, and significant international penetration (or at least legitimate prospects for timely movement into international markets).
3. Catalysts: Acquisitions, new product launches, management turnover, and changes to legislation/taxation are among the types of events that fall under the heading “catalyst.” Taking into account the degree of likelihood that an event will occur and the time horizons involved, catalysts will tend to make us more or less positive/negative on a stock.
4. Our estimates vs. Street consensus: High-beta, high-multiple Internet stocks will, as a general rule, not rally on anything other than clean Beat & Raise quarters. If we believe that a company’s chances of beating the Street are low, we will be less positive on the shares – no matter how bullish our overall view may be. We are not in the business of calling quarters, but we are responsible for taking into account the market dynamics that impact the stocks we cover.
5. Valuation: Although Caris & Company does not publish official price targets, we do employ a P/E- and EV/EBITDA-based valuation framework (based on long-term growth assumptions and historical forward multiple ranges) to generate potential valuation ranges.
6. Sentiment: We use both objective measures (short interest) and subjective measures (how positive/negative the market’s view of a stock seems to us) in order to gauge sentiment. All else being equal, the more negative the sentiment, the more positive we will be and vice versa.
We begin our evaluation by determining a rating for each stock relative to each of our six criteria (we use our existing ratings system, i.e. a “1” is a “Buy”, a “2” an “Above Average”, a “3” an “Average” and so on). Then we calculate the weighted average rating using the following weights:
The cumulative results of this methodology are, obviously, already known. Our current ratings on the stocks are as follows: a 1*/Buy for GOOG, a 2*/Above Average for EBAY, and a 3*/Average for YHOO. Here’s how we got there:
Criterion #1: Company Fundamentals (30%)
This criterion considers both current fundamentals and our fundamental outlook. Here’s how each company’s current fundamentals stack up:
Next, our fundamental outlook:
How do we rate each stock based on company fundamentals?
EBAY: The current fundamentals show decelerating revenue growth, margin compression, and decreased FCF conversion due to increased cap-ex; the deterioration has been fairly modest, however, and we see margin expansion as well as stabilized revenue growth and FCF conversion in 2006 and 2007. We rate it a 3*/Average.
GOOG: The current fundamentals show tremendous revenue growth off of a very high base with only modest deceleration, stable (and very high) EBITDA margins, and decreased FCF conversion due to higher cap-ex; our outlook implies continued modest revenue growth deceleration, a slight hit to EBITDA margins (although we expect margins to remain above the key 60% level), and improved FCF conversion in 2007. We rate it a 1*/Buy.
YHOO: The current fundamentals show decelerating revenue growth, margin compression, and decreased FCF conversion due to increased cap-ex; the deterioration has been fairly modest, however, and we see margin expansion as well as stabilized revenue growth and FCF conversion in 2006 and 2007. We rate it a 3*/Average.
Criterion #2: Industry Fundamentals (25%)
First we’ll look at EBAY, which is essentially a pure e-commerce play. Growth in global e-commerce remains robust, with the U.S. market growing 25% in 2005 and international markets growing (in aggregate) at around 1.5x to 2.5x this U.S. rate. Reliable international e-commerce data is a bit hard to come by, so let’s just take a look at the growth trends in the U.S.:
So U.S. e-commerce is an industry with a high growth rate and modest deceleration off of a high base. What is eBay’s market position in this industry? We estimate that eBay accounted for roughly 21% of all U.S. ecommerce sales in 2005 – at least 15% more than its closest competitor. And while there has been a lot of hand-wringing over the loss of some high-profile Power Sellers over the last 12 months, eBay has been able to raise seller’s fees several times in recent years without triggering anything even remotely resembling an “exodus of Power Sellers.” So there’s pricing power here too. In terms of international exposure, eBay has more of it than any other U.S. Internet stock. And as we stated above, international growth rates are likely substantially higher than the U.S. rate. A notable negative for eBay, however, is that it doesn’t dominate some of these key international markets like it does the U.S. (e.g. China, where eBay is a distant second to Taobao).
Let’s look now at GOOG and YHOO, both of which derive the vast majority of their revenue from online advertising. Again, we don’t have what we’d call reliable data on online advertising growth in international markets, but here’s what the industry looks like in the U.S.:
Growth in U.S. online advertising spend was 30% in 2005, and as the above graphic shows, we expect it to decelerate to 13% in 2008. Keyword search advertising, however, has been by far the fastest growing segment of online advertising (roughly 44% in 2005), and we expect it to continue to grow 1.5x faster than total online ad spend. This is great news for GOOG, which derives 98% of its net revenue from search and dominates the U.S. market with what we estimate to be 40%+ share. We estimate that YHOO derives about 50% of its net revenue from search and garners about 30% share in the U.S. 30% of YHOO’s net revenue comes from display advertising, which has generally underperformed the overall online advertising market but remains its second-largest medium after search. In terms of pricing, the evidence suggests that advertisers have been willing to pay more and more per click and impression.
Finally, we estimate that online advertising in international markets is growing at 1.5x to 2x the U.S. rate – this is a clear positive for GOOG, which we believe accounts for around 65% of international search queries and derives over 40% of its revenue from abroad. YHOO, on the other hand, accounts for about 15%-20% of international queries and generates only 24% of its revenue outside the U.S.
How do we rate each stock on industry fundamentals?
EBAY: E-commerce continues to grow robustly both in the U.S. and abroad; EBAY is the clear e-commerce leader globally, although it is faring less well in some key international markets like China; EBAY has demonstrated its pricing power by raising sellers’ fees multiple times without material client losses; EBAY has more international exposure than any other Internet company. We rate it a 2*/Above Average.
GOOG: Keyword search continues to grow at a very robust rate both in the U.S. and abroad and GOOG derives 98% of their revenue from it; GOOG is the clear global leader (we estimate 60% share of global queries); as more and more advertising dollars have shifted from offline to online, prices have risen – we expect them to continue to rise; GOOG has great exposure to international markets, boasting around 65% share. We rate it a 1*/Buy.
YHOO: Keyword search continues to grow at a very robust rate and YHOO derives 50% of their revenue from it; display advertising, from which YHOO derives 30% of its revenue, is growing nicely but not nearly at the rate of search; YHOO is a distant second to GOOG vis-à-vis global search but the clear leader in display advertising; as more and more advertising dollars have shifted from offline to online, both CPCs and CPMs have risen – we expect them to continue to rise; YHOO does not have great exposure to international markets. We rate it a 3*/Average.
Criterion #3: Catalysts (15%)
EBAY: Amid materially decelerating growth in its core U.S. auctions business, EBAY realized that it had to go after the “new, in-season” segment of U.S. e-commerce, which has been growing much faster than EBAY’s traditional sweet-spot segments (“new", "scarce”, “used” and “vintage”). The company’s solution? eBay
Express, an entirely new platform offering only new, fixed-price goods and a more convenient shopping experience. Now in beta, Express will be officially launched right before the 2006 back-to-school season. We expect Express to ignite incremental revenue growth and margin expansion in EBAY’s U.S. business and believe a financial impact could be seen as early as 3Q06. We rate it a 1*/Buy.
GOOG: There are no apparent catalysts on the horizon, although it could be argued that the company’s earnings reports are catalytic enough. We rate it a 3*/Above Average.
YHOO: “Project Panama,” YHOO’s code name for its new search platform, will not have an impact on the company’s P&L until 2007; we believe that Panama will make YHOO’s search business more profitable, but seven months of roll-out/execution risks remain. We rate it a 2*/Above Average.
Criterion #4: Our Estimates vs. Street Consensus (15%)
EBAY: For the June quarter, we are estimating $1,441MM in revenue and $0.24 in pro forma EPS vs. Street expectations for $1,411MM and $0.24, respectively – an in-line-ish quarter. Normally, this would make us a lot less positive on the shares, given our mantra that Internet stocks must cleanly beat the Street in order to trade up. When a stock is down 27% intraquarter, however, we tend to look at things a bit differently. We believe that an in-line quarter will be enough to spark a rally in the shares. We rate it a 2*/Above Average.
GOOG: For the June quarter, we are estimating $1,650MM in revenue and $2.16 in pro forma EPS vs. Street expectations for $1,624MM and $2.20, respectively – an in-line-ish quarter. With the stock 16% off its high following a blowout March quarter, we believe that an In-Line quarter is more likely to drive the shares up than down. We rate it a 2*/Above Average.
YHOO: For the June quarter, we are estimating $1,138MM in revenue and $0.11 in non-GAAP EPS compared to Street expectations of $1,137MM and $0.12, respectively – a bottom-line miss. The stock is now off 7% intraquarter following a disappointing Analyst Day, but we doubt that a bottom-line miss will be enough to attract many buyers. We rate it a 3*/Average.
Criterion #5: Valuation (10%)
EBAY: We apply a 37x multiple (1.5 PEG applied to our 25% long-term growth assumption) to our 2007 GAAP EPS estimate of $1.02 to yield a potential valuation of $38. Applying a 20x multiple (0.8 PEG applied to our 25% long-term EBITDA growth assumption) to our 2007 EBITDA estimate of $2.04 yields a potential valuation of $42. We rate it a 1*/Buy.
GOOG: We apply a 40x multiple (1.7 PEG applied to our 24% long-term growth assumption) to our 2007 GAAP EPS estimate of $11.58 to yield a potential valuation of $466. Applying a 23x multiple (0.9 PEG applied to our 25% long-term EBITDA growth assumption) to our 2007 EBITDA estimate of $19.58 yields a potential valuation of $472. We rate it a 1*/Buy.
YHOO: We apply a 42x multiple (1.5 PEG applied to our 28% long-term growth assumption) to our 2007 GAAP EPS estimate of $0.74 to yield a potential valuation of $31. Applying a 19x multiple (0.8 PEG applied to our 24% long-term EBITDA growth assumption) to our 2007 EBITDA estimate of $1.67 yields a potential valuation of $45. We rate it a 2*/Above Average.
Criterion #6: Sentiment (5%)
EBAY: Since reporting an in-line March quarter, EBAY has become the whipping boy of large cap Internet stocks, surrendering 27% of its value in less than a month. According to the most recent data (April), short interest is up more than 40% Y/Y, and negative commentary in the press abounds. We think there’s a major disconnect here, and we would be aggressive buyers of the shares during this wave of weakness. We rate it a 1*/Buy.
GOOG: GOOG reported a blowout March quarter, and the stock traded up nearly 10%. The stock is now down 16% from that high. Short interest doubled between March and April. We don’t think anyone can explain why except by attributing it to the weakness in the broader market. We would buy the stock aggressively at current levels. We rate it a 1*/Buy.
YHOO: YHOO has not suffered the same kind of beating that EBAY or GOOG have recently, although based on yesterday’s trading activity it looks like the tables might be turning a bit. Short interest is on the rise, but we would not be surprised to see further weakness in the near term. We would view sustained weakness as an interesting opportunity to get long the shares. We rate it a 3*/Average.
To summarize our Internet stock rating analysis, we proffer the following graphic:
We maintain our 1*/Buy rating on GOOG, our 2*/Above Average rating on EBAY, and our 3*/Average rating on YHOO.