The Internet is revolutionizing the way people communicate throughout the world, but more importantly it is changing the way people live. In the old days people used to write emails and chat on message boards, which allowed complete strangers to interact with each other. The invention of the search engine came next, which allowed people to quickly locate an area of interest and instantaneously browse thousands of links and bring the entire subject matter before them. The invention of the Blog came next, which brought forth information from millions of new sources and the world was no longer dependent on the established media to produce its news.
From there we went to feed technology, where an analyst, like myself, can write an article and within minutes of posting it on a blog, can feed it to hundreds of websites through a method called automatic cross posting. From there we went to Social Media where MySpace, Twitter, Facebook and YouTube allow 100s of millions of people to communicate on a daily basis and have brought communication down to single sentences.
The next stage of the Internet, I believe, will be e-commerce, which until now has been dominated by Amazon (AMZN) and eBay (EBAY), but competition is coming their way from Affiliate Market Networks, and just like blogs took the established media apart by sheer volume of information, all types of mini retailers will spring up and sell on the Internet through affiliate marketers.
The internet is obviously evolving and changing civilization with millions of new websites being created every day. As an investor, though, I have never been able to capitalize on Internet stocks in large numbers, because they have never been able to provide the price to free cash flow numbers that I look for when making an investment. My investment philosophy is quite simple and works very well, because I have brought thousands of data points down to very simple formulas that I have back tested going back some 60 years. Of course when I say a simple formula, I am only describing it as a way to locate interesting opportunities in the first stage of a multi stage process. Once I do locate these opportunities I then do a tremendous amount of qualitative and quantitative analysis, industry as well as Macro-economic analysis. My final goal is to see if each opportunity can achieve “Economies of Scale” and provide some serious barriers of entry to its competition.
The formula I use is Price to Free Cash Flow (PFCF) or what maybe called “Owner’s Earnings”, which is a special form of PFCF that I learned by studying Warren Buffett. Owner’s Earnings has been widely publicized but unfortunately little used by market participants. I say unfortunately because if more people used it they would not be like dogs chasing their tails and consistently buying at the wrong time and selling at the wrong time. By using owner's earnings they could go a long way in understanding what they are buying. I find it very odd that the greatest investor in history has clearly described how he analyzes stocks and it has fallen on deaf ears.
In his 1986 letter to Berkshire Hathaway (BRK.A) shareholders, Buffett defines “owners earnings” as:
(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
(b) Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
In a nutshell, A+B = Net Income + Depreciation – C or Capital Spending = Owner’s Earnings. (All of those component numbers are usually readily available through Value Line and other sources.)
For those interested in seeing a complete analysis of Owners Earnings in action please read my article on Microsoft (MSFT).
Getting back to the article, from a stock picking point of view, Internet stocks really began showing up in the late 1990s and became a popular trading vehicles for day traders and were extremely dangerous places to invest, as the dot com boom and bust clearly showed. As an investor I have always stayed away. But that was then and this is now and since the only constant in the universe is change, I am overjoyed that I am finding intriguing Internet investment opportunities. The industry went from being a wild west day trading phenomenon, to a high beta growth play and has now just turned the corner and become a place to find consistent conservative growth/value opportunities. I, of course, am not talking about the entire industry and though there are many opportunities available, I have decided to limit this discussion to five key players.
When investing it is important to try not to follow the crowd, but instead to envision a potential future for the industry that you are analyzing and then try to find the key players that dominate through Economies of Scale, both now and in the future. (I learned the methodology of how to envision a potential future by reading the books of Alvin Toffler, which though outdated now, can still teach anyone to be a better investor). At the same time, you must also insist that each company is consistent and that you can buy it at very attractive valuations. This is not always so easy to do as most investors do little or no research and end up buying at the wrong time and selling at the wrong time. This unfortunately is our competition and if you want to invest in the market, you need to deal with them. The best way to do so is to have a concrete game plan in place and set your parameters and always keep a large amount of cash on hand to take advantage of the mistakes of the crowd.
What I have attempted to do in analyzing the Internet is find what I call “the foundation stocks” in the industry that provide the services or platforms that allow people to do what they do on the internet seamlessly. I have done this because I relate the Internet as similar to the “1860 California Gold Rush”. The people who made the money then were not those panning for gold, but were those who provided the tools, supplies and essential services to allow them to do so.
There are five key players that I see dominating the Internet in the future as ‘foundations stocks” and what I have done is divide the Internet into five sub categories;
1) Hardware
2) Software
3) Operating Systems
4) Search
5) E-Commerce
And in each of those categories I have found one dominant player that I bought at very attractive valuations.
These five stocks are:
1) IBM (IBM)
2) Oracle (ORCL)
3) Microsoft (MSFT)
4) Google (GOOG)
5) Value Click (VCLK)
IBM is a company that constantly adapts and for almost a century has dominated the hardware arena. Everyone talks about how cloud computing will change the world and how mainframes and servers will be a thing of the past, but the same thing was said when desktops computers and laptops first showed up; they were wrong then and they will be wrong in the future as well, because the Internet is basically a network of servers connected together that send data at the speed of light to one another. Without the hardware to store the data you have nothing. And I assure you IBM understands cloud computing and knows that it still has a long way to go. I remember in 2001 when the big talk around town was how 3G wireless networks were going to go up within a year and everyone’s mobile experience would be amazing, but we are in 2010 and they have only now just gotten the kinks out (don’t say that to an AT&T (T)-Apple (AAPL) iPhone user). I also remember how Linux was going dominate the globe, but the Linux operating system, some ten years later, has only 2-3% of the global operating system market share.
Cloud Computing is still in its infancy and all cloud computing currently makes up about 2% of the combined IT Infrastructure. That means that 98% is still hardware based. Google, for example, buys used servers and mainframes and stores their information on them, so if Google is in no rush then cloud computing should be quite a ways off and should grow to a combined revenue of $3 Billion by 2013.
IBM makes its money from services and not just from the servers and mainframes it makes. The real money in IT is in service contracts that are usually multi-year and fixed. Thus IBM can have a sustainable earnings stream that is very consistent. Their free cash flow generation is so powerful that they just announced Tuesday that they will be buying $10 billion of their own stock back in addition to the $2.3 Billion that they announced previously. If you crunch the numbers and look out to 2011, you have IBM potentially earning $13.45 a share in owner’s earnings for that year, and at Tuesday’s closing price of $140.67 you have IBM selling for 10.45 times its owner’s earnings estimate.
Oracle, our next pick, is the champion of the Software side of the Internet and provides the database software to store all the data that makes the internet work. It is amazing that the governments of the world have allowed Oracle to buy out their competition without charging them with being a monopoly, but if you look at the companies that Larry Ellison has bought and put them together, you basically have a monopoly. Oracle is also a service based company and signs multi-year contracts like IBM does and thus you have consistency and Economies of Scale and an incredible barrier to competition, as they have basically bought up their competition. By buying Sun Microsystems they have also got their hands on JavaScript, which is a language that allows the user to interact with the Internet. Oracle in 2011 is expected to earn $1.95 a share in owner’s earnings, so at Tuesday’s closing price of $28.63 we are looking at a price to owner’s earnings of 14.68.
Microsoft is the world market share leader in operating systems for desktops and laptops and comes in with a market share of 90%. So 9 out of every 10 internet users in the world get to the internet from an operating system that was built by Microsoft. The Economies of Scale for Microsoft are just amazing and I feel very confident that when they report their earnings this week that they should surprise a few people. From what I have been able to determine they have sold over 240 million licenses of Windows 7 and 140 million of those were probably in this quarter. In 2011 we have Microsoft earning $2.50 per share in owner’s earnings and if we take Tuesday’s closing price of $25.90, we get a price to owner’s earnings of 10.36.
Google is my favorite stock as it totally dominates all aspects of the internet and gets more unique visitors and clicks than any other company. I can write volumes on Google but instead will let you read my article on it by going here. I bought Google in the $470s and it has gone up considerably since then, but with expected owners earnings of $27.95 for 2011, I believe those estimates may be a little low and at Tuesday’s closing price of $618.60 it still may have some room to go at 22 times its owner’s earnings. In saying that I would assign a higher premium to Google than I would to other companies as their dominance is unmatched and their future so bright.
The last company on my list operates in a niche area of the internet and is the dominate player in that niche. The company is called ValueClick and they own this website or Commission Junction. The company only has a market capitalization of $1.12 Billion but is extremely profitable and very undervalued in my opinion. What they do is have an E-Commerce Network that has some 2500 clients who are advertisers and it acts as a go between them and tens of thousands of website publishers. I stumbled upon them only because I run this company as well and am a publisher client of theirs along with a dozen other affiliate networks.
ValueClick is the dominant force in the industry and in my opinion (along with other affiliate networks) will allow all kinds of entrepreneurs like myself to create store fronts to compete with the Amazons and eBays of the world, similar to how blogs compete with the established media and are slowly taking them down. Amazon and eBay are still the dominant players in e-commerce, but will eventually feel the heat as companies like Macy’s (M), Wal-Mart (WMT) and Sears(SHLD) are joining up with tens of thousands of website designers to house direct link banners to their sites.
Amazon is smart as they have their own affiliate network, but since this article deals with companies that are market leaders yet also have attractive valuations, I don’t consider it a buy. Amazon’s owner’s earnings are too rich for my taste and I have never had the opportunity to own them, but I would at the right price. As for eBay, their capital spending as a percentage of cash flow is too high for my tastes. I like to pick stocks where capital spending amounts to less than 15% of cash flow consistently over many years and eBay does not pass that test. ValueClick comes in with an estimated $1.13 owner’s earnings per share for 2011 and at Tuesday’s closing price of $13.74 is selling at 12 times its price to owner’s earnings. The company is very well managed and has a tremendous reputation in the affiliate marketing industry, is very profitable and if one includes the estimates for 2010 and 2011 into the equation, they have cumulative owners earnings for the years 2003-2011 of $7.78 a share - or are basically selling for about 2 times their cumulative owners' earnings, which makes it an amazing Main Street owner’s earnings generator.
In conclusion I am sure that many of you may think that these stocks should not be classified as Internet Stocks, but remember that the Internet is actually a physical structured tool and the companies mentioned in this article are market share leaders in each of the categories that make up the internet, and play a major role in allowing the user to access it.
Disclosure: Long MSFT, IBM, ORCL,GOOG,VCLK, WMT, T with No Positions in EBAY, AAPL, AMZN, M, SHLD
