Internet IPOs: What Goes Up...

By Daniel Kadlec

Internet stocks have defied convention and gravity for the better part of two years. Never mind that to these outfits, profit is mostly a concept. They had cool products, hip clients, catchy names, irreverent ads, promise--lots of promise--and more. They had panache. They were cocktail chatter, and their stocks (and stockholders) were giddy. The money-losing online bookseller Amazon.com long ago blew past venerable Sears in terms of market value. At the time, investors gasped and marveled. They kept buying, but at least they noticed. By April, though, Amazon's worth was fast approaching that of Sears and Wal-Mart combined, and nobody was paying attention.

They are now. Amazon's April apex, it turns out, was the top of the market for Internet stocks. On average, they have declined 32%, and many, including Amazon, have halved. So, is it time to declare the Internet bubble burst and set the Net stocks next to other flameouts, such as biotechnology (1980s), computer leasing (1970s) and, yes, tulips (1600s)?

Not so fast. The Net wonders aren't dead. They're just going to behave differently as this industry, like so many before it, enters the next phase of development. That phase will include the creation of tons of stock as new IPOs flood the market in search of easy money (yours). And it will include the inevitable shakeout as investors sort out the jewels from the junk. The only question is, How fast will all this happen?

Internet analysts, as confused as the rest of us, are riding the fence. They recognize that the recent Internet-stock drop could be just another fake-out--"an intrusion of rational thinking," says one--like the dips in January and last autumn. In both cases, patience and faith were rewarded when those stocks roared back from sharp declines. But the pros aren't exactly backing up the truck to get their fill. It's more of a tiptoe laced with caveats.

Kevin Landis, who manages the Firsthand Technology Fund, ventures that this may prove to be a good time to start buying Net stocks if you've been out of the game--and are a long-term investor. So, you're jumping in with both feet, right, Kevin? After he stops laughing, Landis says, "We've just got away from the scary point at which people say, 'I don't know how to value it, but I have to own it anyway.' [But] we're nowhere near levels where you can start making a value argument."

The new-economy Net stocks are now up against some old-economy fundamentals they haven't faced before. Rising interest rates are a big deal. The 30-year Treasury-bond yield popped over 6% last week, its highest level in more than a year, and could well stay there. Speculative stocks (and Internet defines the category) tend to get hard hit when higher rates threaten to slow the economy and the market. There are also basic questions about Internet bellwethers, including AOL (Will AT&T shut it out of cable access?) and Amazon (Can it reverse slowing revenue growth?).

Most troubling, though, is a glut of new Internet shares saturating the market, creating a supply overhang that could last through the summer. This is an entirely new situation for Net investors. In the past few years they have had little choice but to bid against rabid techies for the same handful of precious stocks, driving prices through the roof. Wall Street reacted as expected: by underwriting stock deals for every dot com in sight. A flood of new shares hit the market this year, and now the scarcity premium on Net stocks is gone.

The glut hurts in another key way. It creates well-capitalized competition for companies that have already gone public. This is an underappreciated phenomenon. Each new Internet IPO equips yet another company to steal business from the incumbents. Instead of one online pet store, there are three. That pushes all companies in the same line of enterprise further from the future profits that, to a degree, all Internet investors count on.

So far this year, 88 Internet companies have issued 432 million new shares, raising $12 billion, reports Thomson Financial Securities Data. That's more new Internet shares in five months than were minted in 1997 and 1998 combined. And 90 more companies expect to raise some $8 billion through new offerings this summer, Merrill Lynch reports.

Is this lunacy? Not at all. "The stock market is acting perfectly rational with this Internet thing," says Charles Clough, chief market strategist at Merrill. "It is providing capital because this whole infrastructure has to be built, and it has to be built very rapidly."

This is the nature of capitalism. A new idea comes along. Investors throw money at it. Eventually, an economic model emerges. At that point, the winners win big, and everyone else goes broke. The Street's role is to make sure that enough money gets thrown at the idea so that the profitable model takes shape quickly. This weeding-out process is time-tested, from the advent of trains, planes and automobiles early in the century to the more recent arrival of electronics, computers and biotechnology. Consumers almost always benefit; the average investor almost always is better off waiting to see which companies survive.

It's unlikely that many of the survivors will come from the current crop of Internet stocks making their debuts as IPOs. Now on the docket are many also-rans, third or fourth to market with second-tier managements. Take PCQuote.com which filed last Wednesday to raise $100 million. It competes in the already jammed area of financial data, which includes TheStreet.com Reuters and others. "How new is that? Let's go watch paint dry," sniffs David Menlow of the research firm IPO Financial Network.

On Thursday, HotJobs.com filed for an IPO, hoping to raise $69 million this summer, even though other stocks in the category, like Topjobs.net have struggled. "A story is only interesting the first time," says Chip Morris, manager of the T. Rowe Price Science and Technology Fund. "By the hundredth time an Internet company comes in repeating the same mantra, you just want to scream to somebody, 'Give me a break!'"

Others from the current crop of Net IPOs may represent new opportunities, but in niche--and thus limited--markets. Still others are so nascent that they are little more than a concept hoping to cash in quickly. Profits? They don't even have revenue. Drugstore.com an online prescription-drug company, has filed for an IPO even though it has only three months of formal results. The IPO may do well anyway. The company has a top-notch underwriter in Morgan Stanley Dean Witter. It is the first online company of its kind to attempt to sell shares to the public, and it's backed by savvy Internet investors, including Amazon founder Jeff Bezos.

Now consider quepasa.com a Spanish-language search engine that has none of those qualities--plus a 26-year-old CEO. Despite having virtually no revenue and a $6.9 million loss last year, the company hopes to raise $44 million in an IPO next week.

Ironically, fund managers will continue to buy freshly minted Internet stocks, if only to flip them back into the market for one-day gains. The days when every Internet IPO would double or triple on the first trade have vanished. But most still go up a quick 20% to 30%, low-hanging fruit for any money manager who can get shares at the IPO price. Lately, though, even the easy money has been harder to come by. A handful of recent Internet IPOs quickly fell below their IPO price, and dozens trade below the price of the first trade, which is the price that most individuals end up paying.

That doesn't mean the window is being slammed shut on Internet entrepreneurs. Far from it. The investors who really count in the IPO game are institutions, and they've all made plenty of money by buying at the IPO price. They will continue buying. There is little reason for issuers to pull back, and few have. Last week Drkoop.com a consumer health-care site headed by the former Surgeon General Dr. C. Everett Koop, doubled the first day, proving that a good story still sells. High-profile CNN anchor Lou Dobbs has announced that he will resign to start Space.com proving that entrepreneurs still believe there's time to build a Net company and cash in.

"I don't think it's a bad market for quality companies," says Jay Walker, founder of Priceline.com a money-losing e-commerce site whose value soared 10-fold, to $23 billion, a month after its March IPO and is now at $13 billion. "If eBay went out today, it would still soar. But the fantasy stocks are back where they belong. People are looking for real traction, real sales, real growth." And maybe a little panache.

--With reporting by Daniel Eisenberg/New York

With reporting by DANIEL EISENBERG/NEW YORK