Day In The Sun Over For The Internet?

Unlike 2001, there’s no defining macro crunch ready to end the jitterbugging in big cap Internet houses like Alphabet, Facebook, Alibaba and Amazon. Valuation stands stretched, but not fully beyond security analysis rationalization. In 2001, trashy properties like Akamai Technologies, Equinix, Exodus, Inktomi and Storage Networks dropped over 90% from 52-week highs. Did VCs give them their fancy names? (There were dozens more.)

Almost a generation later, are the same analysts who stretched to justify such trash still in harness? Hopefully, they were dismissed with extreme prejudice. Each generation needs to white-out its self-imposed insanity.

NASDAQ then huddled in tatters, the economy stalled out. Democrats and Republicans were at odds on how to revive the country. Alan Greenspan, seemingly a subconscious captive of Wall Street, cut the Federal Funds rate bimonthly. The Street had discarded belief in a V-shaped recovery, tired of jumping the gun.

Nobody, then, could deal with reality, that corporate earnings were crumbling in what was more than an inventory correction – what we had in the seventies. Capital spending had hit a wall and didn’t recover for years. This is unlike today with GDP chugging along at 15 mph, but not stalled out.

Back in 2001, formerly mighty capitalizations traded in single digits – Nortel Networks, Lucent Technologies and JDS Uniphase (unheard of today). Properties with liquid balance sheets – Corning, Cisco Systems and EMC, sold in mid-teens after hitting par mid-2000.

NASDAQ, then, dropped over 60% in 12 months while Amazon, Yahoo and Cisco crumbled between 80% and 90%. Also bleeding out, proud blue chips like Procter & Gamble, McDonald’s and Coca-Cola. Corning bragged about staying solvent after writing off $5 billion in plant and inventories.

If there were still some standing believers in the efficient market theory, the destruction in tech must have snuffed them out. As a frame of reference, the S&P 500 Index eased below 1,200 while the earnings consensus for 2001 dropped from $60 to $50. The market then sold at over 20 times anticipated earnings.

Late in 2001, the only way of rationalizing the valuation structure was to move further down the listings. Once you got past the top 25 market capitalizations, the median price – earnings ratio stuck in low teens. This construct is eerily like what we live with today.

Internet stocks which dominate the top 10 names in the S&P 500 don’t trade on earnings or even earnings expectations. Rather, they tick on metrics like operating cash flow, particularly Amazon. But, Internet houses sport powerful balance sheets – tens of billions in liquid assets and minimal long term debt. Huge discretionary spending footprints are designed to maintain primacy and build out operational footprints. Amazon’s acquisition of Whole Foods is a good example.

Currently, nobody sees recession around the corner or a decline in corporate earnings. Treasuries in 2001 yielded 5.5%, not the 2.3% rate on 10-year paper today. In 2001, after a breakfast meeting of the Democratic Leadership Council, I was head scratching as my party had taken a fiscal stand then more conservative than Republicans.

Joe Lieberman had voted against the tax cut. You couldn’t get elected pushing for major tax cuts. Both parties seemed resigned to a 5% unemployment rate. It’s only retrospectively that you can dope out how foolish prevailing thought can obstruct sound policy intervention.

The NASDAQ 100 top 10 yearend 2001 capitalizations displayed violent shrinkage aside from Microsoft, off just 20%. Names like Intel, Cisco, Oracle, Sun Microsystems and Qualcomm ranged down from 45% to over 75%, total wipe out. Secondary names like Exodus and Inktomi dropped over 90%. Basically, there was excessive, mindless capital spending while the consumer was loaned up to his eyeballs.

Darkest before dawn players, when there’s no substantive earnings power visible, resort to the metric of revenues to market capitalization. For example, early in 2015, Microsoft was selling at 3.7 times its forward price to sales ratio. Nearly the same for Cisco, Oracle and Intel. Consider, too, that by summer of 2001, major tech houses were priced for a major earnings recovery in 2002.  

My usable metric is not to pay more than 2 times the growth rate for anything that walks. On a price to revenues yardstick, I try to stop myself out at 4 times. Internet houses like Facebook can sell at 10 times revenues but at 20 times enterprise value, a metric that outweighs its revenue multiplier.

Amazon sells at a low price-to-revenues multiple but its bottom line is forever skimpy. Because I expect around 2% GDP growth, comparatively low interest rates and minimal inflation, the S&P 500 Index’s earnings are unlikely to decline, but could flatten out coming 12 months. Although the FRB may flex its muscles, I’ve added to AT&T. Its 5% yield is better than what you get on a BB debenture carrying 10 years’ duration.

I can find no fundamental reasons for the downdraft in Internet properties excepting relative valuation excesses to the market. Earnings growth finally takes care of such overvaluation. Properties like Facebook, Alphabet, Alibaba and Amazon do discount next 12 months’ prospects, but little beyond. They’ve the wherewithal to renew themselves in an economic setting of even moderate growth.

Meantime, the Fed’s clean report card for banks uncorks the bottle for technocratic moves covering share buybacks, higher dividends and other plays to leverage capital structures. Citigroup has most room to flex its muscles and does sell close to 10 times foreseeable earnings.

Banks are my imprudent hedge that I’m wrong on interest rates, that they’re headed much higher. Lest we forget, rates on Treasuries still track a narrow channel, as low as we’ve witnessed over the entire postwar history of interest rates. I’ve doubled up on Citigroup, now equivalent to my Amazon position. I see Citi’s earnings power north of $6 a year out. As for Amazon, I’m dealing in operating cash flow metrics absent substantial earnings, nowhere in sight.

What if I’m wrong, and tech encounters fundamental earnings issues like a consumer and capital goods recession? A major earnings shortfall for Internet houses would schmeiss them in half. Not my call but maybe a 20% chance.

Finally, what about daylight between GAAP and non-GAAP earnings? If earnings drop, does percentage dilution from employee stock grants and options rise or fall? It better fall.

Yes, I know. Nobody ever pronounced tripping to the moon was a riskless mission.  

 

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