Net Stock Plays With an ‘E’ in Their P/E

If you’d like to get in on the Internet stock craze but you’re a stickler for at least one old-fashioned investing rule--black ink on a company’s bottom line--this “Net Profit Portfolio” could be worth a look.

This stock screen was developed with the idea of finding companies that belong in both of two worlds that are, for the most part, mutually exclusive today: a business tied to the scorching Internet sector, with its seemingly limitless growth potential; and a bottom line that is already showing a profit.

The screen, performed by Houston research firm Telescan Inc. for The Times, began with the 50 stocks in the Interactive Week Internet index, which was launched in August 1995 and is one of the best-known Net indexes.

To start, we eliminated 12 of the 50 companies because they weren’t primarily Internet plays--admittedly a judgment call, because many of the companies in the index do business in both the real and cyber worlds. But we wanted companies tied very closely, or exclusively, to the Net.

Next, we dumped any company that did not earn at least a penny in per-share profit over the most recent 12-month period.

Because the vast majority of Net-related companies are still losing money, we figured the profit requirement would narrow the list considerably. And it did: We ended up with 11 stocks.

Finally, we chucked any company whose earnings per share are not projected to grow this calendar year, based on Wall Street analysts’ earnings estimates as compiled by Zacks Investment Research in Chicago.

The final cut: Eight stocks, evenly split between Net sector leaders--America Online, Cisco Systems, 3Com and Yahoo--and some lesser-known names, which are Check Point Software Technologies, MindSpring Enterprises, Security Dynamics Technologies and Verity.

They all have one thing most other Internet-related stocks do not: at least two consecutive quarters of profitability.

Now, a couple caveats. First, there is no guarantee these companies will continue to be profitable. Second, even though they’re earning money, most of these companies’ shares are high-priced relative to earnings, and therefore very risky.

Still, at least they all currently have “Es” in their P/E ratios.

Here’s a closer look at the companies on the list:

2 of Web’s Leading Brand Names on List

Dulles, Va.-based America Online, the leader in Net access service, and Santa Clara-based Yahoo, the leading Internet “portal,” are considered two of the three most valuable brand names on the Web.

What separates them from the other premier brand name, bookseller Amazon.com, is their profitability. And analysts project continued robust earnings growth this year for both companies.

Their Web sites-- https://www.aol.com and https://www.yahoo.com--are the No. 1 and No. 2 domains on the Web, according to traffic tracker Media Metrix Inc.

The most recent statistics show that both had “audience reach” of almost 50% in December--meaning nearly half of active Web users visited each site at least once that month. The more eyeballs, of course, the more advertising money the companies pull in.

One edge for AOL is “its captive audience--which Yahoo doesn’t have, even though it is perceived as one of the best sites,” said analyst Anthony Blenk of Everen Securities.

And though both stocks are pricey, AOL is less so.

“We can’t say AOL is cheap relative to the market, or relative to Internet stocks,” Blenk said. “What we can say is that it’s cheap relative to Yahoo,” whose projected 1999 P/E is more than 400, versus AOL’s of just under 200.

The two other Net sector leaders in the portfolio--Cisco Systems and 3Com--are No. 1 and No. 2 in data networking, which of course is key to the Net’s growth. The networking and computer security companies on our list are not “pure” Net plays, but they are increasingly relying on Web-related revenue to grow.

Cisco and 3Com “each have a sustainable competitive market advantage,” said analyst Christin Armacost of Everen Securities, who gives both stocks her top rating. “Cisco with products for medium-to-large enterprises and 3Com with products for small-to-medium businesses and consumers.”

She notes that San Jose-based Cisco dominates the market for products that direct Internet traffic, while Santa Clara-based 3Com controls half the market for dial-in modems.

Opportunities for Smaller Companies

Two of the portfolio’s smaller companies specialize in online security and thus could benefit from the boom in electronic commerce.

One of these stocks, Security Dynamics, has lost more than a third of its value in the last year and took a jolt Jan. 29, falling 16% when the company reported fourth-quarter profit of 8 cents a share instead of the expected 12 cents.

But analyst John F. Powers of BancBoston Robertson Stephens calls the setback a “great buying opportunity.”

The Bedford, Mass., company had a “better-than-expected quarter on the revenue line,” Powers notes, but got hurt by a variety of one-time charges. “I’d call it a little messy but not a miss.”

Much of the unexpected expense was tied to changes in how the company compensates its sales force--changes that should pay off down the line, Powers said, as the company books more orders to Net service providers.

Security Dynamics rival Check Point Software, meanwhile, is rated “long-term attractive” by Powers. The Israeli company, whose products include the FireWall suite for virtual private networking, is “one of the most profitable companies in the sector, with operating margins in the 40%-to-50% range,” he said.

But Powers thinks Security Dynamics’ depressed shares have better upside potential from here than do CheckPoint’s shares.

Another potential beneficiary of the e-commerce explosion: Sunnyvale, Calif.-based Verity, which sells “knowledge-retrieval” software.

Customers include Web retailer CDNow, whose visitors search for specific artists and song or album titles using its technology, said analyst Greg Vogel of NationsBanc Montgomery Securities. He notes that CDNow visitors have had 20% more success at finding--and buying--the CDs they want since the firm switched to Verity software.

“A high percentage of Web sites are going to be needing this technology,” Vogel said.

A new Verity management team has instilled a stronger sales discipline, he said. The average transaction rose from $68,000 in August 1997 to $170,000 in November 1998.

“They’re showing customers how they can benefit from a better software package,” Vogel said.

Finally, the portfolio includes a company that is sort of a miniature AOL: Atlanta’s MindSpring Enterprises, which provides Net access to 1.1 million subscribers.

“MindSpring is not only seeing dramatic subscriber growth but also a breakout in earnings production,” said Frederick W. Moran, analyst at ING Barings.

And while AOL may be cheap relative to Yahoo, MindSpring looks cheap next to AOL.

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On the Net, in the Black

These eight members of the Interactive Week Internet stock index all posted earnings over the last year--a relative rarity for Net-related companies. Here are details on the stocks, including earnings per share (EPS) for the most recent 12-month period, number of consecutive profitable quarters, projected 1999 EPS growth according to analysts’ consensus earnings estimates, and each stock’s projected price-to-earnings ratio (P/E) based on analysts’ consensus EPS estimate for 1999.

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No. of Trailing consec. Proj.’99 Proj. Mon. 12-mo. profitable profit ’99 Company Ticker close EPS* quarters growth P/E MindSpring Ent. MSPG $85.38 $0.34 5 91.3% 136 Yahoo YHOO 158.63 0.24 2 68.9 441 America Online AOL 159.00 0.50 6 49.0 179 3Com COMS 34.06 0.80 5 43.5 17 Verity VRTY 34.00 0.31 3 42.1 39 Security Dyn. SDTI 19.19 0.56 9 35.1 28 Cisco Systems CSCO 101.94 1.32 30 25.8 56 Check Point Soft. CHKPF 41.06 1.77 6 15.2 20 Interactive Wk Idx IIX 718.90 --0.58 -- 161.1 60**

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*Net income per share (including any special items)

**Only 15 of the 50 stocks have a projected P/E

Sources: Telescan, Bloomberg News, Zacks Investment Research

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Josh Friedman can be reached by e-mail at josh.friedman@latimes.com.

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For more details on the companies featured in this screen, visit https://www.latimes.com/netstocks.