Inktomi Investors Trapped by High Values; Fannie Mae for Near Term

Inktomi (INKT) Jim: (Don’t buy)

Mike: (Don’t buy)

Mike: This stock is something of a major departure for us.

Jim: As far as what?

Mike: Well, I believe--you can correct me on this--that Inktomi is the first stock we’ve discussed whose name derives from the Lakota Indian language.

Jim: You sure we haven’t had another one? Anyway, this name--which by the way is pronounced “INK-to-mi”--is Lakota for “clever spider,” right? Why do you think they picked that name?

Mike: Well, twee as it is, their Web site suggests it’s because they defeat their rivals through wit and cunning.

Jim: Whether they can defend that or not, it’s always interesting to look at a company that’s selling for 1,700 times its expected annual earnings per share.

Mike: That’s a huge change for them, by the way, because just a couple of quarters ago they were selling for infinity times earnings. It’s only within the last six months that the company has actually had earnings.

Jim: Now Inktomi is a big “dot-com” company . . .

Mike: Let me interrupt you here to say that I’m not entirely sure it’s fair to call Inktomi a dot-com.

Jim: Why not? What do you define as a dot-com?

Mike: I’d define it as a company that mainly provides services to Internet users--not a company that provides the infrastructure for those companies that serve users, which is what Inktomi does.

By my definition, Inktomi is no more a dot-com than Cisco Systems is. Traditionally, Inktomi has provided house-brand search engines for the Internet the same way a food company provides, say, Price Club with all those cereals and mustards and what-have-you that go out under Price Club’s private label.

In other words, Inktomi is the technology that actually performs the Web searches for all the well-known search engines, including Yahoo. Now, Yahoo recently replaced Inktomi with Google.com for most searches, but Inktomi still has many, many other customers.

Jim: And there’s a lot they do besides Web searches. Among other things, aren’t they the ones that developed software that lets you do comparison shopping on the Net? And also software that speeds up the delivery of Web pages to your PC? This is a rapidly growing company . . .

Mike: . . . though still small by the scale of things.

Jim: Yes, but in the nine months ended June 30, Inktomi’s sales more than tripled from a year earlier, to about $145 million. And as we said, it earned a modest profit in its fiscal third quarter.

However, the share price has taken a real whack in this year’s Tech Wreck. The stock hit a high of $241 in late March, and now trades for little more than half that.

Mike: Only half? Gee, so its price-to-earnings multiple based on 2000 earnings estimates is only 1,700 rather than 3,400.

Jim: Precisely. Now, I think a lot of what has happened to the stock has to do with the increased competition in the business of improving the speed and efficiency of Web sites. Inktomi faces rivals no less than such firms as Cisco and Novell. And those are big, big rivals.

Mike: Right. Let me paraphrase Ronald Reagan, not one of my heroes, by saying: “Here we are again.”

Jim: That’s a mangled paraphrase, but go ahead.

Mike: I’m thinking Inktomi is an excellent company by Internet standards. It has several great businesses that will grow like gangbusters, and it is now profitable, unlike most young Net firms.

But one of these days, Inktomi’s stock value is going to have to dwell in the realm of Newtonian physics, which is to say, reality--rather than in the realm of quantum physics, which is to say, weirdness.

Even based on 2001 earnings estimates, which allow for robust growth, the stock’s P/E is about 500. In short, I have a lot of respect for the company, but the stock’s valuation is completely bananas.

Jim: We’re both on the same track here.

Mike: Now I’m not taking a moral stand against high valuations, like many people do, as though there were something sick and twisted about people paying the current price for the stock.

I merely argue that as a practical matter, when a company is selling at this kind of valuation, the risk is high that its herd of investors is going to continue to get culled at various points along the company’s--and market’s--migration, like wildebeests traversing lion country.

Fannie Mae (FNM) Jim: (Buy)

Mike: (Don’t buy)

Jim: Well, Michael, our next stock is Fannie Mae. And I wish, for purposes of this discussion, that this was Fannie the chocolate company, because it would be a lot easier to describe that business than to describe the company that we’re talking about.

Mike: Aren’t you thinking of Fannie Farmer?

Jim: No, there is a Fannie May chocolate maker, with which Fannie Mae is sometimes confused. Anyway, our company used to be called the Federal National Mortgage Assn. . . .

Mike: . . . which is how it got the nickname Fannie Mae. Then its leaders must have thought, “What the hell? If Consolidated Brands can change its name to Sara Lee, we might as well just be Fannie Mae.” So they made that the official company name.

Likewise, the company’s brother-in-law, the Federal Home Loan Mortgage Corp., officially took its nickname, Freddie Mac.

Jim: Now, Fannie Mae is a gigantic financial-services company, the nation’s biggest provider of funds for home mortgages. What it does is issue bonds by the billions of dollars. Then it takes the proceeds from those bonds and buys mortgage loans from banks and other institutions that actually make the mortgages for you and me.

Fannie Mae profits from the “spread” between the interest rate on the mortgages it buys and the rate it pays to borrow the money in the first place, via the bonds.

Mike: Right. In other words, if it pays 7% to borrow money, then buys mortgages on which you and I are paying 8%, it pockets the 1 percentage point difference.

Jim: You got it.

Mike: I like to think of Fannie Mae as the company that gave new meaning to the term “jumbo.” As many homeowners know, particularly in Southern California, a jumbo loan is a mortgage that’s too big to be bought by Fannie Mae. At the moment, Fannie Mae buys loans only up to $252,700. And, of course, here in Southern California, that will buy you a packing crate over by LAX. And not even with a pool. Maybe an open sewer pipe.

Partly because Fannie Mae doesn’t buy jumbo loans--and therefore, lenders may have more trouble selling such loans--jumbo borrowers pay a slightly higher interest rate.

Jim: This business of buying and selling loans is what’s known as the secondary market for mortgages, of which Fannie Mae is the king, or should we say queen. And to hear Fannie Mae and its fans tell it, the company is a tremendous asset to the nation because it keeps banks and S&Ls; flush with cash to make more home loans.

Mike: Indeed, 70% of the mortgage loans--that is to say fixed-rate loans--taken out by Americans last year were ultimately bought by Fannie Mae and Freddie Mac.

Which means that 30% of us--all of us, I guess, in California--must have jumbo loans.

Jim: Now, what’s interesting is that Fannie Mae and Freddie Mac are getting criticized from all quarters these days. Fannie Mae was created in the late 1930s by Congress to keep a ready supply of mortgage money available for consumers.

Even though Fannie Mae is shareholder-owned and operates for profit, it is officially a “government-sponsored” enterprise--and has special borrowing rights with the Treasury. Today, those rights are largely symbolic. Even so, Fannie Mae’s government-sponsored status means it gets to pay lower interest rates to borrow money than other financial institutions.

Mike: Fannie Mae and Freddie Mac even have their own federal regulator, the Office of Federal Housing Enterprise Oversight, the euphoniously named OFHEO.

Jim: Bet their office parties really rock. Anyway, now the banks and other financial institutions are carping to Congress that Fannie Mae is invading their turf in other areas, such as sub-prime lending, to keep up its earnings growth and make shareholders happy. And the company is doing so unfairly, critics say, because it has its government-sponsored advantages.

Others are griping that Fannie Mae might be undercapitalized relative to the huge sums that it’s handling. Which is raising fears of another S&L; crisis, or worse.

The upshot is that a lot of people think Fannie Mae and Freddie Mac should just be privatized completely, and let them compete with everybody else--without a government backstop.

Mike: So as far as Fannie Mae stock is concerned, the practical problem is that these companies are on Washington’s radar screen right now. And I think they are going to stay there for the foreseeable future.

Jim: I do, too.

Mike: Now, this stock normally would be a great buy because it’s a financial stock selling for 12 times this year’s expected earnings per share, which is remarkably cheap. But it’s hard to know what’s going to happen when the D.C. circus saddles up the show horses. And that’s too bad.

Jim: Well, I agreed with you until the end. I would buy this stock.

Mike: You mean you don’t think Washington’s a circus?

Jim: No, it’s just that, from an investor’s viewpoint, I don’t think pondering the pros and cons of these attacks on Fannie Mae is worth the effort. They have weighed on the stock, that’s true. But I would buy the shares anyway, with a one-year outlook. I don’t think anything major is going to happen to Fannie Mae within that time, regardless of all the complaining.

Mike: Well, actually that’s bad news.

Jim: How so?

Mike: Because that means that for at least the next year there is going to be this cloud over Fannie Mae’s head, like the cloud that always hovered over that Li’l Abner character, Joe Bfstplk.

Jim: Say that 10 times really fast.

Mike: Your point?

Jim: Fannie Mae’s annual earnings growth remains in the 15% range. I think investors are going to realize that they’re looking at a valuable yet cheap stock, now down 28% from its peak. Yes, all this complaining is a problem. But I still think there’s an opportunity in the stock in the near term--though I’d have my finger on the sell button a year from now.

Write or e-mail with a stock you would like to see discussed in this column. Peltz (james.peltz@latimes.com) covers the markets and corporate financial trends. Hiltzik (michael.hiltzik@latimes.com) covers technology and entertainment and is the author of the book “Dealers of Lightning: Xerox PARC and the Dawn of the Computer Age” (HarperBusiness). Either can also be reached at Business Section, 202 W. 1st St., Los Angeles, CA 90012.

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