The boom is back

Net companies are on fire again. Here's the smart way to invest without getting burned

(FORTUNE Magazine) - Back when the Internet bubble was deflating disastrously, the fashionable view was that we'd never see its like again -- and thank goodness.

No more supercilious twentysomething zillionaires. No more insta-companies with billion-dollar valuations. Slapping a dot-com name on absolutely anything would no longer guarantee entrepreneurs millions from gullible VCs and, shortly after, from IPO-happy individual investors.

That whole Internet mania, gone from our lives for half a decade now, left a sour taste. Careers were interrupted. Reputations were destroyed. Billions of dollars vaporized. Hell, those stock market losses still show up on our tax returns.

But brace yourself--it's time to say hello to the new Net boom. And believe it or not, it's a boom you'll very likely want to invest in--even if you think (as we do) that Google (Research) at $400 a share is too scary to consider. The Internet, as you well know, didn't vanish along with all those dubious dot-coms. While shell-shocked investors were licking their wounds (or trying to make back all their money by flipping condos), folks in the Internet industry kept right on dreaming up new ways to use the revolutionary technology that created the fuss in the first place.

You don't need us to tell you that today the Net is fulfilling many of the visions its wild-eyed prophets were preaching about just a few years ago. All the impossibly cool applications that seemed so elusive in the late 1990s--Internet phone calls, (legal) downloadable music and movies, high-speed web access on cellphones, online bill paying--are a taken-for-granted part of daily life.

Young people talk about themselves and their favorite rock bands at MySpace. College students get the 411 on this weekend's party at Facebook. Moms post their family photos at Flickr. Dilberts waste their companies' time watching homebrewed videos on YouTube.

And even some infamous icons of the '90s are back. Says Henry Blodget, the now-banned Wall Street analyst who now, like just about everyone else these days, is a blogger: "The trends that people got excited about when Netscape went public in 1995 are very much in place and will be for 20 to 25 years."

Driving this transformation is the extraordinary growth in the number of people with access to high-speed Internet connections. In 2000 just five million Americans had fast Internet access at home. At the end of 2005 that figure was 73 million, according to the Pew Internet and American Life Project.

Those speedy connections have supercharged the online experience, and people are doing exactly what you'd expect: spending vast amounts of time with their eyes glued to computer screens. More important, companies have finally figured out the long-sought key to "monetizing" those eyeballs, mainly by selling advertising, but also by charging for music and video downloads, not to mention for the access itself.

The not-so-surprising result is that the Internet industry isn't just back, it's better than it was before. Google isn't merely a ubiquitous (and free) research tool, though it certainly is that. Google, the online advertising company, generates billions of dollars in profits. (Yes, billions, and yes, profits.)

The iPod isn't just the hottest toy on the planet. It's a product that pumped $4.5 billion of sales into Apple's coffers last year--and wouldn't be such a success if it weren't tied to Apple's digital jukebox, iTunes. The iTunes Music Store has sold more than a billion songs online in the past three years.

We know what you're thinking right about now: If there's a boom underway, then the Wall Street crowd must be fixing to sell us something. After all, we've been down this path before. But the investing landscape is very different this time.

Sure, early-stage investors (endearingly called "angels") and venture capitalists are indeed breathing air into something of a bubble for the so-called Web 2.0. (That's a catchall name for the blitz of companies running websites like del.icio.us and Writely that make it easy for users to create their own content online and then share it with others.)

In Boom 1.0, any company with buzz and a business plan rushed to go public long before it had any profits. Now standards for IPOs are higher. And with tough reporting requirements imposed by the Sarbanes-Oxley corporate-governance law, fewer companies are even attempting to go public.

Another crucial difference for investors: Today's Net stocks are far more reasonably priced than the highfliers of the dot-com era. For instance, at $400, Google trades for about 33 times Wall Street's estimates of 2007 earnings of $12 per share. That's rich but hardly stratospheric. Compare that with shares of Internet Capital Group, which at their peak in 2000 traded for well over 400 times the company's 2001 sales.

Exuberance unquestionably has returned, but with a dash of rationality. "Last time people just dove in and forgot to check to see if the pool was full of water," says Lise Buyer, a former Wall Street analyst and later an investor-relations executive at Google. "This time people understand the concept of the businesses and can look at the financials."

Yet even if many things are different--i.e., saner--this time, you still have to follow the basic rules of sound investing. Don't buy a "story" stock if you don't understand the story. Don't invest just because you heard a pick on TV--or, dare we say, read it in a magazine. Look for profits, sound financials, and reasonable prospects for growth. Pay attention to valuation. Make sure you know the bear case--the arguments against buying the stock. And most important of all, devote only a small portion of the cash you're investing to a hot area like Internet stocks.

With these maxims in mind, we set out to find the best ways for investors to participate in the new Net boom. Even if you have no intention of committing fresh money, understanding this landscape is an increasing imperative for every investor and every business. A company doesn't have to be a dot-com or a "Net stock" to be a beneficiary--or a casualty--of this boom.

We looked at five key areas: big tech, pure Net plays, infrastructure firms, broadband providers, and media conglomerates. In the end we identified seven stocks--as well as three mutual funds--that seem poised to profit.

The Internet giants

Any discussion of investing in the new Net boom naturally begins with Google. No one argues that Google isn't a fantastic business. The company is on track to earn $3.7 billion next year on sales of $9.5 billion. That's about nine times the profits and three times the revenues it had in 2004, the year it went public.

The company makes almost all its money from Internet search ads, and its U.S. market share is at 42% and growing. "We're in this amazing gold mine of search advertising," says Google CEO Eric Schmidt.

If Google's so good, it has to be a buy, right? Not necessarily. Google, the stock, has several things against it, starting with its high valuation and high expectations. The company's own chief financial officer has acknowledged that the law of big numbers--the added volume needed to make a big firm even bigger--will eventually slow Google down.

And the company's refusal to give detailed financial guidance to Wall Street has led to wild ups and downs. In 2006 alone, Google has traded as high as $475 and as low as $331, a swing of $43 billion in market value, or nearly what McDonald's is worth. Says Arnold Berman, technology strategist for Cowen & Co.: "Each quarterly report is a massive nail biter from here out. It will be a back-and-forth stock for the rest of 2006." (Google's next nail-biting event is its April 20 report of first-quarter earnings.)

The more reasonable option for value-conscious investors is Yahoo (Research). Very much a media company, where Google emphasizes its technology roots, Yahoo has similarly benefited from the tsunami of online advertising. But unlike Google it has struggled in the lucrative search area--and that may provide the opportunity for investors.

If the company can improve in search (and it has a crack team working on the problem), the potential upside is dramatic. Especially considering Yahoo's price: It trades at 15 times its estimated 2006 earnings before interest, taxes, depreciation, and amortization, about two-thirds of Google's Ebitda multiple. That's the kind of valuation you would give a newspaper company, not a Net powerhouse, says UBS analyst Benjamin Schachter, who thinks Yahoo's shares--recently around $31--could hit $39 within the year.

Indeed, Schachter speculates that if Yahoo stays cheap for much longer, Microsoft might even buy it, a megadeal that would rock the online world--and reward Yahoo investors.

The smaller fry

What about those superhot user-driven web sites that are attracting legions of fans? Many, such as YouTube and Facebook, aren't public--and if they were, might well be wildly overpriced. The truth is that these kinds of buzz-worthy names tend to offer the worst risk-reward profile for individual investors; it's too easy to mistake cool for profitable.

The best opportunities often come from targeted niche players like Navteq, a Chicago software maker that is one of the brains behind Google Maps. Navteq (Research) shares have doubled since the company went public in 2004 (the same month as Google), but not because of its Internet business.

It gets three-quarters of its revenues (which totaled $500 million last year) selling mapping databases to companies that make global-positioning system, or GPS, devices for automobiles. It's a rewarding business, enabling Navteq to maintain 27% operating margins and 20%-plus earnings growth. But Navteq also supplies data to the most popular online mapping sites, including AOL's Mapquest, MSN, Yahoo, and Google.

"We're only in the second or third inning of this as a growth company," says Henry Ellenbogen, a fund manager at T. Rowe Price, which is Navteq's second-largest shareholder, with a 9.6% stake. Ellenbogen reckons that onboard navigation is just starting to take off in cars, and that online sites, currently a small portion of Navteq's business, are an untapped opportunity. "It's almost as if you're not paying for this Internet growth option," he says.

The suppliers

During the last web frenzy, some of the most successful players were the so-called arms dealers in the Internet wars. Companies like Dell, Microsoft, and Juniper all benefited because PCs and routers went hand in hand with the growth of the web.

That rationale remains compelling in the new Net boom--but that doesn't mean those big-cap stocks are screaming buys. Profits at Dell, for example, have jumped smartly in the past five years, but the stock chart remains a flat line because valuations were so high at the peak.

One web enabler that's roaring again--and, given its size and position, may well be able to keep up the momentum--is Akamai Technologies. Akamai (Research) was one of those bubblelicious companies that investors probably never understood. Shares ran up to $345 in 2000 on revenues of $90 million and profits of zero; two years later they traded as low as 56 cents.

Throughout, the Cambridge, Mass., company kept doing pretty much the same thing. Using a vast network of servers and software that connect to customer web sites, Akamai speeds up the delivery of web pages. Marquee customers include Microsoft, Apple, and Yahoo.

The more downloading people do, the more valuable Akamai becomes. It turned profitable in 2004 and earnings growth has accelerated since then. Trading at about 44 times Wall Street's estimates for 2006 earnings, Akamai isn't a bargain; its stock has doubled in seven months. But every time another major media conglomerate announces a plan to offer free downloads from its web site, odds are that Akamai is ringing the cash register.

One company that has kept right on raking in the cash, but without getting much credit, is Cisco Systems (Research), the most important supplier to the web's first growth spurt. Cisco's profits have more than doubled since 2002 (it made $6 billion last year on sales of $25 billion), but its stock was stuck for four years.

Cisco's impossibly high valuation during the bubble is partly to blame. Then, after an initially giant comeback from the bust, Cisco's earnings growth rate plunged as corporations concluded that they had bought all the routers they needed.

Times are about to change for Cisco, and the new developments on the web are the reason. Cisco just bought Scientific-Atlanta, the big maker of cable set-top boxes. The strategic shift reveals Cisco's plan to be as important to video-over-the-web upgrades by cable and phone companies as it was last time for big businesses.

"This positions Cisco favorably not only as a core network provider but also in the home," says A.G. Edwards analyst Aaron Rakers. Cisco's shares have begun moving again as investors have noticed how cheap they'd gotten. But at $21, Cisco is trading at about 20 times what it will earn in 2006, compared with 25 times for its peers. Rakers and other analysts see Cisco's earnings finally accelerating. And Cisco's main business is healthy as well.

Another well-positioned company is an old software warhorse, Adobe Systems (Research), maker of the popular programs Acrobat and Photoshop. Adobe's bid for Web 2.0 greatness is its $3.4 billion acquisition last year of Macromedia, whose Flash software is behind some of the web's coolest applications--everything from the drag-and-drop stock charts on the new finance site at Google to the free videos bands are using to promote themselves on MySpace.

At $37, Adobe's stock is 10% off its recent peak. That presents a buying opportunity. When the company finishes weaving its products together with Macromedia's, it will have a one-stop shop for content designers, and its revenues should accelerate.

"The market is playing a shorter-term game with Adobe right now," says Jeff Rottinghaus, manager of T. Rowe Price's Developing Technologies fund. "But this is such a high-quality business, and the combination of those products is going to be real powerful."

Broadband providers

One of the buzzwords of the new Net boom is "triple play"--the selling to consumers of bundled broadband web access, TV programming, and telephone service (often using voice-over-Internet protocol, or VoIP, in geek-speak).

AT&T's $89 billion acquisition of BellSouth has helped direct much of the hype toward the big phone companies. As a result cable stocks are hated right now. There's no question the phone-cable competition will be fierce. What's in doubt is how quickly the phone companies will get in the game--unlike the cable firms, they need to build new infrastructure to offer video programming.

For investors the bargain-priced opportunities are among pure-play cable firms. Comcast president Steve Burke recently told a gathering of investors that by 2010, Comcast will have between eight million and ten million phone customers, up from 1.3 million today. By contrast, he estimates that over the same period the phone companies in the regions where Comcast operates will have one million video customers.

Yet the negativity surrounding Comcast (Research) is extreme. The stock, in the words of UBS debt and equity analyst Aryeh Bourkoff, is "priced for destruction." The last time Comcast's stock was this low--at $28, it trades for about seven times cash flow--was during a company credit crisis. Now it's too cheap to pass up.

Old media

Each of the thought leaders in the four most important entertainment categories today--Apple in music, Pixar in movies, Google in advertising, and Electronic Arts in videogames--is based in Silicon Valley. So it's no surprise that the four biggest media conglomerates--Disney, News Corp., Time Warner, Viacom--are grappling with the repercussions of the new Net boom.

Disney's stock popped 17% this year after new CEO Bob Iger agreed to buy Pixar for $7.4 billion in January and put hit shows first for sale on iTunes and then for free on the web.

Yet how much do new media initiatives affect the bottom line at huge old media firms? Consider Rupert Murdoch's News Corp. Investors--and nearly all of Silicon Valley--chuckled when it bought the youth-oriented site MySpace.com last summer as part of a $580 million acquisition of Intermix.

Since then the site has zoomed from 32 million users to 65 million, and it soon should overtake Yahoo as owner of the web's biggest audience. Yet that audience produces little cash flow. UBS's Bourkoff assigns the company's Internet operations, of which MySpace is only a part, just 43 cents of his $22-a-share overall valuation of News Corp.

The long run, however, will doubtless be different. And what the acquisition shows is that "Rupert Murdoch is seeing things clearly," says Bourkoff. Among the big-media conglomerates, the newly slimmed down Viacom is just building an Internet strategy, and Time Warner has yet to prove that AOL isn't a declining asset.

Disney, while showing signs of life under Iger, is no longer the bargain it was before this year's share run-up (and the price it paid for Pixar may end up a longer-term drag). News Corp. (Research) is largely done with a billion-dollar-plus Internet buying binge, and while MySpace is a less-than-ideal ad environment (scantily clad teenagers present a challenge for wholesome marketers), revenue there certainly will skyrocket. The rest of News Corp.'s highly profitable operations, meanwhile, seem moderately priced at their current $18 level.

The fund options

Considering the perils of Net investing, you may want to hire a mutual fund manager to do your stock picking for you. Our first suggestion isn't a Net head or even a tech jockey, but he's one of the most astute stockpickers around: Bill Miller, manager of Legg Mason Value Trust.

Miller is famous for topping the S&P 500 index for the past 15 years--the longest streak going. He also has a real knack for spotting Net winners. Indeed, while the fund, classified as a large-cap blend by Morningstar, owns traditional blue chips like J.P. Morgan Chase and Aetna, it's gotten a lot of its pop in recent years from Net plays like Amazon, eBay, and Google, all of which are among its top ten holdings.

At the other extreme from Legg Mason Value is a pure Internet fund like Jacob Internet. Manager Ryan Jacob focuses on web-centric small caps and microcaps. And he's been on a tear. After losing 79% in 2000, the fund has earned an annualized 19% over the past five years and 47% for the past three. Among its drawbacks are its high annual expenses (2.64%) and concentration in the riskiest niche of a volatile sector.

A third option is a more diversified tech-sector fund. One standout is Fidelity Select Technology, managed by James Morrow, which has earned an annualized 21% for the past three years. Its big holdings include tech stalwarts Microsoft, Dell, and Cisco, plus Google.

Then again, with Google recently having been added to the S&P 500 index, the odds are you're already invested in the new Net boom and didn't even know it. So enjoy the ride. But don't let your guard down.

REPORTER ASSOCIATES Doris Burke and Eugenia Levenson. Additional reporting by Jon Birger, Oliver Ryan and Corey Hajim.