Pricing improvements? Taking the pulse of the internet space

In February, S&P Equity Analyst Scott Kessler raised his fundamental outlook on the internet software & services industry to positive from neutral, reflecting what he views as a stabilized global economy that would contribute to more overall advertising spending, an increasing percentage of related budgets being committed to the Internet (versus so-called traditional media), and pricing for associated online offerings that is showing signs of improvement.

U.S. online advertising revenues rose 11% in 2008 and 3% in 2009, and Standard & Poor’s projects increases of 12% for 2010 and 10% in 2010. Although Kessler believes the U.S. accounts for less than half of this market, he sees it as a good proxy for the rest of the world.

More people are spending more time online, as the costs of computers and access continues to decline and the Digital Revolution morphs into a sort of mobile millennium, with the advent and popularity of Apple’s iPhone, iPod Touch and iPad, as well as tablets, netbooks, and devices aplenty running on Google’s Android operating system and with its applications.

Moreover, Internet marketers can relatively easily conceive and create engaging campaigns, make extensive buys across various properties and platforms, target users based a multiplicity of criteria, and measure and analyze results based on data delivered in real time.

In a little more than six months after Scott Kessler became positive on the internet software & services industry, he thought it made sense to reconsider and recast his thesis – although he maintains his positive 12-month fundamental outlook.

Economies around the world have stabilized and shown growth, and Global Insight recently projected 3.7% growth in worldwide GDP for 2010, up from a projection of 3.2% in February. More marketing spending is happening online and on mobile devices, and the Interactive Advertising Bureau indicated U.S. growth in Internet advertising revenues rose 7.5% in the first quarter, while in mid-2010, Zenith Optimedia saw overall advertising spending rising only 1.1% in 2010. Associated advertising pricing has strengthened smartly, and according to GroupM, the consolidated media investment operation of WPP Group, this should continue as Yahoo’s transition to Microsoft search technologies at least temporarily reduces competition and increases uncertainties.

Perhaps not surprisingly, Kessler’s two top stocks picks in the Internet space are Yahoo and Google. However, his rationales for these recommendations are very different, even though both companies are large-caps that should benefit from more Internet users and usage, more Internet advertising spending, and strength in online marketing pricing.

Kessler thinks Google offers a compelling combination of growth and value. He sees revenue growth of 20% for 2010 and 14% for 2011, improving margins, and significant cash flows. Kessler also believes Google’s new Instant search offering, Android mobile ecosystem, and YouTube online video platform have been performing well and provide considerable opportunities for growth and margin improvement. Kessler also believe that the company’s outsized overseas exposure will benefit from recent strength in the euro and British pound. Google nonetheless trades at discounts to his Internet coverage universe based on 2010 and 2011 P/E multiples and P/E-to-growth ratios.

Yahoo is more of a turn-around story that offers deep value, in his view. Kessler’s investment thesis is focused on the company’s investments in Asia-based companies Yahoo Japan and China’s Alibaba Group that he recently valued at $9 per share. Although many know Yahoo Japan as that country’s dominant Internet entity (with offerings ranging from content and communications, to Internet access and shopping), they perhaps don’t appreciate that Alibaba is a holding company controlling the world’s largest business-to-business marketplace (Alibaba.com), China’s largest person-to-person e-commerce trading platform (Taobao), an emerging payments platform (Alipay), and a small-business management software provider (Alisoft).

Yahoo has also sold and outsourced nearly a dozen businesses and investments in a little more than a year, and has been focused on improving its content and applications, integrating more social platforms and features into its offerings, and better monetizing its extensive business and consumer relationships. Kessler thinks the company is positioned to execute better, with a smaller and more focused business and a solid management team.

Kessler thinks strength in online advertising pricing could also negatively impact two stocks he recently downgraded on which he has a Strong Sell or Sell opinion – Expedia and ValueClick. Expedia spends considerable capital on Internet advertising to promote its worldwide brands such as Expedia and Hotels.com, and ValueClick relies on online marketing to generate critical traffic to its sites.

Although these companies also sell online advertising and could benefit from the strength in Internet advertising that Kessler sees, he thinks overall current industry trends and dynamics constitute risks to these companies. He also thinks Expedia’s media businesses are too limited a part of that company to offset possible negatives associated with advertising price inflation, and ValueClick’s relatively small size makes it more challenging to keep up with larger competitors looking to generate site usage.

S&P’S RECOMMENDED INTERNET STOCKS

S&P employs a proprietary methodology for ranking mutual funds and exchange-traded funds (ETFs); rather than looking only at past performance, S&P also incorporates analysis of the underlying holdings and their likely future prospects, as well as risks and costs. Funds or ETFs that hold stocks viewed as undervalued by S&P equity analysts are more likely to get a high ranking from S&P’s proprietary quantitative ranking tool.

Of the more than 600 ETFs that S&P ranks, only two are seemingly focused on the Internet segment: First Trust Dow Jones Internet Index Fund (FDN 27 Underweight) and PowerShares NASDAQ Internet Portfolio (PNQI 28 Underweight). Why does S&P have an underweight ranking on these ETFs when S&P’s Internet equity analyst has a positive fundamental outlook for the industry? Both ETFs have limited assets and performance histories; also, both contain holdings with low average S&P STARS and S&P Quality Ranks.

“Despite a possibly appealing focus on the Internet, and some familiar holdings, these ETFs weren’t as attractive as might have been expected or hoped for,” says Kessler.

And two mutual funds specialize in the Internet industry and garner a high score in S&P’s ranking, which ranges from five-star (best) to one-star (worst).

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