In recent days, the financial press has been filled with stories regarding the fifth anniversary of the current bull market. The market bottom came in on March 9, 2009, and few would have guessed that the next half-decade would bring such terrific market action.
Yet March 9 also stands out to investors for another reason: Back on March 9, 2000, the Nasdaq Composite Index hit 5,000 for the first time ever. A few days later, the index went into freefall, eventually moving below 1,500 a few years later. (In a potentially eerie parallel, the Dow Jones Industrial Average has closed lower in each trading session since March 9, 2014.)
The reason for the demise of the Nasdaq in general and dot-com stocks in particular back in 2000: Valuations had become disconnected from the fundamentals. There was simply no way to justify stock prices in the context of sales or profits, and many investments became known as "story stocks."
More than a decade removed from the dot-com bubble, it's easy to forget that painful lesson. But you shouldn't. This chart shows us that another bubble appears to have formed -- and once again, it involves dot-com stocks.
While the SP 500 Index has risen a very impressive 150% over the past five years and the Nasdaq has racked up a 200% gain, a basket of leading Internet stocks are up more than 400%. That works out to be a roughly 70% annualized gain.
This Time Is Different (?)
The reason why few investors are talking about a dot-com bubble right now is that the current group of dot-com stars have solid revenue platforms and are positing impressive growth rates. The dot-com stars of a decade ago were often constructed to satisfy investment bankers and desperate IPO investors.
Yet after a 400% gain for this group, it's important to pause and see if we can draw a connection between the fundamentals and current valuations.
For starters, you can throw out bubble talk on any company that has proven its ability to generate high levels of free cash flow (FCF). That excuses Google (Nasdaq: GOOG) from the room, as it has generated more than $10 billion in FCF for each of the past three years. (For this discussion, I am also excluding Yahoo (Nasdaq: YHOO), whose valuation incorporates a large stake in China's Alibaba.com.)
Most of the rest of the Internet camp can be broken into two groups: mature businesses and younger upstarts.
Let's take a look at eBay and Priceline to see if they are in a bubble. First, are these companies growing at a solid clip and are they expected to continue doing so?
Revenue Growth Rates
The ability to maintain double-digit growth for the foreseeable future is impressive. International expansion gets much of the credit. Yet these forecasts aren't baked in: eBay's PayPal division is the high-growth engine, yet emerging payment platforms from Square, Google and Amazon aim to take market share. Priceline, for its part, is expecting to see a deceleration in growth, largely due to market saturation, and newly popular apps such as Hotel Tonight bear close watching.
Are these two stocks overvalued? Let's look at how they are valued in the context of UBS' 2016 financial forecasts:
The key conclusion: These stocks aren't in a bubble, but their valuations are quite rich.
Priceline is a very impressive company with gross and operating margins in the stratosphere. Yet shares trade for almost 20 times projected 2016 FCF, and FCF is unlikely to grow at fast pace beyond 2016. Shares of eBay sport lower multiples, and are likely close to fair value -- unless Paypal starts to see some market share erosion.
OK, so no bubble here -- but what about the dot-coms that went public in the past few years, all of which have racked up an impressive post-IPO performance? Let's start by again looking at projected growth rates:
Revenue Growth Rates
This table neatly summarizes the lifecycle for these stocks. They grew at a torrid pace in 2011 and 2012, are still posting very good growth rates right now, and will see growth rates decelerate in the next few years. It's nearly impossible to know how these companies will be growing in 2017, but it will surely represent further deceleration as the Laws of Bigness take root.
To be sure, these stocks are trading so robustly because growth right now is extremely good. Still, it's fair to see what that growth will do for them in terms of profits and cash flow by 2016.
The fact that every one of these stocks trades for more than 30 times projected 2016, FCF tells you that investors aren't concerned about these firms' ability to create real shareholder value. It's understandable to take that approach in recent years as these companies are in high-growth mode. But there is no reason they shouldn't be cash cows by 2016, especially since their gross margins are so impressive.
How long until these companies stop getting a free pass? As noted earlier, companies like Google have always managed to focus on revenue growth and solid cash flow. It's not a trade-off that investors should have to swallow. The real alarm bells for these stocks will go off when analysts start to look beyond the current high-growth phase and see what kind of cash flow these companies will generate later this decade. That could signal a deep reckoning for these stocks.
Risks to Consider: As an upside risk, the market could deliver another year of double-digit gains, leading short sellers to throw in the towel on these richly valued stocks.
Action to Take -- We're unlikely to experience another dot-com meltdown like we saw in 2000, simply because these are real businesses with real customers. But these companies still have much to prove in terms of FCF generation -- and at least a few of them will see their shares tumble once that challenge becomes more apparent.
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