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December 11, 2006 8:45 pm

Focus on winners when riding volatile web wave

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The internet economy resembles the economy of any emerging market. It has a lot of volatility, spurts of huge growth with the inevitable pockets of slowdown before growth resumes, crazy valuations, and a cesspool of crime, murder, and corruption. I’m kidding on that last part but, with all the vitriol still directed at the “bubble”, you would think at least a radioactive poisoning happened to some dotcom executive back in the day.

But nothing of the sort happened, and now the internet is due for more double-digit growth across the categories most important for this discussion: online advertising dollars and online retail sales.

The question is, how much is too much to pay? For instance, did Google do the right thing in buying YouTube for $1.65bn and how can we use that knowledge to buy some more stocks now?

I think the management of Google is thanking it various gods that it was able to get away with paying so little for YouTube. Basically, for the mere price of 1 per cent of its company, it now has a lock on online video for the foreseeable future.

Here is the conversation it could be having. “The internet is only going to keep growing. Bandwidth is going to get wider and cheaper. The tools for making video are going to become easier and easier. What happens, for instance, when people wirelessly send videos from their cameras, while they are on vacation, up to their YouTube pages so people can view them immediately? It is going to happen, advertisers will pay for it, and we, Google, will dominate the world!”

Compete.com, like Nielsen/Netratings, has various tools for measuring internet statistics. It just released the most recent November data on the most popular websites. This makes it possible to pinpoint sites with advancing traffic and the sites with declining traffic. I am willing to bet that a long/short trade made up of going long the most popular websites and going short the declining guys would be a reasonable bet.

We know, thanks to a recent e-marketer study, that online ad growth is going to exceed ad growth for all of the other media categories. Online ad spending as a percentage of total ad spending has gone from 4.7 per cent in 2005 to 5.8 per cent in 2006 and is expected to reach 8.6 per cent by 2009. Every other category, with the exception of outdoor billboards, has been going down. Newspapers went from 29.8 per cent in 2005 to 29.1 per cent in 2006; magazines from 13.3 per cent to 12.9 per cent.

In terms of dollars, online ad spending has gone from $18bn in 2005 to $24bn in 2006 and is expected to hit $42bn by 2009. In order for the Google/YouTube deal to make sense (and the same logic can apply to any new start-up or M&A deal in the internet space) only a small slice of those ad dollars needs to go to YouTube for this deal to pay for itself.

So what stocks should we go long? Yahoo is first with 117m users, not to mention Geocities (owned by Yahoo) in the number 19 slot with 21m unique visitors during the month of November. Yahoo’s attempt to monetise those users through its Panama product is currently valued by Wall Street at about $0 after delays forced it to push the launch back into 2007. This will change once people realise that the product works, the new acquisitions by Yahoo (Delicious, Flickr, Bix, etc) are great, and that Sue Decker is a quality executive who will shine in her new role.

Google is second, coming in at 108m users. It is probably the best company in the world, so I am not a big fan of shorting it as a hedge against going long other internet stocks. Google is the best. Do not try to fight it.

Time Warner is third (Aol.com with 107m users) and eighth with mapquest.com at 48m users. People are finally starting to realise that AOL is worth something but I think they will still be surprised when Time Warner finally spins AOL partially off to the public. Google valued it at $20bn a year ago when it put $1bn in. My guess is that the market values it at $40bn-$50bn when all is said and done. Meanwhile, Time Warner, even at a multi-year high, is trading cheaply at 10 times earnings before interest, tax, depreciation and amortisation.

Microsoft is fourth (msn.com), sixth (live.com), ninth (Microsoft.com), and 17th (passport.net). Don’t forget Vista and Office are being released next year and the company is trading at only 13 times ebitda.

Then we have Ebay trading below its full potential thanks to the horrible acquisition of Skype, Newscorp (seventh with myspace.com ) and Amazon .

And who should we short? Expedia falls off the list as online travel gets commoditised. Monster.com went down as well. Craigslist, Yahoo’s jobs and 100 niche job-hunting sites are all competitors.

Focus on the winners, ride the strong demographic tidal wave that is rolling in, and surf the inevitable volatility.

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