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Tech Industry

Finding the bargain e-business investment

Technology stocks in 2000 have been volatile and weak, but what does this mean for e-business IT service companies?

After a strong 1999 performance, technology stocks in 2000 have been volatile and weak. Periodic pullbacks and skepticism are healthy for tech stocks, as they weed out the weaker businesses and attract further investment in the leaders.

So, what is the current tech weakness telling us about e-business IT (information technology) service companies? Were valuations too high? After all, the 30 e-business IT service companies my firm tracks are off by about 60 percent from their highs in late 1999 or early 2000.

E-business IT service companies provide business and technical electronic-business consulting, branding and creative design, and development, implementation and hosting of electronic-business systems.

While I believe some companies may have been overvalued, the industry's business fundamentals remain strong and trends continue to look favorable. The industry's growth will be a direct result of how much corporations and consumers increase their use of the Internet.

As is the case with any fast-growing, early-stage market, signs of a shake-up are emerging. However, strong first quarter earnings reports from the e-business industry should attract investors looking for bargains.

During the first quarter, key metrics such as average bill rate (the per hour rate these companies charge their clients for the services they provide); net billable employee adds (the number of consultants hired--an important factor because revenue is generally a function of the number of consultants working); and utilization (the measure of how many hours the consultants are actually billing during the period) are tracking at or ahead of my projections.

Revenues, however, are tracking lower than expected for almost all traditional IT services companies across the board. Traditional IT spending was hurt by a continued Y2K lockdown effect in the first quarter, which resulted in a weak January and soft February. March and April sales, however, picked up.

Investors need to consider several issues when shopping for bargains.

Keep a watchful eye on the customer base. Some of these e-business services companies have dot-com customers with business models that have yet to prove successful. A number of these customers also face new competition from bricks-and-mortar companies that have jumped in with both feet under their dot-corp units. Dot-com businesses that are failing or not receiving sufficient funding may pose a collections risk for the e-business services provider.

Investments in public Internet-related businesses seem to be dominated by momentum investors, who look less at fundamentals and valuation and more at stock price action. Even fundamental analysts may be caught up in momentum. It's not so much the momentum of a stock as it is events, particularly when due-diligence efforts indicate a company's business is strong.

Investors also should be wary of peer comparison. To say one stock is cheap because it is trading at one-half the price of its peer's shares can be flawed logic.

One way to check against these pitfalls is through valuation using discounted cash flow. Discounted cash flow is a technique used to estimate the present value of future expected cash receipts and expenditures using net present value (NPV) or internal rate of return (IRR).

Although discounted cash flow is a good method to use, it should not be the only one used. Use it in conjunction with other peer-based valuation measures, such as price to revenues and price-to-billable head count.

When calculating discounted cash flow, I also use a 10-year model for the companies. I think about how realistic my seven-plus-year assumptions are, relative to existing companies in the industry. Of course, many people shrug off such models, saying it is impossible to make such long-term projections.

Of course, there is a great degree of uncertainty in the projections. That's why tech stocks are so volatile. The benefit of doing the models, however, is that the underlying assumptions to growth projections and valuation become more transparent.

Smart investors, such as portfolio managers who lead the moves that momentum investors jump on or off of, are making such long-term projections and not blindly buying and selling without regard to valuation.

If an analysis of a company's long-term revenue outlook shows it will match the current revenue outlook of IBM Global Services or EDS, there should be compelling reasons that indicate how the company will get there.

If the stock price is hard to justify using discounted cash flow or economic value-added models, even with aggressive assumptions, it's time to questions whether the "peers" are overvalued.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker, Inc., Baltimore. He can be reached at wrloomis@leggmason.com. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security. Opinions expressed are subject to change. Additional information available on request.