The Internet's Big Three

Why would this be? It seems apparent to me that investors are doing a poor job of predicting Internet company earnings and revenues and, as a result, their valuation models are turning out to be off the mark. The companies themselves aren't yet mature businesses, so their growth rates can gyrate from quarter to quarter. As an owner of all three stocks, I've been watching market reactions to the earnings releases fairly carefully now for more than a year. Last week, Google and Yahoo surprised on the upside, and eBay disappointed. The previous quarter, it was exactly the opposite: eBay surprised with positive results, and Yahoo and Google were both punished severely. Each time this happens, analysts redo their calculations, and so far they have overreacted, setting investors up for another round of surprises.

While I'm a long-term investor in the Internet stocks, this pattern has generated a series of trading opportunities. Last quarter, suspecting a typical market overreaction to the latest earnings, I sold eBay calls into the ensuing rally and bought Yahoo calls as Yahoo stock fell, as I explained in an earlier column. When Google plunged, I sounded the call to buy shares, comparing Google's trajectory to the early days of Cisco Systems (CSCO) and Microsoft (MSFT). When Google shares subsequently surged on news that it was being added to the S&P 500, I sold some calls. How are my bets faring?

The big winner has been Google. Earlier this year, after Google suffered its first earnings disappointment and shares plunged, I confided in some friends that I "had to find another Google." That's because my Google position alone ensured that I had significantly outperformed the major averages in 2005. But at the rate things were going, Google was going to guarantee that I underperformed this year. Now it looks like my "other Google" was, in fact, Google. The stock is up $100 since I recommended it (and bought more for my account), which is a nearly 30% gain in just four weeks.

True, I hedged my bet somewhat by selling calls when Google jumped after the S&P decision. Those September 420 calls I sold for $20 each are now trading at $50, just three weeks after I sold them. I may have to deliver those shares in September, but if so, I'll still have a nice gain.

And September is a long way off by options time horizons. How much higher can Google go? I wouldn't want to hazard a guess, but the recent earnings, while very strong, gave me some cause for caution. While profit surged 60% and market share increased, the growth rate has slowed, just as Google's chief financial officer had predicted (which at the time caused another selloff in the stock). Capital spending was surprisingly high. I think that's fine for the long term, but could hold investor expectations in check for the next few quarters. With Google trading this week in the neighborhood of $440 (the break-even point in my options experiment), the stock strikes me as fully valued.

In contrast to Google, both eBay and Yahoo have been caught in a widespread Internet downdraft, with both stocks down last quarter regardless of their earnings, even with Yahoo's 7% jump on the earnings news. So my options, both of which expire in July, have declined. But in relative terms, my bet is paying off. The eBay $50 calls I sold are now all but worthless, and on most days no longer trade. It looks like I'll be keeping that money. The $35 Yahoo calls I bought have dropped to $1.25, and with Yahoo shares at about $33, this could be a cliffhanger as to whether they'll finish in the money.

Following my previous pattern, I would now sell some Yahoo calls and buy eBay. EBay certainly looks cheap at these levels. But Yahoo, too, strikes me as undervalued. Prices of both stocks may have been impacted by the fact that the earnings results for the first time reflected the cost of stock options, so comparisons to prior years looked worse than they would have on a comparable basis. I'd buy both on further weakness. Google has always expensed options, so that wasn't an issue. Selling Google calls is also a strategy I'd recommend. The September 450s were recently trading at $34.