Big Internet Call Out of Barclays – Ups Internet Rating

Alas, an Internet analyst who can think outside the box and hold onto big picture themes, in stark contrast to his brethren at other banks who are essentially spelling doom for Internet stocks. Barclays and former Lehman Brothers analyst Doug Anmuth upgraded the Internet sector to Positive from Neutral and upgraded a few names in spite of the current economic environment. He cites several criteria such as industry leaders, sound business models, free cash flow generation, organic growth, and strong management teams. With that he identifies Google, Amazon, Netflix, and Blue Nile as top picks. His rationale for selecting winners is sound and I agree with Google and Amazon but Blue Nile is a stretch. I will report on his analysis in subsequent posts but on the surface I am seeing that numerous offline jewelry retailers are going out of business and I don’t think their sales are moving online.

Investment Conclusion
We are raising our Internet sector rating from 2-Neutral to 1-Positive. We believe the Internet sector's underlying fundamentals continue to strengthen despite the clear near-term effects related to the macro environment, and to a lesser extent foreign exchange. We are also upgrading shares of Amazon.com and Blue Nile to 1-Overweight, and downgrading IAC to 2-Equal weight. While we can't judge the duration of the current macro weakness, we think it's time for investors to focus on quality—specifically, those sectors and companies that are positioned to come out stronger as the environment improves. We think the Internet group broadly and certain leading Internet names fit this criteria.

Summary
We have identified 7 key characteristics that serve as our framework for determining quality in the current environment: 1) company is an industry/franchise leader; 2) has a structurally solid business model despite being currently impacted by macro and foreign exchange; 3) has strong free-cash-flow generation and is mostly self-funding: 4) is a market share gainer; 5) has strong organic growth; 6) management is of highest quality and is execution oriented; 7) company has high ROIC, in excess of the cost of capital.
On this basis, our top picks in rank order are: 1) Google; 2) Amazon; 3) Netflix; and 4) Blue Nile.

We recognize that growth is slowing, but we believe the Internet still remains an area of secular growth and we are confident that both ecommerce and online advertising will re-accelerate when macro stabilizes. Importantly, we believe certain segments within e-commerce and online advertising may actually be widening the gap with their competition more during this recession than even if we were in a more favorable overall economic environment.

As in the last major downturn from 2000-2002, Internet activity continues to increase as the medium plays a more significant role in people's lives, and this increased usage and dependence should leave the Internet companies well-positioned when the macro
environment improves. The tailwinds of broadband penetration and search are not as strong now, but we are optimistic on international growth, mobile, video, and more targeted advertising.