BUSINESSWEEK ONLINE : AUGUST 16, 1999 ISSUE
NEWS: ANALYSIS & COMMENTARY

The Great Net Stock Sell-Off
Now, investors want more than just a ''dot.com'' before they buy

This summer, Internet stocks have taken their worst beating since the Net craze started. Dozens of Internet stocks, such as TheStreet.com Inc. (TSCM) and Marketwatch.com, are hitting new lows. The most widely held stock in the group, America Online (AOL), is down almost 32% since July 9, and other cyber blue chips, such as Yahoo! (YHOO) and Amazon.com (AMZN), have also suffered similar slides. Initial public offerings of dot.com shares are also suddenly sinking, rather than soaring at birth. Overall, the sector as measured by the Goldman Sachs Internet Index plunged almost 30% between July 9 and Aug. 4, and now stands nearly 43% below its all-time high in April.

To some observers, this looks like the long-predicted puncture of the Internet bubble. ''This is a real liquidation, not just trading action,'' says Patrick Manning, a technology portfolio manager for hedge fund Perry Partners in New York. ''We're entering a period where there's heightened discrimination on the part of investors of what they will buy. Over the next five years, more than half of the companies that have gone public will likely be out of business.''

That may be extreme. But the signs of a possible shakeout are there:

-- Companies ranging from eBay to theglobe.com have turned in disappointing revenues or exceeded expected losses.

-- Once-profitable companies such as CNET are deciding to go into the red as they plow money into massive marketing campaigns to grab ''eyeballs.''

-- Online retailers are slashing prices to keep volume up, cutting into earnings or postponing profitability.

-- Internet brokers may face the first-ever decline in trading volume in the third quarter.

-- Four Net IPOs launched on Aug. 4 fell below their offering prices, despite expectations that at least a couple would sell at lofty premiums. The average Internet IPO this year is off 18% from its opening price.

-- Statistics about Web traffic indicate that growth may be slowing, particularly in the number of consumers going to ''portal'' sites.

The good news is that few people are predicting much more of a decline from here. But the ranks of Net skeptics are swelling rapidly. ''First-quarter Internet results were spectacular,'' says Steven Shapiro, president of the technology fund Intrepid Capital Management in New York. ''But in the second quarter many of the marquee companies' growth rates slowed, and management talked about widening losses ahead.''

Perhaps the biggest chill has come from the slowing of revenue growth. In an industry where earnings are scarce, investors have used revenue momentum as a gauge of value. Now that needle is wobbling. Take Amazon.com Inc. Revenues are still expanding, but its growth rate has been cut in half. At the same time, Amazon has unveiled plans for increasing spending--and losses--over the next six months as it builds up its warehouses and distribution centers and pushes into new lines such as toys. According to First Call Corp., analysts now expect losses of $1.84 a share for the year, up from an earlier consensus of 91 cents.

Amazon's troubles, analysts conclude, foreshadow similar problems for rivals. Says Frederick R. Kobrick, head of Kobrick Funds: ''When Amazon said it would be spending a lot more, that was a message to everyone that business on the Internet would be a lot more competitive and costly. A shakeout has to occur.''

Meanwhile, America Online's growth is declining. Its subscriber base grew by 4.5% in the second quarter, to 17.6 million, but that was down from 11.9% in the prior quarter. And Paul Cook, lead portfolio manager at $2 billion Munder NetNet fund, says he's concerned about AOL's challenges in Europe.

At eBay Inc., a 22-hour outage on the auction site in June caused revenues for the second quarter to fall short by $5 million. And for the first time, the company seems headed for an operating loss in the third quarter because eBay feels the need to spend more to generate growth. ''There's some concern that the company is growing past its limits,'' says Cook.

High flying community-site theglobe.com actually did better than its estimates on Aug. 3. Instead of the expected 32 cents loss, the company reported a 27 cents loss. Since April, the company's market capitalization has slipped from over $1 billion to around $320 million.

Revenue decline isn't the only factor that is worrying Net analysts and investors. Instead of more profitable Net companies, there are fewer. CNET Inc. announced in June that it's launching a massive ad campaign to bring more consumers to its site, which will take it into the red. Its stock has since dropped by 62%. E*Trade, a once-profitable company whose stock is off more than 67% this year, is also now losing money because of its advertising spending. Meanwhile, on Aug. 3, Credit Suisse First Boston analyst Bill Burnham predicted that online-trading volume would decline this quarter. That cast a pall on E*Trade and other online brokers.

S. Jerrold Kaplan, CEO of Internet retailer Onsale Inc., admitted that when Onsale charged higher prices to its customers, its revenue growth slowed. So during the most recent two quarters, Onsale has seriously lowered its prices. Not surprisingly, the company has achieved a 20% growth rate in the most recent quarter as opposed to its previous 15% rate. But Onsale's margins have dropped from 8% to 3%. ''We are being competitive on pricing in order to maximize the likelihood of continued high growth,'' says Kaplan.

Then, there are those storied Internet IPOs. Now, they're following a different plot line. The deals are still coming. About 40 Net IPOs were launched last year. This year, 125 had been launched by Aug. 4, and 100 are registered to go public before yearend. But the poor performance of the Net IPOs since Net stocks began their plunge bodes ill. Says Christopher R. Ely, portfolio manager for Loomis, Sayles & Co.: ''It looks bad. Real bad.'' He adds: ''Institutions are stepping back and asking what is this really worth?'' So, too, are investors apparently.

Internet companies insist that the outlook for the industry remains unchanged. One sign: On Aug. 3, VentureOne Corp. reported that $3.8 billion had gone into Net companies in the second quarter, more than half of the total venture capital invested in the period. Still, some investors are betting that the growth rates are slowing. ''We have left the parabolic growth phase of the Internet. There's a hell of a lot of people online already,'' says Patrick Manning. ''The growth in users coming online is slowing significantly and will be much more closely linked to the growth in PC sales which is about 15%. It's hard to say where the bottom is, but it doesn't look like it's bottoming yet.''

The Internet stock boom isn't going to turn into a bust, at least not soon. But recent market jitters are giving Wall Street--and Silicon Valley--a healthy scare.



To read a correction/clarification about this story, click here and here.

By Debra Sparks, with Jeffrey M. Laderman, in New York

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