Technology

Some Faint Signs of Life at Net Incubators


By Amey Stone It might seem like a harbinger of a cold, snowy spring: Pasadena (Calif.) Internet incubator idealab! (which backed eToys) announced on Mar. 7 that it is shuttering its Silicon Valley operations. But hold on. The truth is that the big, publicly traded Web incubators, including Internet Capital Group (ICGE), Safeguard Scientifics (SFE), and CMGI (CMGI), have all retrenched and seem ready to weather the dot-com winter for at least another year or two. That may not seem like much for investors to hang their hats on, but in the current depressed environment for Web startups, it's actually pretty good news.

ICG reported a dramatically reduced burn rate when it released fourth-quarter results on Feb. 21 and seems to have enough cash to get through three more years. In its Feb. 22 statement on fourth-quarter results, Safeguard said it had the cash to last through 2002. And CMGI, which is in the midst of a restructuring and has frustrated Wall Street by being unable to say much about its future burn rate, declared on Feb. 12 that it had $970 million in cash on hand. It will say more when it releases quarterly results on Mar. 13.

Only a few months ago, these publicly traded Web conglomerates didn't look half so hardy. Comprised of dozens of money-losing startups -- and with little opportunity to raise more money or take private holdings public in a dead Net IPO market -- they seemed all but doomed.

NOWHERE BUT UP? But bad news has a way of focusing the mind. With stock prices in free fall, CMGI and ICG are in the midst of plans to sell, shut down, or combine their most troubled units and stick with the holdings that have the best shot at making it. As ICG CEO Walter Buckley puts it, the goal is to become, "a smaller but stronger group of companies."

"Right now they are in survival mode and hoping they can get through the downturn before they run out of money," says Chris Nerney, senior analyst for Internet.com. Can they? Well, says Nerney, "that all depends on how long the downturn lasts."

At least one Wall Street analyst, Charles Grom of Salomon Smith Barney, was brave enough to go out on a limb in mid-February and initiate coverage of ICG and CMGI -- a positive in itself since it's a sign the firm believes these stocks will be around for a while. "We did get some calls" from skeptical clients, admits Grom, who barely endorsed the companies. ICG earned a "venture accumulate" rating and a $7 price target, which translates roughly into a recommendation to maybe start thinking about buying the stock at some point in the future -- if you're brave enough to try venture-capital-style investing in the current market. He rated CMGI only "venture neutral" and gave it a $6 price target, which essentially means: Don't even think of buying this one right now.

"It's just our gut that these things have reached a floor," says Grom. "All the bad news has been priced into them." Both CMGI and ICG traded around $150 a year ago and now are around $4. Safeguard, a company with a much longer history, has fallen at a slightly less precipitous rate, from $100 to $8 in the past year.

Given how high investors' expectations were for CMGI, its fall is remarkable even among Internet companies right now, says Nerney: One of the Web's darlings in 1999, CMGI's 96% drop in 2000 sharply exceeds the 58% decline for Internet.com's index of Internet stocks.

PREMIUM ON PATIENCE. Grom doesn't expect these stocks to bounce back until the market for Internet initial public offerings comes back from the dead. "If you're looking for a turnaround in two to six months, you're not going to get it here," he warns. In 9 to 12 months, however, Grom thinks there could be some upside.

But with reduced burn rates and lots of cash, these companies seem to have a new confidence that they can stay afloat until the environment for Internet startups improves. "We have a very strong group of companies that are providing real value to customers and are going to grow into very large substantial businesses," says ICG's Buckley, pointing to 260% annual revenue growth at the 16 strongest companies ICG has stakes in.

"We've made tremendous progress against our plan," says Bill White, executive vice-president for marketing at CMGI. He points out that the company has reduced its core holdings from 17 to 12. "We've made a lot of progress in a relatively short period of time," he says.

FAULTY THEORY. And with $201.5 million in cash as of Dec. 31, 2000, Safeguard Chief Financial Officer Gerald A. Blitstein was able to point out, in the 2000 yearend statement, that "throughout its history, Safeguard has never begun a year with more cash on its balance sheet as it has in 2001." Safeguard executives could not be reached for comment.

Even if they can weather the hard times, the idea behind Internet incubators has taken a severe hit. The theory was that startups would benefit from being part of a large network of companies working together. That's still the goal: "We're providing a family of companies with a backing that includes knowledge-sharing, financial resources, and other effectiveness-generating resources," says White. But as the incubators dump failed holdings and the stock prices of their strongest fall through the floor, there isn't much of a cushion. For example, ICG has VerticalNet (VERT), now at $1 from a high of $95.

Investors, the 1999 theory also went, would benefit both from the holding company's skill at selecting the most promising companies and some measure of diversification, since the holding companies comprised a basket of Web startups. Sorry, folks. As it turns out, these companies are really just vehicles to take advantage of a hot market for IPOs, which made them even riskier than your average Net stock. It's unlikely they will return to their former highs anytime soon.

Near-term catalysts for these stocks will be strong results for the companies the incubators have stakes in, says Grom. As with a venture-capital fund, for the entire company to benefit, "all they really need is 1 out of 10 to be a home run," he says.

SUM OF ITS PARTS. But that fact alone points to a major reason why most investors may want to stay away from these stocks. Getting a grip on the company's potential requires sorting through a lot of holdings. "Practically speaking, an incubator is only as good as the sum of all its companies," says Pat O'Neil, portfolio manager of the Loring Hedge Fund. That means all the bad holdings can dilute the effectiveness of the one or two good ones. Says O'Neil: "It adds more variables."

And since most of their holdings are private companies, it makes it virtually impossible for individual investors to see through the veil. In an environment this difficult for all Internet companies, "it's tough to say which startup has long-term potential," Nerney says.

For most investors, there's no mincing words: Internet incubators have been a short-term disaster, and it would be better to stay away. But for those who don't mind holding on until the market for Internet IPOs comes back, some investors may find encouragement knowing that these incubators aren't going quietly into the night. They'll be around for a while, for those with a taste for high risk and venture capital. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum


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