Internet Meltdown, Phase Two


By Amey Stone Internet companies continue to disappear at an alarming rate, whether it's through bankruptcy, mergers, or "spin-ins" as corporate parents absorb failed dot-com units. Kozmo.com, Quokka Sports, and NBCi are just a few recent examples. With 28% of all Internet companies trading below $1 a share and burn rates accelerating as revenues slow, that number will grow through the next quarter, says Greg Kyle, president of Pegasus Research, which focuses on Internet investment research. He notes that the number of companies filing late to the Securities & Exchange Commission this quarter -- a sign of financial difficulty -- is up to 1,500, a 50% jump over this time last year.

Even the supposed success stories of the Internet continue to stumble. Yahoo! (YHOO) posted its first loss in two years, and revenue came in at about half what was expected only a few months ago. Procurement-software maker Ariba (ARBA) posted recent revenues at half what was expected as well. As companies run out of cash, "many models that could have been successful in 12 to 18 months just don't have the time anymore," says Eric Kintz, manager of the San Francisco office of consulting firm Roland Berger & Partners.

LONELY AT THE TOP. No longer do analysts talk of one or two winners in each category. It will just be a handful of really big companies and thousands of tiny smaller ones, predicts Sanford Bernstein analyst Faye Landes. W.R. Hambrecht analyst Derek Brown recommends only eBay (EBAY), Alloy (ALOY), Homestore.com, and FreeMarkets (FMKT). Homestore.com (HOMS) CEO Stuart Wolff, while confident, says he thought roughly 40 of 400 companies would survive. "Now, it's more like four of us," he says. "I'm feeling a little lonely out here."

Of course, some winners will emerge. "The pessimism has gone too far," says Chris Nerney, senior stock analyst at Internet.com, noting that 260 of the 361 Internet stocks he tracks trade below $5 a share. "It's easy to project out from what's happening and get ahead of the market." He looks for 50 to 100 companies to survive but concedes that it's hard to tell now given the weakness of the overall economy, especially the tech sector.

We're clearly in Internet Meltdown, Phase Two, where dot-com failures are being followed by a wholesale rethinking of the value of Internet technology. This seems to be taking the rest of the tech world -- and possibly the broader economy -- down with it. "The genesis of all our problems now really begins with the dot-coms," says Mark Zandi, chief economist at Economy.com, an economic consulting firm.

"LINES TO NOWWHERE." Many analysts sum up today's speedy downturn as the mirror image of the earlier ascent. It was the unprecedented growth at some of the early stars that created the excitement over the Internet's potential. After all, America Online increased its subscribers from 8 million in 1997 to 16 million in 1998, and Amazon.com built annual sales from $16 million in 1996 to $1.6 billion in 1999. In many ways, this spectacular growth fed the boom in the technology sector. Whether it was a desire to participate or the fear of missing out, traditional businesses spent big to keep up. Meanwhile, telecom companies borrowed billions to rapidly build out the networks.

"Part of the reason companies built fiber-optic lines to nowhere is all this supposed Internet demand, which is not materializing at the rate anticipated," says Chuck Hill, First Call's director of research. Jupiter Media Metrix research shows 89 million people tapped into the Internet in the U.S in March (out of a total population of about 280 million), growth of only 36% from March of 1999. Visitors to retail sites grew faster, up 68% in those two years, but still at only 63 million people. Total time spent online averaged just 20 hours that month, a 6% gain the past six months vs. high double-digit percentage increases a year ago.

When Internet stocks first started to melt down in early 2000, it would have been almost heresy to link Cisco Systems (CSCO) with their descent. The thinking then was that profligate Web startups were being punished for unworkable business models and greedy management but that the Internet buildout would continue as traditional companies embraced the Web -- and the giant maker of computer-networking equipment would continue to prosper.

"PRETTY SHELL-SHOCKED." It hasn't worked that way. Sure, the first dot-com stumble was a mere pebble in the ocean of tech spending. But now that Cisco has announced that demand for its router gear has dried up, it's clear that the ripples from the dot-com implosion are not only spreading but swelling. In the first decline in the company's history, Cisco's sales are expected to drop 30% from the prior quarter as Internet expansion stalls. The company is writing down $2.5 billion in inventory and cutting 8,500 in staff. "This may be the fastest any industry our size has ever decelerated," CEO John Chambers says.

March was particularly punishing. "The whole Valley was pretty shell-shocked at the speed and depth to which things dropped," says Scott Gordon, managing director of the Internet and technology practice for recruiting firm Spencer Stuart. Outplacement firm Challenger, Gray & Christmas says March brought a 66% increase in job cuts at Internet technology providers over February. It also counts more than 75,000 dot-com layoffs in the past 16 months. But it notes that the number of pink slips dot-coms handed out slowed in March, possibly because outfits that closed their doors didn't have anyone else left to furlough.

The overall picture for the tech sector has reversed in April. The Nasdaq is up nearly 30% this month. With the Federal Reserve's surprise half-percentage-point rate cut on Apr. 18, there's some hope that the worst of investors' pain is behind us. "Relative to where we were, it feels as if things have stabilized," says W.R. Hambrecht's Brown. "Not to suggest that the outlook is extremely rosy right now. But the sense of free fall and total lack of visibility has dissipated." But Darren Chervitz, head of research at Internet investment firm Jacob Asset Management isn't confident. "There's a real chance of it continuing to spiral out of control," he says.

TIME-LAG EFFECTS. Indeed, the aftershocks are still being felt. Every $1 of e-commerce revenue supported an additional $1.49 in related spending, estimates Internet strategy consultant Peter Cohan in his upcoming book E-Stocks. That $1.49 included 63 cents that went to Web consultants, 34 cents to venture capitalists, 18 cents to Web security companies, 17 cents to Web advertising, 14 cents to Web software and tools, and 3 cents to content providers.

It's hitting so hard now because of the significant time lag between different phases of the food chain, notes Cohan. First came the dot-coms, then the consulting firms, then the infrastructure companies. But the equipment suppliers (such as Cisco) were still able to post strong sales because they made the mistake of financing their customers' purchases, notes Zandi.

And as the tech sector has deteriorated, the pain continues to spread to the rest of the economy. Financial firms are suffering as the market for initial public offerings dries up and burned investors stop trading. Leading discount broker Charles Schwab reported first-quarter earnings that were down 65% from the prior year. Credit Suisse First Boston analyst James Marks called it: "Not surprising, just depressing."

AWAITING A REBOUND. Some segments of the real estate market are feeling the impact -- especially office buildings that housed failed dot-coms and high-end apartment buildings. Northern California, Boston, and suburban Washington are being hit, says Jay Leupp at Robertson Stephens. He expects that office-building occupancy rates may drop 5% to 8% in those markets, but rents could drop as much as 25% to 30%.

But all indications are that the Fed will keep cutting rates until it sees some evidence that the economy is beginning to right itself. Toward the end of this year and into 2002, a rebounding economy should bring a boost to online advertising and e-commerce spending. Internet software and equipment companies will eventually get a lift as CEOs loosen the purse strings for more spending on information technology.

Traditional businesses will use the Web for greater efficiency and improved customer service, and many still look to Amazon.com for how to do it, says Kintz. "This whole innovation movement hasn't stopped," he says. "People have learned a lot, and the thinking is much more mature and the implementation much more efficient."

OLD SLOWDOWN VETS. But a recovering economy won't save many of the imploding dot-coms. For Web pure plays to work, Internet penetration and broadband connections need to climb in order to "create a better experience for consumers but also a more dynamic marketing environment for sellers of products," says W.R. Hambrecht's Brown. Meanwhile, many tech companies need management skilled at handling a downturn, when it gets harder to recruit, says Spencer Stuart's Gordon. Executives thinking of moving to a struggling dot-com want to be assured that "the story has to be good, and there's money in the bank," he says.

For most of today's bombing dot-com pure plays, it's too late to reverse the slide. Near-term, the best we can hope for is that the economy will stabilize and the ripples from the Internet Meltdown will stop spreading. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

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