Markets & Finance

The Internet's Second Phase


By Scott Kessler The past year has been an extremely painful one for the Internet sector. Many companies in the industry have been decimated by slowing and disappearing growth, eroding margins, and elusive profits. And that's not to mention increasing layoffs, bankruptcies and stock-market delistings. A sluggish U.S. economy and resulting reductions in corporate spending on technology haven't helped. Now, anecdotal evidence suggests that Europe's economies are weakening as well.

Even though the U.S. economy appears to have avoided a recession thus far, I would argue that the Internet sector (in terms of revenues and earnings) has not.

The question now is: "What's next?"

THE BIG PICTURE. The saying goes that it's always darkest before the dawn. That couldn't be more apropos with regard to today's environment for dot-com companies and stocks.

Apparently investors agree. The Internet sector (as measured by TheStreet.com Internet Index) has risen sharply from the low established in early April. With dot-com stocks up more than 55% over the past month, I'll follow the lead of the investing public and look to the future of the Internet sector (from a big-picture perspective).

The Internet boom of the latter half of the past decade was typified by a focus on primarily one thing: growth -- in traffic, transactions and revenues, as well as losses. The failure to appreciate the significance of increasing losses doomed many dot-coms. With new-found wisdom, companies will be emphasizing operations, costs, and most importantly, profits, in this second phase of the Internet economy.

For many companies, this shift in priorities has been fast and dramatic, in great part because their survival depends on it. Others have followed suit to improve or maintain their competitive positions. Thus, over the past few months, scores of companies have reduced cost and expense structures, written down the values of suspect acquisitions and investments, and sold non-core and underperforming assets.

NEW BLOOD. Not surprisingly, many dot-coms have acknowledged the new importance of profits with changes in their executive teams. A trend that has emerged is the ascension of managers with extensive operational and financial experience as CEOs, often replacing the entrepreneurs who founded or played a major role in growing the company. Some companies that have done this over the past month include Ariba (ARBA), At Home (ATHM), Drugstore.com (DSCM), i2 Technologies (ITWO) and Webvan (WBVN).

Yahoo! (YHOO) appears to be the exception to this trend. It recently replaced a Chairman and CEO with an operations background with one who's considered more of a visionary. Understandably, many members of the analyst community were somewhat critical of Yahoo!'s choice.

An emphasis on operations in this tough climate portends well for the future. As dot-coms continue to struggle due to waning demand for their offerings and limited access to financing, those companies whose businesses are structured to generate profits and conserve resources will survive and benefit. When opportunities present themselves -- to gain market share, make strategic acquisitions, or hire talent -- the well-managed companies will be ready to take advantage. Not only will they be able to endure the difficult demand environment, but they will also be extremely well-positioned once the economy rebounds. Kessler is Standard & Poor's Internet analyst


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