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Break Out the Black Ink


One of the lingering effects of the dot-com bust is that the phrase "profitable Internet company" has become a sniggering joke. In this sadder-but-wiser era, it's the ultimate oxymoron. Even CEOs of Internet companies can't resist getting in their digs. When asked how many Net companies are making money, Srivats Sampath, the boss of profitable online software maker McAfee.com Corp. (MCAF), quips: "About four?" Fortunately for his stockholders, Sampath is better at running his company than he is at sizing up the performance of his e-business peers.

This is the Net's pretty little secret: By our count, 52 Net companies were profitable last quarter, and analysts project that at least four more will clear the bar by yearend. There are two ways of putting the numbers into context. Of the 456 Internet companies that went public since 1994, 11% are profitable. If you look at just the 208 public Net companies that are still in business and were not acquired, a full 25% make money. If you count companies that profit on a pro forma basis--before noncash charges, that is--another 30 or so are in the black. The market "has weeded out bad companies very quickly. And the rest have reduced their operating losses dramatically," says Greg Kyle, CEO of market researcher Pegasus Research International, and a longtime bear on Net stocks.

Profits are coming in from all over. The big winners are e-travel and e-finance--headlined, respectively, by Expedia (EXPE) and Priceline (PCLN) and by IndyMac (NDE) and Schwab (SCH). But almost every Web sector has at least a couple of profitable public companies. Here's a surprise: Health services company WebMD Corp. (HLTH), once branded a loser, is making money before noncash accounting charges. And forget the notion that mixing the Internet with physical stores is the only way to make money online: Virtually all the profitable Web companies are selling information-based products rather than items that require shipping. So they don't need bricks to go with their clicks.

Nor do dot-coms rely any longer on pro forma accounting to show profits. Indeed, the oft-criticized gap between net income under generally accepted accounting principles and Web companies' pro forma results has never been smaller. Why? Lower stock prices mean noncash stock option payments take a smaller bite out of earnings. Also, companies can now write off merger-related goodwill in a single stroke, rather than taking write-offs every quarter for years. That boosts the quality of earnings at companies such as e-tailer Amazon.com Inc. Its stock compensation costs fell from $11 million in 2001's first quarter to $3 million in the quarter ended Mar. 31. Goodwill amortization fell from $51 million to $2 million. Analysts now say Amazon will break even for the year--not in pro forma earnings but by conservative accounting principles.

Indeed, our rules for sizing up the profit picture are conservative in a number of ways. We don't count profitable startups that were acquired, such as travel agency Travelocity.com Inc. Nor do we count businesses that have become profitable since being bought out, such as online dating site Match.com. We also don't count private companies such as search company Google Inc., which claims to be profitable.

The education of the first wave of Web companies is hardly over. But their performance so far works out to a C average on our report card--an average that should rise over the next two years. Here are our grades for eight of the Net economy's biggest sectors:

Travel

A

The valedictorian so far. The three remaining public companies are

profitable--Expedia, Hotels.com, and Priceline. Travelocity was

profitable when it merged with Sabre Inc. in April.

The reason Web travel agencies make money is simple: Travel reservations are just data, which can be shipped easily over the Net. And the interactive nature of the medium lets customers do more research on vacation options online than they can do with brochures.

Even the ever-slimming commissions agencies collect on airline tickets are tidily profitable once online agencies get big enough. And now they are. Leading agency Expedia Inc. (EXPE) got $123 million in travel commissions last year, up 107%, but the cost of processing those reservations rose just 57%, to $53.4 million. What's more, smart online agencies have protected themselves against falling commissions by moving into the tour-packaging business.

Finance

A-

Ten public companies are profitable--with up to five more due to be

profitable by yearend. Online brokers are in the black, despite slow

trading volume. Now, online mortgage, tax-prep, and banking companies

are joining them.

E-finance has the same advantages as online travel: a bottomless ability to crunch numbers and compare products, and no boxes to ship. Online brokers such as E*Trade Group Inc. (ET) and Charles Schwab & Co. (SCH) began making money first---and still do, despite trading declines that have prompted consolidation.

The Web's impact on financial services is hard to miss. Productivity gains already are beating bullish forecasts, and established companies are responding. No. 1 mortgage lender Washington Mutual Inc. (WM) issued $60 billion in loans on the Web last year. Online brokers forced incumbents such as Merrill Lynch & Co. (MER) to slash commissions. And market researcher Gartner Group Inc. says 25 million Americans will pay bills online this year.

Media and advertising

B-

Eight of the 50 that went public are profitable. The ad slump hurts, but

online media is still a $7 billion business. AOL Time Warner Inc. is the

Goliath, while specialty sites such as job site Monster.com make money,

too.

It's easy to snark about Web advertising. Boosters promised hypercatchy ads that would be targeted at precisely the right customers. Moreover, they said consumers' behavior could be predicted by tracking what Web pages they visited. That hasn't happened. Still, profits have arrived for companies that handle advertising innovatively--such as Overture Services Inc.'s (OVER) paid-search engine. Bottom line: Advertising is a cyclical business, online advertising included. Web advertising may not become more effective than other media soon, but it can support a number of companies with even a modest recovery.

Retail

C+

Five of the 40 that went public are profitable, including

1-800-Flowers.com Inc. and teen site Alloy Inc. Amazon.com should join

the group with a good Christmas. About a dozen of the public e-tailers

failed.

Funny, but there was no recession in online retailing last year. Sales rose 13% last Christmas, to $10 billion, compared with a 2% gain in total shopping. The gorilla: Amazon (AMZN), whose Christmas and first quarter beat expectations. The one to watch: Ticketmaster (TMCS), which books about 35% of its ticket sales online--and operates the Match.com dating site and the CitySearch hometown activities sites. Ticketmaster is looking for more Net acquisitions.

Exchanges

C

EBay is one of only two exchange companies to make money. Still,

corporate-auction site FreeMarkets Inc. and hospital supply exchange

Neoforma Inc. are making progress.

Online exchanges were supposed to transform business by squeezing inefficiencies from business-to-business deals and putting buyers and sellers in direct contact with one another. And they were supposed to do it by, say, Tuesday. Oops! Still, three years after they debuted with much fanfare, enough is happening that exchanges aren't a total fizzle.

EBay (EBAY) has been the benchmark for profitable online companies. Its magic is that it collects fees on transactions without ever holding inventory. Other companies are now proving that eBay was not a fluke. Online bond exchange eSpeed Inc. (ESPD) made $7.8 million in the fourth quarter. ESpeed's success was especially poignant: The Web spin-off of Cantor Fitzgerald LP saw its automated bond-trading system help the parent company keep going after the World Trade Center attack killed 658 Cantor and eSpeed employees.

Software

C

Only 14 out of about 150 companies are profitable. The money makers are

Intuit Inc. and McAfee.com, which deliver software over the Web mostly

to consumers. Startups that target corporations, including Commerce One

Inc., have had problems.

This sector has gotten whipped much harder by the corporate spending slump than by the dot-com bust--although both hurt. It was investment delays by big companies that crimped companies such as Commerce One (CMRC), Ariba (ARBA), and i2 Technologies (ITWO), which were about as big a trio of Internet rock stars as anyone could be in 1999. BroadVision Inc. (BVSN) and Art Technology Group Inc. (ARTG) are scrambling to make themselves more enterprise-friendly and less focused on e-commerce. It could be a tough road.

Access/Infrastructure

D+

Seven companies out of 80 are profitable. Startups bet big that

companies would outsource major computing applications to others. Those

bets haven't paid off.

Remember back in April, 2000, when venture-capital incubator Safeguard Scientifics Inc. (SFE) rattled Web stocks by saying it would invest only in "infrastructure" companies? Bad plan. Infrastructure is among the Web's toughest businesses. The reason: A glut of companies wanted either to sell Internet access or convince corporations to hire someone to run their computing applications and deliver them via the Web. The profitable ones are mainly companies that provide services corporations can't easily provide for themselves. Example: WebEx Communications Inc. (WEBX), a seller of Web-conferencing services. An uptick will come only when businesses decide to risk handing their operations over to outsiders in exchange for fewer headaches.

Consulting

F

Only 3 of the 14 public companies make money--Modem Media, Razorfish,

and Inforte. Consultants such as Scient Inc. got hammered when

corporations lost interest in e-commerce.

Of all the mind-bending Web moments, one of the most recent came when left-for-dead Razorfish (RAZF) reported a first-quarter profit of $2.5 million. The Web consulting industry was one of the first Net businesses to make money. One pioneer, Sapient Corp. (SAPE), reported net income every year from 1997 to 2000. But the whole sector crashed in 2000 because the e-commerce boom led them all to expand their staffs too fast--then the bust left them with sky-high expenses. And don't look for lots of comeback stories. The business that's around now comes from bigger companies that are the customers of giants such as Electronic Data Systems Corp. (EDS) and IBM (IBM).

Amazon, Priceline.com Inc., and their dot-com brethren may never again be as sexy as they once were, but they're shaping up to be far sounder companies. If this profit-making trend continues, we may have to coin a new name for them: the com-back kids. By Timothy J. Mullaney in New York


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