In Shakeout of Internet Tree, Dots Are Poised to Fall

The wild dot-com party is ending for some companies. And as the hangovers take hold among Internet stocks, many of the Web’s retailers and information services may soon become dot-gones.

In the last few days auditors for several well-known Web businesses issued warnings that the companies’ survival is in “substantial doubt.” On Thursday, drkoop.com, a leading health information site, and Value America, a PC retailer, got such warnings, sending their share prices near all-time lows. A day earlier, CDNow, a top online music seller and one of the Web’s most popular sites, saw its share price plummet on news of a severe cash crunch.

And Peapod.com, an online grocery service, said it is urgently seeking a buyer before its dwindling cash reserves run out.

“This is the beginning of a major dot-com shakeout,” said Joe Sawyer, an analyst with Forrester Research in Cambridge, Mass. “Consumer shopping online is going to grow no matter what,” but only a handful of players will survive in many commodity categories--such as pet supplies, books, cosmetics, music, flowers and software.

It isn’t just online retailers facing an uphill struggle toward profitability. News and information services, and community sites (a mix of advice, shopping, home-page services and online discussions) also are suffering.

Industry watchers have not lost their confidence that technology businesses in general and Internet businesses in particular--including many e-tailers--will be dominant forces in the economy for decades.

But in this era of online experimentation, many businesses will fail. And this year may draw a dividing line between the likely winners and the casualties of the new economy, experts say.

Of 182 Internet stocks tracked by Yahoo’s finance service, only 19 turned a profit in the last quarter. Among those, two heavyweights--America Online and Yahoo--captured the lion’s share.

“This is the year where they will really sort out which ones of these companies have business models that will ever become profitable some day,” said Michael Murphy, editor of the California Technology Stock Letter.

Profits were never expected immediately from most Internet companies, but investors are growing restless.

Until recently, stratospheric market capitalizations fueled by the Internet stock frenzy allowed many dot-coms to build their businesses by selling stock or attracting eager venture capitalists. The mantra of the time: “Get big fast,” regardless of the cost.

This happened despite mounting evidence that ad sales and consumer purchases--the primary source of revenue for many Web companies--weren’t generating sufficient revenue to offset escalating ad campaigns and competitive salaries in a marketplace swelling with competition.

The recent market shift has sent stocks of scores of Web firms reeling. More than 40 Internet stocks hit 52-week lows in the last two days, including the e-commerce companies drkoop.com, Pets.com, PlanetRx.com, E-Stamp, Egghead.com, the Web-search company FatBrain.com, health care giant Healtheon/WebMD, and the online community site Women.com.

Scores of other prominent Web businesses--including EToys and Ivillage--have seen their stock prices fall to a fraction of their highs only a few months ago.

Orange County companies EMachines Inc., Buy.com Inc. and Tickets.com Inc. also saw their shares slump to new lows this week, although their survival is not in doubt--so far.

The broad decline in Internet stocks means that many companies searching for fresh investments “are finding the well is dry,” said Kevin Fong, a venture capitalist with the Mayfield Fund in Menlo Park, Calif.

His firm is investing freely in a range of Internet start-ups but has raised the bar for investments in some categories, such as business-to-consumer e-commerce.

Forrester will release a study next week that shows the average request from dot-com retailers for investment money is now $40 million.

“But there are few takers,” Forrester’s Sawyer said. “That’s a problem when you come around with your hand out every six months.”

For many Web concerns, this has created a perilous “burn rate”--in which quarterly losses outpace revenue and rapidly eat into a company’s cash reserves--leading to the kinds of auditor warnings that CDNow and drkoop.com received. And many other companies face only slightly less urgent conditions.

Software vendors Egghead.com and Beyond.com are on a slippery slope toward insolvency, said Barry Parr, an analyst with International Data Corp. Other analysts have cited impending cash shortages at health information provider Medscape and financial information site MarketWatch.com.

“It’s going to be a lean period between now and Halloween,” Parr said. “A number of companies will try to hang on until the next Christmas season.”

When a company suffers from a cash crunch and declining stock price in today’s competitive environment, it faces grave difficulties holding on to key employees--many of whom choose employers based on the relative appeal of stock option plans.

Some analysts suggest that a comeuppance for once high-flying Web firms will benefit old economy titans looking to build an online base, said Sawyer.

For example, brick-and-mortar retailers such as Wal-Mart already have a massive infrastructure for the delivery of goods that dot-coms such as Amazon.com or Etoys are building from scratch at great cost.

And with so deflated a stock price, CDNow, a well-regarded site with skilled employees and strong technology, can be purchased for a relative song by a company that wants to establish or enhance a Web presence.

Analysts also believe that dot-com stock shock could stimulate calls for changes in what many investors view as misleading accounting methods.

For example, hundreds of Web companies have padded their revenue balance sheets with barter transactions, such as trades of advertising space. Others have counted the costs of delivering goods or of discounts on product prices as marketing expenses. Such practices are widely viewed as efforts to disguise financial weaknesses that could cut into high stock prices.

Last month Virginia-based MicroStrategy Inc., a top e-commerce software maker, lost a jaw-dropping $11 billion in market value in a single trading day when it was forced to revise revenue statements sharply downward in compliance with new guidelines from the Securities and Exchange Commission.

In the long run, dot-com disasters may benefit survivors. “Well-managed companies will emerge even stronger because the public markets will realize that they really have something going,” said Warren Packard, a partner at Redwood City, Calif., venture firm Draper Fisher Jurvetson. “The public markets are smarter than any company.”

Another venture capitalist, Roger McNamee of Integral Capital Partners, views the current malaise of many Web companies as natural. Just as in the rest of the business world, a few companies will be highly successful, some moderately successful and most will fail, he said, adding: “Wall Street has been funding these things like they are all going to work, which is silly.”