Up In Smoke
Dot.coms are still burning cash, but the market has forced big changes
By Jack Willoughby
What a difference three months make. When our cover story, "Burning Up," appeared March 20, the technology-laden Nasdaq had just topped 5000 and the initial public offerings market still was raining buckets of money on Internet companies. But all that was about to change.
By focusing on 'Net companies' burn rate -- how fast they were depleting their cash reserves -- and how long it would take before some would be tapped out, Barron's pinpointed the key risk that many dot.coms faced: They were critically dependent upon a continually receptive stock market to keep funding their furious spending. Since then, the Nasdaq has fallen sharply, the euphoria surrounding initial public offerings has evaporated and venture capitalists have donned green eyeshades when looking at deals.
"Since the Barron's article, a mantra has developed in boardrooms. The two biggest investor concerns have now become cash and the business model," says Jon Flint, general partner of Waltham, Massachusetts-based Polaris Venture Partners, and a lead investor in Akamai. "If companies don't have enough cash for at least 15 months or can't show significant progress by then, private investors are not going to buy in."
In our original 207-company study, we calculated the burn rate for the fourth quarter of 1999, and then projected how long it would take for each fledgling Internet company to burn through its cash. In this issue, we update those estimates, using burn rates for this year's first quarter. We also note what actions these companies have taken since to bolster their financial positions since their last reported quarter.
The good news: Internet companies burned their cash more slowly in the latest quarter. They did consume a hefty $1.15 billion, but that was off 24% from the $1.52 billion that went up in smoke in the fourth quarter of 1999, according to an expanded study conducted exclusively for Barron's by Pegasus Research International. But the heat is still on for more than 60 companies that face the prospect of running out of cash in the next 12 months, according to Pegasus.
Protecting the cash supply has become a No. 1 priority. And with 'Net companies' revenues rising to $12.5 billion in the first quarter from $10.3 billion in the previous quarter, Pegasus figures the industry's combined cash stash should support it for 13 years, up from eight years at the time our first study was done.
Fewer dot.coms now report negative operating cash flow (earnings before interest, taxes, depreciation and amortization) -- 227 in the first quarter, down from 238 in the preceding period, according to Pegasus. Among the nine outfits that turned cash-flow positive in the first quarter were Exodus Communications, Lycos, Ameritrade and E*Trade.
But of the companies reporting negative cash flow, 29%, or 66, stand to run out of cash within the next 12 months, based on their first-quarter numbers, up from 59 three months earlier. To be sure, many of these companies have taken action -- radical in many cases -- to husband cash. Still, ISI Group tallied some 69 "problem.com" companies in just the past four weeks that were forced to announce layoffs, postpone financings or close up shop. No doubt many had assumed that capital would continue to be available in infinite amounts and on generous terms forever.
This survey contains 20 more companies than the last one because more corporate disclosures were available and more companies were willing to discuss the cash-burn issue. Seven of the top 10 companies didn't appear in the previous study.
"The numbers clearly show the Darwinian process at work in the Internet," says Greg Kyle, president of Pegasus Research International, which covers the sector for institutions. "The weak falter, while the strong surge ahead. The focus has now shifted from growth-at-any-price to how soon profitability can be achieved."
Many of the new potential burn victims -- such as GenesisIntermedia, a Van Nuys, California-based multimedia marketing company, and Convergent Communications, an Englewood, Colorado networking company for small business -- already have obtained financing from private sources through small doses of preferred stock or debt. They're Nos. 1 and 2, respectively, on our list.
But, indicative of the profound change in the financial zeitgeist, 'Net companies are assiduously avoiding the public equity markets. Claimsnet.com, a Dallas-based health-benefit processor ranked No. 11 on our list, said last week that it had finalized a $3 million sale of restricted stock, enough for the near term, according to Paul Miller, chief financial officer. "We're confident of our business model, and we really don't see any sense in raising huge amounts of capital at a time when the public markets are temporarily shut." Cavion Technologies of Englewood, Colorado, No. 35, which helps credit unions patch into the 'Net, actually withdrew an offering of about two million shares. "We just felt it made no sense" selling equity at depressed prices, says Marshall Aster, chieffinancial officer. The firm now looks to raise money in the private market.
Indeed, some managements have resolutely put their own money up to buy shares at depressed prices. James Condon, president and chief executive of Reston, Virginia-based CyberCash, an Internet payment services company ranked No. 24, says his directors have added to their holdings. "We certainly have no intention of running out of cash," said Condon as he outlined cost-cutting measures.
Many different types of e-businesses now appear in need of funding. Denver telecommunications concern RMI.net, No. 8, has raised $12 million from a finance company to meet a self-imposed deadline to stop burning cash by yearend. But Westwood, Massachusetts-based RoweCom, No. 7, which manages the purchase and distribution of magazines, journals and periodicals for businesses, told Barron's it's still looking for fresh money. Earlier this month, it used up some reserves and brought in new private investors to redeem $16.1 million in notes. Venture capitalists backing Sunrise, Florida-based Mortgage.com, No. 18, recruited Stephen Foltz, a former Transamerica executive, as interim chief financial officer to evaluate the various divisions of the company, after the previous CFO departed. Foltz says that Mortgage.com has enough cash for at least the next two quarters.
E-tailers, perhaps more than any other group, have had to raise needed cash. New York-based clothing discounter Bluefly, No. 5, has hired Credit Suisse First Boston to find strategic partners and is talking with bankers about working-capital loans. Westwood, Massachusetts-based e-grocer Streamline.com, No. 15, has also hired an investment banker. CDNow, the Fort Washington, Pennsylvania, music seller, No. 9, reported that Mexican tycoon Carlos Slim had increased his stake to 9%-plus, and said last week that merger talks with several interested parties continue. No. 4 Peapod's $73 million-plus deal with Dutch grocer Ahold appears likely to be completed following an earlier abortive deal. Value America, the electronic etailer, No. 6, says an equity infusion has bolstered its prospects, but the share price continues to be hampered by an overhang of stock for sale by deposed former directors.
Naturally, a few managers opted not to discuss plans about burn-rate problems. Pilot Network, an Alameda, California, information security company, No. 13, and US Search.com, No. 14, a Los Angeles-based records search firm, offered no comment. Efforts to reach Audiohighway.com, No. 17, were unavailing.
As with the previous study, some companies took issue with our methodology. New York-based Juno Online, No. 29, says it doesn't even release a burn rate quarter-to-quarter because of the cyclical changes in its business. Steve Valenzuela, CFO of South San Francisco-based PlanetRx, an e-medicine company, No. 19, said: "Our actual cash burn was lower than represented in the firstquarter because of a one-time capital investment. Since then, the company has promised to reduce its burn rate by up to 20% this year." No. 3 on the list, Atlanta-based bank service firm Netzee, noted the firm has a $15 million line of credit issued from InterCept Corp., a 34.8% shareholder in NetZee, $7.8 million of which has been drawn down. The credit line -- not measured in the Pegasus methodology -- plus the money on the balance sheet provides sufficient cash, the company contends. "Your original article caused us untold nightmares because we couldn't find analysts who could understand us," says CFO Rick Eiswirth. "We feel we have sufficient funds to become cash flow-positive by the middle of next year."
Lest we forget, the reason for this new dot.com austerity: a collapse in the price of dot.com equities, which has constricted the size and number of public deals. Since March 10 when the Nasdaq peaked, the public markets have absorbed only 39 Internet IPOs worth $4.2 billion, 23 secondary or follow-on offerings for $6.4 billion and six convertible deals for $1.7 billion, according to CommScan, a New York statistical information firm.
The market value of Internet stocks has been slashed by 50% since their peak -- to $693 billion from $1.4 trillion, according to Pegasus. In the meantime, Internet offerings comprise 55% of the backlog 202 deals worth $21 billion, out of a total of 368 deals worth $39 billion, according to CommScan. Psychology has changed profoundly. "The long upward ride in technology stocks that has lasted for 10 years appears to be interrupted for a while," says Jay Hoag, general partner of Technology Crossover Ventures, based in Palo Alto, which manages some $2.5 billion and is one of the Internet's more influential investors. "Right now, people are scared."
"March certainly was a wake-up call for venture capitalists who asked: 'Do I stay with my investments, or take my money and go elsewhere?' " adds Hoag.
Others saw opportunity in the chaos. "Clearly, some investment firms used your last story for a shopping list," says Tim DeMello, founder of Streamline.com. "Days after it appeared, we were faxed at least nine term sheets from firms we'd never met. The terms were really onerous, ridiculous. We're now dealing with strategic investors because the private venture firms that four months ago flew out to see us now won't even take our phone calls."
Sales by insiders and other investors while companies seek to raise more equity capital just intensifies the pressure. Says Peter Jackson, chief executive of Orinda, California-based Intraware, No. 45 on the list: "It's tough to have your venture capitalist hold stock for only one or two years, and then flip out to go into another deal, especially when they initially tell you they hold for five years. The early sale gives the impression of a lack of faith in the company management and its direction. It confuses employees, customers and partners."
While some mourn the end of the euphoria seen at the end of 1999 and in the early months of 2000, many observers welcome a return a more sober atmosphere. "We're probably in for one more downward motion, but later this summer, we could well have a rally," says William Smith, chairman of Renaissance Capital in Greenwich, Connecticut, which runs the IPO plus Aftermarket fund. "The deals are continuing to come. The best news for our fund has been the declaration by some pundits that the IPO sector has crashed."
To be sure, these declines in stock-market valuations have no direct impact on the cash these companies had in the till. But the slide has profoundly altered the way the public values most Internet propositions. And that has made it vastly more difficult for 'Netcos to raise new cash -- just when they need it most.
When we did our first burn-rate survey, business-to-business companies were all the rage, while the e-tailers were under siege. Now B2B is just as out as B2C, and Pegasus has found B2Bs have moved onto our list of the most cashstarved. "In five months, the B2B sector has gone from complete euphoria to being totally out of favor. Values in the private sector are way down," says Walter Buckley, CEO of Internet Capital Group, No. 197, which has 22 new issues in the pipeline. "We're sticking to our basic development plan, telling our management teams to focus on building their businesses. And increasing our stakes in companies that we believe are strategic to our long-term success."
The business models that were cobbled together so hurriedly during the Gold Rush months in late 1999 now receive icy treatment when the dot.coms return for more cash. Never mind that the "skeptical" venture-capital firm might be the very one that put together the management team, pressed for the business plan and lent its name to the public financing. Now venture capitalists say privately that they are duty-bound not to throw good money after bad. Table: Twelve to Watch
Even so, the VCs are in a ticklish situation. Do they support the old deals, or sponsor new, more attractive ones? Some say they're putting their money behind the winners and cutting the losers off. "The venture capitalists are putting their money behind the category killers they own, and then holding off contributing more until the capital markets reopen," says Steven R. Gerbsman, president of Internet Recovery Group, a California restructuring specialist that has supervised the combination of five faltering 'Net ventures. "More of these companies are having to fend for themselves."
Until the public markets flow once more, the dot.coms will have to depend largely upon private sources. Since March, CommScan reports, 14 separate Internet follow-on or secondary offerings valued at $1.3 billion were withdrawn or postponed. All but a few involved a large number of shareholders selling down positions.
One sector that still has ready access to cash: companies building the infrastructure for the 'Net. These offerings are included in the telecommunications sector tracked by CommScan. Year-to-date, some 36 telecommunications offerings have raised $17.5 billion and returned an average 49%. Could the rest of the dot.coms get back in gear? "The numbers clearly show that we've had a bear market in new issues for the last eight weeks," says Revell Horsey, managing director and head of equity capital markets of San Francisco-based Banc of America Securities, a technology underwriter. "But when you look closely at the trouble, you find that we're suffering from a first-quarter hangover when new issues were priced too aggressively."
The selloff presents some buying opportunities. Kyle points to Allaire, Pivotal and Multex.com as companies with negative cash flows that have done the best job in reining in expenses. Among those companies that went cash flow-positive, Kyle likes Exodus Communications, E*Trade and ixL Enterprises.
While the VCs and institutions took big hits, day traders, especially those using margin, suffered the most grievous reversals of fortune. "The damage to the small-time individual trader has been horrific," says William Hambrecht, head of W.R. Hambrecht and designer of the OpenIPO system of electronic equity distribution. "We've wrung about 1.5 years' worth of gain out of the new-issue market," says the founder of what's now Chase H&Q. "The most recent downturn has simply ravaged individual portfolios. They're down 80% or more. Remember, they're the ones who bought from the institutions after the offering."
Hambrecht sees the big challenge being posed to the VCs. "The venture capitalists are being tested as never before in the current market," he says. "Now they're going to have to finance the whole business plan to profitability rather than just the front end, as well as demonstrate their commitment by investing alongside the public."
One of the most astute performers in the Pegasus survey has been Amazon.com, No. 147, which has pared expenses while it increased revenues. But the Seattle dot.com may soon be tested to see how firmly it supports several of the 'Net companies on our list in which it has big equity stakes, such as NextCard and drugstore.com, Nos. 156 and 64, respectively. Amazon spokesman Bill Curry says the company plans to support all the current agreements with its partners, but added that the firm must weigh all investment opportunities to obtain the best possible return for shareholders.
And so it goes: The strongest companies get the funding; the weak fall by the wayside both in the public markets and in the portfolios of venture capitalists.
It's evident in hindsight that a watershed of sorts was reached three months ago. Dot.coms no longer can burn cash with abandon now that the stock market has refused to provide fresh fuel. But in the long run, these ventures may be better-served by the new focus on such Old Economy nostrums as profitability.