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Barron's - March 20, 2000
Burning Up
Warning: Internet companies are running out of cash -- fast
By JACK WILLOUGHBY
When will the Internet Bubble burst? For scores of 'Net upstarts, that unpleasant popping sound is likely to be heard before the end of this year. Starved for cash, many of these companies will try to raise fresh funds by issuing more stock or bonds. But a lot of them won't succeed. As a result, they will be forced to sell out to stronger rivals or go out of business altogether. Already, many cash-strapped Internet firms are scrambling to find financing.
An exclusive study conducted for Barron's by the Internet stock evaluation firm Pegasus Research International indicates that at least 51 'Net firms will burn through their cash within the next 12 months. This amounts to a quarter of the 207 companies included in our study. Among the outfits likely to run out of funds soon are CDNow, Secure Computing, drkoop.com, Medscape, Infonautics, Intraware and Peapod. (For a full list, see Find Your 'Net Stock.)
To assess the Internet sector's financial position, Pegasus assumed that the firms in the study would continue booking revenues and expenses at the same rate they did in last year's fourth quarter. While this method cannot predict the future precisely, it helps answer a question that has been nagging many stock-market analysts: When will the crowded Internet industry begin to be winnowed?
The ramifications are far-reaching. To begin with, America's 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market. Any financial problems at these Internet firms would affect the myriad companies that supply them with equipment, including such giants as Cisco Systems and Intel. Another consideration is that a collapse in highflying Internet stocks could have a depressing effect on the overall market and on consumer confidence, too. This, in turn, could make Americans feel less wealthy and cause them to spend less money on everything from cars to clothing to houses.
It's no secret that most Internet companies continue to be money-burners. Of the companies in the Pegasus survey, 74% had negative cash flows. For many, there seems to be little realistic hope of profits in the near term. And it's not just the small fry who are running out of cash. Perhaps one of the best-known companies on our list,Amazon.com, showed up with only 10 months' worth of cash left in the till.
Pegasus was working with the latest public financial data, from December 31, so the table doesn't reflect the fact that Amazon early this year managed to raise $690 million by issuing convertible bonds. But that money will last the firm only 21 months. Moreover, raising fresh funds will be more difficult if Amazon's operating losses continue to mount and its stock price continues to flag.
"What's critical is the stock price," says Scott Sipprelle, co-founder of Midtown Research in New York. "It's only when the stock price comes unglued that the burn rate means anything."
Several signs suggest that the era of "unglued" stock prices is fast approaching. Amazon.com, for example, is trading at about 65, down from its all-time high of $113. Then there's Internet Capital Group, trading at a recent 117, down from a high of 212. Many other net fledglings are in far worse shape. ELoan's shares have plummeted to about 10, from a high of 74.
Table: Fire Alarm
The broad picture isn't much better. The Dow Jones Internet Commerce Index had fallen 25% from the all-time high achieved last April.
Little wonder that so many 'Net firms are following Amazon's lead and looking for new funding. "The hunt for cash will become more desperate as the reserves deplete," says Greg Kyle, founder of New York-based Pegasus Research International.
Take, for instance, the firm at the top of our list, Pilot Network Services. It was just about at the bottom of its cash hoard when it managed to get a $15 million investment from Primus Telecommunications. To obtain the funds, Pilot had to give Primus a 6% ownership stake. At the current burn rate, the cash infusion should last Pilot about 10 months.
VerticalNet, which helps businesses transact on the Internet, had to turn to Microsoft to replenish its dwindling cash supply. In exchange for a $100 million investment, Microsoft is getting a 2% stake in VerticalNet and requiring the Internet upstart to use Microsoft's technology.
Medscape, No. 9 on our list, apparently solved its cash problems by agreeing a few weeks ago to be bought by MedicalLogic Inc. for $733 million in stock
Not all 'Net firms have been so lucky. Peapod, the fourth company on our list, unveiled crushing news last week. Peapod Chairman Bill Malloy intends to step down for health reasons from the online vendor of groceries. As a result, investors who had agreed to pony up $120 million in financing are backing out of the deal. Peapod has hired Wasserstein Perrella to seek out new investors, but with only $3 million of cash on hand, Peapod's coffers could be empty within a month. That's even sooner than indicated by the financial data that Pegasus used to create its burnout rankings.
Another 'Net company in disarray is the online music retailer CDNow, No. 2 on our list. CDNow executives thought their problems were solved when they agreed to a takeover offer of more than $300 million from Columbia House, the mail-order record seller that's jointly owned by Time Warner and Sony. One problem: It turned out Columbia House did not itself generate enough cash to make the merger work. Nancy Peretsman, a managing director at the investment bank Allen & Co., has been hired by CDNow to assess strategic options. Her job may not be easy. CDNow has enough cash to last less than one month, and its shares are trading at 6 3/4, down 80% from their all-time high.
As noted above, a depressed share price limits a company's ability to raise fresh funds. Let's face it, with lots of investors looking at losses on a stock investment, selling more shares into the market can be difficult, at best. A good example is eToys, a toy retailer that came public at $20 and surged to well over $80 amid great public enthusiasm. The concept was easy to understand and promised great riches. But the competition, in the form of Toys R Us, did not roll over and play dead. Toys R Us launched its own Website, and ardor cooled for eToys. Today shares of eToys repose at 11 3/4. All those people who bought in at prices ranging from $20 to $80 are none too eager to buy more shares, even at $12. EToys has enough cash on hand to last only 11 more months, so stay tuned.
Even a celebrity like Dr. Everett Koop is not immune. His Website, drkoop.com, came public at $9 a share, surged to over $40, and has since fallen back to $9. Drkoop.com ranks seventh on our list, with three months' cash left.
Another easy-to-understand e-play that has disappointed investors is FTD.com, the flower retailer. Its shares have wilted to a recent 3 5/8, from an all-time high of 12 1/2. FTD.com has about six months' of cash remaining.
"That's the problem with these IPO run-ups. They introduce so much hype and emotion, when what's really needed is stability," says William Hambrecht, founder of Hambrecht & Quist, owner of W.R. Hambrecht, a pioneer in offering IPOs to investors via the Internet. "A volatile price on a new stock kills your ability to finance in the future. It's very destructive."
'Net companies are also finding it more difficult to raise funds by issuing convertible bonds. One reason: investors in these instruments are attracted to the possibility that the issuer's stock price will rise, enabling bondholders to reap a nice profit when they convert their bonds into stock at some future date. "Slowly the door's beginning to shut on the pure Internet plays in the convertible market," says Ravi Suria, chief of convertibles research at Lehman Brothers in New York. Indeed, E*Trade, Amazon.com and Ameritrade have had to offer unusually generous interest rates and conversion terms to sell their latest offerings of convertibles. With so many Internet stocks well off their highs, the promise of converting bonds into stocks at a huge profit seems more remote, making such deals a lot less alluring.
Egghead.com, with an estimated 4.4 months' worth of cash on hand, recently solved its hunt for capital, but its success may prove pyrrhic. Although a Bahamian outfit called Acqua Wellington agreed to invest $100 million in Egghead.com, Acqua plans to make its investment over a nine-month period, buying up stock at an unstated discount to the current market. "It's a curious situation, to be sure," says Pegasus' Kyle. And it's yet another sign that cash is getting more difficult for 'Net firms to come by.
Investors' distaste for 'Net stocks is especially prevalent when the business plans of the companies in question depend solely on selling goods to consumers. "The business models are coming under intense scrutiny for companies in the business-to-consumer sector, because both investors and venture capitalists are skeptical about the potential for profitability," says Jon A. Flint, founder of Boston-based Polaris Venture Partners, an initial backer of the successful Internet company Akamai Technologies.
Could the depression felt in consumer-oriented 'Net companies spread to the business-to-business sector? Right now the sector is so beloved that it hardly seems possible. For instance, a purchasing site for businesses, PurchasePro, has a mere 10.2 months of cash remaining, yet the stock market totally sloughs it off. Recently, PurchasePro shares touched a spectacular 175, up 2,000% from the firm's $8 offering price (adjusted for a split) last September.
Still, don't be surprised if at some point such popular business-to-business stocks go the way of the consumer offerings such as eToys, FTD.com, or drkoop.com. "Many of these B2B companies have strategies that depend upon continuous access to capital," says Kyle. "If any of these firms were not able to raise their cash, the implosion would certainly affect stockholder confidence. We know that B2B stocks have to eventually come down, the question is when: five months or five years from now?"
Don't bet on the latter.
Part of the problem is that the 'Net companies' founders and early backers are eager to sell their shares while they still can. So far this year, 38 publicly traded Internet companies have tapped the markets for $16 billion in capital through secondary offerings. This represents a fivefold increase in the number of secondary offerings compared with the same period last year. Another key difference is that this year a far larger number of second-round deals involved insiders unloading their shares on the public. This hurts the companies in question because the cash raised by selling shareholders goes right into the pockets of those shareholders, and not into the companies' coffers.
Sure, venture capitalists and other early-stage investors are in the business of selling out at a profit eventually, but large sales of insider stock while a company is still reporting losses can choke off that company's access to fresh capital, thereby diminishing the chances for survival. In the investment world, this is akin to men on a sinking ocean liner pushing women and children aside to commandeer the lifeboats.
"The IPO market used to be available only to seasoned companies where the insiders' exit strategy didn't matter," says Hambrecht. "When you take a company public that still needs capital to continue as a going concern, you are taking a huge risk. Insider selling only makes it harder to raise money."
Venture capitalists, quite rightly, become incensed when their integrity gets impugned. After all, they were behind more than half of last year's 501 initial public offerings. For them, selling down positions to cover startup costs happens to be a business strategy.
The conflict of interest between venture capitalists and the public is well illustrated by the case of MyPoints.com, an Internet direct-marketing firm. With four months' cash left, MyPoints filed to raise $185 million by selling as many as four million shares to the public. At first blush, the offering would appear to refill MyPoints.com's coffers quite nicely. But a closer look reveals that 40% of the shares on offer are being sold by insiders. Thus, money seemingly destined for the company gets diverted to insiders.
Another notable insider selloff occurred at the Internet real-estate seller HomeStore.com, which at yearend 1999 had enough cash remaining to last a little over a year. The stock came public at 20 in August, rose to a high of 138, and has since slipped to 50. In January, HomeStore announced a $900 million secondary offering, in which the insiders reaped more than half the gross proceeds.
More often than not, venture capitalists sell when retail investors are eager to buy. As noted above, shares of PurchasePro.com recently touched $175. With 10.2 months' cash left, it should be no surprise that PurchasePro recently sold three million shares, one-third of which are owned by insiders.
The evidence shows the race for the exits is especially pronounced among Internet companies. So far this year, in two-thirds of the secondary stock offerings by Internet companies, 25% or more of the shares were sold by insiders, according to CommScan. In non-Internet deals, only about one-quarter of the deals involved insider selling of 25% or more.
The Internet investing game has been kept alive in large part by a massive flow of money out of Old Economy stocks and into New Economy stocks. Last week's steep slide in the Nasdaq and the sharp recovery of the Dow Jones Industrial Average may mark a reversal of this trend. As illustrated last week, once psychology changes, cash-poor Internet issues tend to fall farthest, fastest.
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Fire Alarm
Here's when the 51 'Net companies below are likely to run out of cash, according to year-end 1999 data. Some can raise more funds through stock and bond offerings. Others will be forced to merge or go out of business. It's Darwinian capitalism at work.
March 2000 Pilot Ntwk Services CDNow
April 2000 Secure Computing
May 2000 Peapod VerticalNet MarketWatch.com
June 2000 drkoop.com Infonautics Medscape Intelligent Life Digital Island Splitrock Services VitaminShoppe.com
July 2000 Intraware Interliant MyPoints.com Egghead.com MotherNature.com ImageX.com BigStar Entmt Mail.com
August 2000 Cybercash Applied Theory WorldTalk Corp Primix Solutions Newsedge
September 2000 FTD.com ShopNow.com Beyond.com Healtheon
October 2000 E Loan Interactive Pictures Ask Jeeves LoisLaw.com PlanetRx.com
November 2000 LifeMinders.com SmarterKids.com drugstore.com Ashford.com NorthPoint Comm.
December 2000 EarthWeb NetObjects Tickets.com
January 2001 Salon.com Amazon.com PurchasePro.com
February 2001 Cobalt Group Multex.com eToys Kana Comms E-Stamp
Source: Pegasus Research International