Are 'Net Co's Running Out of Cash?
By Eric Janszen • Bankrate.com

Fresh on 4/04/00: A Barron's article looks at the burn rate of some Internet companies -- did they miss the point?

In the March 20, 2000 Barron's, Jack Willoughby wrote "Burning Up," a toothy story about cash-starved Internet startups. Basing his remarks on a study by Pegasus Research International, Willoughby concludes, "Internet companies are running out of cash -- fast." It's a good piece, but Barron's covers only half the story.

I have argued since late 1998 that a major risk to holders of Internet stocks is the psychological impact of even one major Internet firm running out of cash. But just as dangerous to the valuations of Internet stocks is the revelation that the rest are actually profitable, but only modestly so. That will bring to a close a long period of speculation in Internet stocks.

Why? Because one cannot speculate on the knowable, only the unknowable.

Given that the stock prices of most Internet companies reflect investors' mass delusion of infinite future profits, the stock prices of these companies will fall to reflect their true capacity for earnings growth once the delusion is dispelled.

During the railroad stock mania, for example, all of the speculative investing that drove railroad stocks to very high values happened over the land rights of railroad companies, before any wheels turned. As soon as investors figured out how much a railroad company could actually profit from the business of running a railroad, the stock prices collapsed to reflect more traditional price/earning ratios, after overcompensating in the other direction for a while.

The instant an overvalued Internet company reveals its ability to produce profits, or inability to produce profits, its stock price declines. In the case of an Internet company that begins producing profits, the stock price adjusts to accommodate a realistic ramp in earnings over a period of several years. Since the Internet stock P/E pre-revelation reflects the hopeful belief that earnings will be infinite once the company "refines its business model," its stock price deflates when the company reports its first profits and investors discover that earnings will instead be finite. As Bezos has learned, to justify a P/E that won't return an investor's principle before the sun goes supernova a few million years from now, better to keep digging for the super-high profit pony than to declare the evident low-profit mule as the prize. At least until the money runs out.

Many Internet companies will do even worse than show a measurable profit; they will show that they can never do so. These unfortunate companies were born in the atmosphere of apparently limitless private and public financing and have survived so far by relying on the greed of strangers.

These are iTulip.com companies (see definition below), the kind of company that my site parodies. These companies were created for the sole purpose of selling stock to investors in the hope that the revenue raised will allow them to buy real companies. It should surprise no one that these companies will never turn a profit if they cannot go public and buy the business that will make them profitable.

We award the name "iTulip" to:

1) Acorporation that relies on the Internet to deliver products and services to its customers at a loss.

2) An uneconomical Internet-dependent business that a) requires private or public capital to maintain uneconomical operations indefinitely, and b) raises capital through the public markets to achieve an historically unprecedented market capitalization influenced by the stock performance of similar companies, none of which are profitable.

Unfortunately, Barron's does not do a good job of distinguishing between iTulip.com companies and those Internet companies that can reach profitability more quickly than they can run out of money.

Barron's says, "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." We assume they used that metric to avoid the more complex formula of averaging four quarters' revenue and expenses and included companies that were not public and reporting for the whole period.

The "one quarter" metric has obvious problems.

For example, what about those companies that were trying new marketing programs in the final quarter of 1999 and incurred far higher-than-normal marketing costs? The benefits of those programs are not likely to show up in the same quarter.

If they discontinued the program to measure results the following quarter, as most companies do, they are likely to show lower costs and higher revenue then. An Internet company can do what all companies do under normal conditions when diminishing cash flow threatens the business. They can cut expenses by reducing head count and marketing programs, eliminate unprofitable product lines (as distinguished from Amazon.com, which continues to add them), and so on.

We've been involved with more than a couple of companies that dealt with falling margins, diminishing market share or a shrinking market. It's no fun, but these events are survivable. The success depends on how close the company is to profitability and to new sources of funding.

Statistically, investors nearly always overreact to these events, and that makes for a great buying opportunity. Bet you never expected to hear us use that expression about an Internet stock. Just about every successful technology startup ever launched was once unprofitable.

What's new is that unprofitable startup companies were once insulated from fickle public markets, and the spread between expenses and revenue has never in history assumed wildly optimistic projections of the future enthusiasm of the public markets to fill the gap.

In the old days -- three years ago -- a company needed at least two quarters of profitability before investment banks would consider them for an IPO. Sure, they had to deal with fickle venture capitalists and other private investors, but at least these investors have more experience with the roller coaster ride that is a new company, a stronger stomach and a greater ability to influence the outcome of inevitable setbacks.

This idea of "public venture" is, frankly, a bunch of bull. The public invests because it thinks Internet stocks are not risky.

It remains to be seen what "public venture" does as it learns that there's a big risk coefficient related to those returns. At some point, the stock market expects predictability from public Internet companies -- and not just predictable losses.

We'll stick to the prediction we made in late 1998. When the correction in Internet stocks is over, the average Internet stock will fall to 87 percent of its peak price.

The average profitable Internet company that survives will fall 73 percent and those that never make it to profitability will, needless to say, go the way of American Austin Car company's stock -- to zero.

ERIC JANSZEN is the Executive Director of Osborn Capital, LLC, an angel investment firm in Lexington, Mass., and also is the founder of iTulip.com.

-- Posted: April 4, 2000