Profit or Perish

It was as if a lenient parent suddenly started making the kids go to bed without their supper.

As 1999 drew to a close and 2000 began, some Net stock analysts finally started asking Internet companies to pay attention to the bottom line.

The trend started with Henry Blodget, the Net's own Father Flanagan. The Merrill Lynch analyst began to demand some self-discipline from his young charges, taking to task late last year for announcing plans to spend yet more money and for failing to chart a clear path to profitability.

A few other analysts also registered frustration, and a couple of weeks later Amazon capitulated, somewhat. The firm forecast that its U.S. books division - its oldest and largest source of revenue - would turn a profit in 2000.

The question for the new year is: Will investors follow suit and start measuring Internet companies by their bottom lines?

If the early days of 2000 are any indication, the answer is yes. Traders who had been holding onto pricey Net shares at the end of 1999 started unloading them quickly, shifting their money into safer equities like blue-chip stocks, utilities and mining stocks.

Many traders likely made up their minds weeks or months ago and put off selling in order to delay their tax bite until the new year. In any case, though, the result was the same: The market swooned.

The Nasdaq Composite Index was down more than 5.5 percent on Jan. 4 alone - this after a whopping 85 percent gain in the index in 1999. The sell-off continued later in the week.

Amazon was among the hardest hit. On Jan. 5, the company announced that fourth-quarter sales would be higher, but it still expects no drop in losses.

That was too much even for stalwart Internet-stock enthusiasts. Amazon shares tanked, suffering a one-day decline of nearly 15 percent. As the week wore on, so did Amazon's market losses.

It's still too soon to say for sure whether the market downturn is the beginning of the end of investors' love affair with profitless Net companies or just a profit-taking blip in the bull market. But analysts nevertheless are predicting changes in the landscape ahead.

"I suspect that when we start seeing [additional quarterly financial reports] come out, people will start looking at these stocks a little differently," says Richard Schottenfeld, who runs a technology hedge fund that invests in value stocks and hence doesn't own any profitless Net companies.

When results are announced, "there are going to be winners and losers, and there will be a realization among investors that there can be losers," Schottenfeld anticipates.

Perversely, when companies do report profits, investors may be in for a rude awakening. The price-earnings ratio for a profitless company is zero. The ratio for a firm with a small profit and an incredibly high market valuation lays out in stark terms just how much a company's earnings have to grow to justify the valuation.

When Amazon bowed to pressure and forecast earnings for its books division, it may have been a turning point for the company.

"Now investors will be expecting profits and Amazon will be measured on profits," says Schottenfeld. When those profits - if and when they come - look weak compared with other firms, investors could flee.

Lycos is expected to report its first clear profit in 2000, and ExciteAtHome says it will report operating profits. But if the market keeps cooking, their valuations will be incredibly high compared to earnings.

Nevertheless, black ink may help these companies survive any shakeout.

Lycos, with a $7.4 billion market cap, has always said it aims to boost its bottom line, and it has a history of keeping spending under control, at least compared to its competitors. It has a long way to go before it can measure up to its $16 billion valuation, but ExciteAtHome is the leader in a sector - broadband Internet service - that is expected to see huge growth.

The sheer number of Internet stocks on the market could raise investor expectations as well.

Depending on whom you ask and how broadly you define what an Internet company is, between 200 and 300 Net IPOs hit the market in 1999. Much of the run-up in the value of the sector is due to the flood of investors who were drawn to the allure of Internet stocks and arrived to find that, until lately, there were only so many issues to go around.

If the IPO trend continues, "the supply of companies will catch up with demand," says Christine Nairne, an analyst with online investment bank E-Offering. "At that point people will start looking for companies with profits."

Companies with no real plans for turning profitable could see their stocks dive.

"A year ago we were actually talking about a shortage of Internet stocks," Schottenfeld says. "Well, the investment bankers have taken care of that, and now there are too many. There's going to be a shakeout in the whole sector."

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