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Waiting for the Dough

Thanks to the recent market swoon, the pressure on e-business to show a profit is greater than ever. Here's how five internet CFOs plan to do it.

1Jun

No New Economy CFO is going to tell you that profits don't matter. You might hear that market share, revenues, or brand awareness matters more. Or that the first priority is to fine-tune the business model for scalability and leverage. Or that the company could turn profitable in the current quarter, if it wanted to, but that doing so would be a big mistake.


"Being profitable now would not only be shortsighted, it would be suicide," exclaims Russ Surmanek, CFO of Net Objects Inc., an E-business software and services provider in Redwood City, California, with revenues of $10.2 million and a net loss of $4.3 million in its most recent quarter. "Our largest spend is research and development, and we could save a lot of money there if we told everyone to go home. Advertising and promotions could also be cut, but we wouldn't have any leads."


But Surmanek, like other New Economy CFOs, realizes that today, profits matter more than ever. The recent cooling off of the market for technology stocks, coupled with the well-publicized troubles of such E-tailers as CDnow and Peapod, has made investors impatient with quarterly losses. "There was a period where you were expected to stake out a position in the marketplace and capture market share before you turned on the profit engine," says Geoffrey Moore, a consultant and author of Living on the Fault Line, a new book on managing for shareholder value in the Internet Age. "That period is over."



The Red And The Black

Profitability among New Economy companies is not as foreign a concept as many may think. Major players like America Online Inc. and Yahoo Inc. have been making money for years, and Ebay Inc. was that rare Internet company that was in the black when it went public. In all, 15 of the 40 public companies on Internet audience- measurement firm Media Metrix's top 50 digital media and Web properties are profitable, according to Business 2.0 magazine.


As for CFOs at red-inked companies, they insist that the notion of building a profitable business has never been far from their thoughts. For example, the day after VerticalNet Inc.'s initial public offering in February 1999, CFO Gene Godick was on the phone with consultants about installing a budgeting and planning system. And in April 1999, its first month as a public company, Priceline .com Inc. vowed that it would show steady progress toward profitability every quarter. "We recognized that Internet companies would, sooner or later, have to demonstrate that they had a business model that could be profitable," says founding CFO Paul Francis.


It remains to be seen how tolerant skittish investors will be of ongoing losses and what signs they will be looking for to measure progress. Will ramping up revenues still be enough? Merrill Lynch analyst Henry Blodget calls revenue multiples "a fine shorthand valuation technique," but Blodget is looking to future earnings when he predicts that 75 percent of the 400 or so Internet companies will disappear (through consolidation or failure) before ever making a dime.


Observes Tomas Isakowitz, an analyst at Janney Montgomery Scott, in Philadelphia: "I measure the commitment to profitability by looking at expenses as a proportion of revenues. There are exceptions where a company needs to spend more in one quarter to get more revenues in the following quarter. But everybody needs to have a business model that scales, or they'll never make money."


Everybody knows that--or should--but perhaps the biggest risk is panicking. Could the pressure to show profits force companies to make bad strategic decisions or play games with their reported earnings? "Different sectors are at different places in their development cycle," Moore notes. "The consumer sector is in the 'Show me the money' phase, but because that sector has been hit, the entire Internet has been hit, and everybody is expected to turn profitable tomorrow. That isn't appropriate."



Welcoming The Shakeout

Yet some E-CFOs actually welcome the recent market gyrations. "Now that some money has been taken off the table, maybe investors will be more selective and look for quality," says Chris Baudouin, CFO of Internet.com Corp., an E-business content provider in Darien, Connecticut, that has seen its stock fall more than 50 percent since the market peak on March 10, but became cash-flow positive in the first quarter of this year. "Hopefully, people are finally looking at the bottom line when they decide where to put their money."


Even Amazon.com said recently that its core book and music businesses would turn a profit in 2000. The famously unprofitable company's shares slid from $113 in December to $40 in April, but they may soar again if investors decide the company will emerge victorious from an Internet shakeout.


We talked to five New Economy CFOs about their strategies for managing through such turbulent and skeptical times. Each CFO operates in a different sector and works with a different business model, and each has a different timetable for profitability. But all agree on one thing: Profits matter.



PRICELINE.COM :



Managed Margins


Will the Securities and Exchange Commission compel Internet companies to modify some of their more controversial revenue- recognition practices? That question has been pointedly put to Priceline.com almost since the name-your-own-price E- tailer with the Web's second-most-recognized E- commerce brand went public last year. But according to founding CFO Paul Francis, even if Priceline were forced to make a change, that would only slow, not stop, its march to profitability. "It would not affect the economics of our business," he says.


With revenue growth a key metric for valuing Internet companies, the SEC has expressed concern that some E-businesses may be using accounting tricks to pump up their sales numbers. Priceline became ensnared in this debate over its practice of reporting the total value of the airline tickets, hotel reservations, and other products and services it sells on its Web site, rather than the spread between the price a customer pays and the company's cost.


Francis contends that Priceline's accounting is valid, since the company takes ownership of the items it resells and doesn't receive a fee or commission as, say, a travel agent would. (He discussed Priceline's approach with the SEC when the company went public last year, but Priceline has not had any further discussions with regulators.) Furthermore, says Francis, who in March became CFO of Priceline WebHouse Club, a name-your-own-price grocery- service affiliate, the gross margin line--which hit a record 15.6 percent in the first quarter--would not be affected by a change in revenue recognition.


Indeed, because Priceline essentially serves as a market maker and can accept or reject a customer's bid, the company has complete control over the gross margin on each transaction; it is entitled to more than just a straight percentage as a commission. This factor underscores the beauty of Priceline's business model: the company can manage the profitability of each sale, which has enabled it to deliver on the stated objective to improve its operational results each quarter.


"Priceline has the ability to acutely manage its gross margin by the very nature of its business," says Ryan Alexander of Wit Soundview, in New York. "As the gross margin has improved, based on cross-pollinating its customer base and extending its brand awareness, the company has been able to sequentially reduce its operating losses." Thanks to evidence in its first-quarter earnings announcement of growing customer acceptance of Priceline's offerings, several analysts predict that profitability could come as soon as the fourth quarter.


That's why Francis has a what- me-worry attitude toward the issue of revenue recognition--as does Heidi Miller, who became Priceline's new CFO in March. Analysts are similarly blasé about any bottom- line impact, though some express concern that Priceline's stock, which is down about 33 percent from the market's peak in mid-March, might get hammered. An accounting change would put 2000 revenues at slightly more than $200 million, instead of projected revenues of more than $1 billion.


Perhaps a change, if it comes, will not take effect until after Priceline turns profitable. Then investors can value the company on the money it makes.



COVAD COMMUNICATIONS:



Low Cost Wins


If it's not one thing, then it's another. This spring, CFO Tim Laehy had to fend off everything from speculation that Covad Communications Group would have to restate its revenues to rumors that it would miss its first-quarter targets on earnings and subscriber lines installed. "We told people we were comfortable with all aspects of the range [of both metrics], and then they got goofy about which part of the range we were most comfortable with," he says.


All the while, Covad's stock plummeted by more than half, from a split-adjusted all-time high of $67 per share in mid-March to about $30. But Laehy isn't worried. "This most recent correction has not taken our eye off the ball," he says. "Investors sell indiscriminately on the way down, but they buy very discriminately on the way up. The companies with the best track record, the best management team, and the best business plan will be the ones rewarded by investors coming back into the market."


Covad's business plan is to build the next-generation Internet infrastructure. It was the first company to roll out digital subscriber line (DSL) services, and analysts expect the company to offer its high- speed Web access over telephone lines in 100 markets by the end of the year. Consequently, Covad is in a massive capital- spending mode, and any thought of making money is far into the future.


Laehy, a veteran of Union Carbide Corp. and Liberty Mutual Insurance, has raised more than $2.1 billion since joining the company soon after its 1996 launch, and plans to spend some $400 million this year. But while some competitors are giving away service to add subscriber lines (new subscriber lines are the leading indicator that the business is scaling), Laehy has been pushing operational efficiencies to reduce installation costs per line, and has expanded services to increase profitability per line.


"In this business, low cost is going to win," he says. "People are going to want high-speed Internet access at about the same price as low-speed Internet access."


Although analysts project larger Ebitda (earnings before interest, taxes, depreciation, and amortization) losses through 2001, Covad is already Ebitda- positive in its two most mature markets, and turned free- cash-flow positive in San Francisco, where it first launched, this year. "We want to replicate that experience around the country," Laehy says.


One source of the negative buzz about Covad revolved around the new rules for recognizing nonrecurring revenues in the SEC's Staff Accounting Bulletin 101. Merrill Lynch analyst Ken Hoexter doubts that the company will have to restate revenues, because Covad's nonrecurring fees for equipment and service activation are collected up front and are nonrefundable. More uncertainty came from concern that glitches associated with a new internal operating support system would slow the installation of new subscriber lines.


Covad executives say that issue has gone away since the release of first-quarter results in April, which put a stop to the recent spate of rumors. After all, the company ended up exceeding analyst estimates for new lines installed and reporting losses of 73 cents a share, 6 cents better than the Wall Street consensus. "When the facts are introduced, people stop worrying," Laehy quips. And when the stock falls? "We're confident that if we continue to beat our targets, we will be rewarded with superior market valuation."



MYPOINTS.COM:



Just Say No


As far as CFO Tom Caldwell is concerned, achieving profitability at MyPoints.com requires little more than basic financial management: keeping revenues real, controlling discretionary spending, making accretive acquisitions only. "I have refined the practice of saying no," boasts Caldwell, a former M&A adviser with a Big Five audit firm and ex-CFO of a privately held Silicon Valley electronics manufacturer.


MyPoints is known by some as the S&H Green Stamps of the Information Age, because it rewards its 8.1 million members with redeemable points for receiving E-mail solicitations from its merchant- partners. Soon after joining the company in April 1999, Caldwell said no to all barter transactions--a move that was as much symbolic as it was sensible at a time when such in- kind trades made up only about 2 percent of revenues. Many Internet companies have pumped up revenues with the noncash sales, but Caldwell wanted "strong, quality revenue streams, not something that might cast a pall over our stock because of accounting," he says.


Caldwell was also skeptical of plans to spend heavily on television advertising. In mid-1999, an internal study found that ad rates were rising fast and that the money might be wasted amid an anticipated clutter of dot-com commercials. He took some $5 million out of $17 million slated for TV advertising and used it to improve systems, launch new products, and expand the number of advertisers MyPoints serves.


Even without the TV blitz, MyPoints reported sequential revenue growth of 20 percent in the first quarter, while membership was up 40 percent. "They have reduced their advertising costs at the same time that their customer base has grown rapidly," says Safa Rashtchy, an Internet analyst at US Bancorp Piper Jaffray.


Saying no has kept expenses in check, but Caldwell knows how to say yes, too. A series of recent price increases for direct-mail services has helped bring gross margins to about 75 percent, and a secondary offering in February beat the recent market downturn, giving Caldwell an additional $105 million. He even approved a plan to hire new software engineers before they're absolutely needed, to avoid hiring more-expensive consultants when a crunch comes.


The most recent yes came in April, when MyPoints announced the acquisition of a key competitor, Cybergold Inc. Combined, the two companies have nearly twice the number of members and a broader array of products to offer direct-marketing advertisers. "We hope that MyPoints will be able to demonstrate the leverage inherent in its business model all the more quickly," wrote Lanny Baker of Salomon Smith Barney in a research note.


Caldwell expects that to happen, and projects that profitability might even come up a quarter or so sooner. There was little overlap of customers, and Cybergold had been both underpricing its services and doing a poor job of monetizing its customer base. Not only that, Caldwell was dismayed to see that the acquired company was spending heavily on brand advertising and had made investments in noncore assets.


"They didn't practice saying no," he says disapprovingly.



PLANETRX.COM:



Conserving Cash


Steve Valenzuela of PlanetRx.com has heard all the doom- and-gloom reports about Internet E-tailing--how the sector is headed for a shakeout, how burn rates are bringing dozens of companies to the brink of bankruptcy, how financing opportunities for replenishing cash have dried up. The CFO believes every word, but he doesn't think the dire predictions apply to his company.


"We're not immune to market conditions, but we're not in a desperate situation whatsoever," asserts Valenzuela. "We have plenty of cash, and we're going to conserve our cash as long as possible, because we're not going to assume the market will come back. We are taking the necessary steps, in a logical and methodical manner, without hurting the growth of the business."


Valenzuela laid out PlanetRx's plan in a conference call on April 18 after announcing first-quarter results that beat analyst estimates. The company would lower operating expenses by 8 to 12 percent in the second quarter, he explained, and by 15 to 20 percent in the third and fourth quarters. The bulk of the savings would come out of the marketing and sales costs associated with brand building.


Analysts frequently express concern when E-businesses reduce spending on marketing and sales, because brand advertising is seen as important to driving revenue growth. But Valenzuela points out that PlanetRx's first-quarter revenues grew 72 percent from the previous quarter, while marketing and sales expenses remained flat. At the same time, customer acquisition costs (which reflect discounts and branding campaigns) fell nearly 30 percent. "This shows we can scale the business," says Valenzuela.


Working in PlanetRx's favor are the recent completion of its state-of-the-art order-fulfillment center in Memphis; its new partnership with Express Scripts Inc., a leading pharmacy benefits management company; and the nature of its business model. Unlike many E-tailers, which are built around Internet selling, PlanetRx operates 7 of the 29 health-related domains it owns that bring visitors to the Web site. Membership for the first quarter reached 854,000, while buying customers hit 400,000.


"The content and community get people to come back to the site," Valenzuela says. "Over time, we will continue to drive revenue growth at a lower cost, which will help us achieve profitability."


But like most business-to- consumer firms, PlanetRx can't get to that point without additional funding. With $76 million in cash on hand, down from $109 million in the previous quarter, the company could get through the next two quarters without an infusion. Lowering operating expenses will certainly reduce the burn rate and buy some time. But Valenzuela doesn't believe what he hears about financing being unavailable.


"The cash is out there to be raised," he says.



VERTICALNET:



A Portfolio Approach


Minutes after the market closed on March 31, VerticalNet CFO Gene Godick surveyed the carnage on his computer screen. The stock was off almost 10 percent for the day, down for the third session in a row. Comparable B2B E-commerce companies were also down, but Godick found little comfort in the misery of others.


"If I told you I didn't care, you wouldn't believe me anyway," the Big Five veteran said to a visitor to his suburban Philadelphia office. "Obviously, everybody here has a lot of their net worth tied up in our stock, but we've had four or five major dips since we went public, and every time we've come back and hit new highs. I have to walk around telling people, 'The stock will recover.'"


That message would become an increasingly hard sell over the next three weeks, as the market swooned and VerticalNet fell another 50 percent. The stock bottomed out at about 80 percent below its all-time high in mid-March. Godick's more recent retort: "Events like [the market plunge] need to happen to separate the winners from the losers, and we believe we will be one of the winners."


That belief is rooted in VerticalNet's evolving business model. Operating 56 vertical Web-based communities in industries ranging from sewage treatment to dentistry, the company derives about 90 percent of its revenues from advertising and the sale of Web storefronts. VerticalNet has also begun to pursue the potentially more lucrative B2B E-commerce revenues. Two purchased electronic-component brokers have been converted into online exchanges, and another acquisition, of a B2B technology firm, is expected to help VerticalNet link buyers and sellers in its other industrial categories.


"Last year we went broad by adding more communities," Godick explains, "and in 2000 we're going deep into our existing communities to develop new revenue streams."


For Godick, the key to profitability is a matrix that lets everyone look at the company's trade communities across an evolving set of products and services. Taking a portfolio approach to building the business, he meets weekly with his planning group to analyze performance at all intersections of the matrix. Eventually, the poor performers will get weeded out.


"Every time they tweak their model, it's a better model," comments analyst Isakowitz at Janney Montgomery Scott. "There is still a path to profitability, and profitability comes sooner rather than later. That's a good sign."


Oddly, Godick suggests that the stock's wild ride has helped bring into focus the goal of becoming the first profitable B2B company: "That's what we've been shooting for all along," he says. "Now more than ever, profits matter."



Stephen Barr is senior contributing editor of CFO.

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