FOOL ON THE HILL: An Investment Opinion
Many Internet companies are running out of cash. These companies have options, none of them immediately beneficial to shareholders. Investors need to break out the 10-Q and a calculator and decide if a company's cash crunch can be cured.
We've heard it all at this point. The death of tech, the slaughter of the dot-coms, the comeuppance of the momentum traders. Certainly the last three months have caused some investors to suffer huge losses: The Nasdaq is still down some 20% from its high, the Internet index (the DOT) more than 40%. For some, the losses ate into their long-term gains; for others, their investment capital has disappeared as well.
And the media, from Barron's to BusinessWeek to Business 2.0, have been dancing on the ashes. It's understandable -- it's just too good a story to walk away from. What no one seems to be telling investors is how they should treat these companies.
Well, I'm gonna. At least I'm going to give a little guidance. But remember, Fools, we are business-centric, so we should keep our view squarely on the potential for a business to provide an outsized return.
The reason many companies have such low share prices is quite simple -- they are running out of cash. Maybe they've got a great business, but if they have no cash, they're not going to be around long enough to find out. I am reminded of an earlier article I wrote in which I accused companies of being shortsighted for underpricing initial public offerings (IPOs) so they could build buzz about their company. I'll bet many of these companies wish they had the cash they left on the table now. No amount of analyst hyping will change the fact that a company walked away from its public offering with half or a third of the cash it should have garnered if it had been priced better. This was a spectacular racket for the investment bankers while it lasted. Of the 501 IPOs in 1999, the average return on the first day was 64%.
Doesn't help them, or us, much now. But some companies that have lost huge amounts of market value are just in the downdraft of other companies that are there for a good reason. Where last year anything that sniffed of Internet was guaranteed to run through the roof, this year some companies -- including Infospace (Nasdaq: INSP) -- have quietly dropped the ".com" from their names.
So, when all is said and done, you need to break out the company's financial statement and a calculator. You need to find the most recent 10-Q, but you may also go back a little farther as some companies do have cyclical revenue patterns. Many companies that believed earlier that they had easy access to funding have recently been disabused of this notion and have become much more austere. The more recent, the better you can determine what a company's future needs are now that the era of "let them eat cake" has passed.
Let's use Beyond.com (Nasdaq: BYND) as our example. The most recent 10-Q has the company losing $45 million over the first three months of 2000, with $24 million of this amount being related to a onetime restructuring charge, so the actual operating cash burn is $21 million for the first quarter, or $7 million per month. Additionally, the company's 10-Q states that Beyond expects the restructuring to save $6-8 million in expenses per quarter, so we can subtract this amount out and assume the going forward cash burn would be $14 million per quarter, or $4.6 million per month.
If you compare this to the company's cash position, you can determine how long a company can go before it will require additional financing. In Beyond's case, they have $64.5 million in current assets as of March 31, 2000. Of this, $50.1 million is cash, enough for 12 months of operation.
But Beyond.com also has $27 million in current liabilities, leaving a net current asset position of $37.5 million. This means that as of the company's last 10-Q, the company had a sufficient current asset base to carry it through November before it would require additional funds.
And Beyond's stock price reflects this uncertainty, trading at $1 1/2, down from a high of $30. So Beyond's got to make some choices, only one of which is even marginally good for current investors. Let's start at the top:
1. Move quickly to profitability: A company that has not worried about earning money, instead focusing upon its brand, could try to reverse course. Some have suggested that Amazon.com (Nasdaq: AMZN) go this route, even though the company's cash position is really pretty good. Well, relatively speaking. Fortunately for Amazon, its terms for the other choices would be much better than it would for Varsity Group (Nasdaq: VSTY), iTurf (Nasdaq: TURF), or other basement dwellers. Beyond had a gross profit of $1.3 million per month in the last quarter, with a gross margin of 13%. The company would have to increase both, and at the same time strip out some of its $6.6 million in monthly sales, general & administrative expenses. A company that can do this can operate on existing cash for a much longer period, meaning that shareholders would not have to face dilution of their shares. For Beyond, this option will be difficult to achieve on its own unless it can find a way to increase its gross margins.
2. Secondary public offering or additional debt: Companies that need to raise cash may sell additional shares of stock on the open market in a secondary offering. This invites two problems: a) The company is diluting the existing shares by increasing the total share count, and b) because of a depressed share price, the amount of money raised is going to be low. The company may also choose to take on more debt, but the interest rate and terms are going to be severe.
3. Private Financing: Companies could go to other companies or to private investors for additional funding. Boo.com did this several times, at first raising its valuation price each time. Then, when it had fired its way through most of its $200 million, it approached several financial groups, who would only invest money if the existing shareholders stakes were revalued at pennies on the dollar, an offer which was refused. Within a few weeks, boo.com was done. When a company takes on a "down round" of financing like this, look out.
4. Merger or Acquisition: Most likely the latter. This happened recently when pets.com (Nasdaq: IPET) took over petstore.com. The acquired company gained 5.8 million shares of pets.com stock, about $12 million at current prices. This represents an enormous unrealized loss for petstore.com owners, and now attaches their fortunes to another company. Companies with dwindling cash reserves rarely get to negotiate from a point of strength.
5. Bankruptcy: Chapter 11 if there is a viable reorganization plan, Chapter 7 if no such plan is viable. The important thing to note about bankruptcy is that equity shareholders are on the bottom of the list to get money back. All debt holders, creditors, and preferred stockholders come first. For Internet companies, the asset bases are so small that in a liquidation, the chance of a shareholder receiving any money from the proceedings is almost nil.
The point is this: You may have made a mistake when you bought the company. The market, unfortunately, does not care what YOUR purchase price was. For severely depressed stocks in particular, your best bet is to wipe the slate clean, ignoring losses already incurred for the sake of the decision. Riding a company all the way into the ground for fear of admitting that you made a mistake is no way to preserve your capital.
As disasters such as Iridium will show, there is no such thing as "nowhere to go but up." Companies that do not find a path to profitability, or at least sustainability, will and should drop out of existence, their shareholders left holding the bag.
Beyond.com has exactly $1.50 that it could fall farther; other long-term money losers such as MicroStrategy (Nasdaq: MSTR) and Amazon may in the end drop the final 30-40 points to their demise. Your job, as an investor, is to determine whether losses incurred now are helping to build something valuable for the future, or are signs of greater losses for both the company and ultimately its shareholders.
Come tell us your analysis of a company you hold on the Fool on the Hill discussion board. Some companies with rotten stocks are in fact poised for growth. Got a diamond in the rough?
Bill Mann, TMFOtter on the Fool discussion boards