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A Dot-Bomb Postmortem

It has been a brutal autumn and winter in the Internet sector with numerous companies painfully scaling back operations or just plain going out of business. Luckily, there is a silver lining to the seemingly dire situation. Those Internet companies that can survive the shakeout should benefit greatly from the reduced competition.

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By Paul Larson (TMF Parlay)
January 18, 2001

It has been a terrible few months for the Internet sector. Every day seems to bring news of another dot-com significantly scaling back operations, laying people off, or even closing its doors altogether. In November, an estimated 9,000 people in the Internet sector lost their jobs. In December, another 10,000 people working for Internet companies were involuntarily thrown back into the job market, and the rate of layoffs and outright dot-com deaths does not look like it will slow any time soon.  

It's not just those who work in the sector who are feeling the pain. Investors who dared to touch any company related to the Internet have taken hits. Nearly all of the dot-com stocks are trading at a fraction of their old highs, and there is a long and growing list of former Internet high-fliers that have filed for bankruptcy. Even those Internet companies whose businesses have remained on track have had their stocks pummeled.

The capital spigot has been turned off
One of the reasons so many companies are going belly up is that Wall Street has completely lost its patience with companies that have no reasonable expectation of near-term profitability or positive cash flow. Firms that treated the stock market as a renewable source of unlimited capital got a harsh lesson in reality last year. Cash burn is out of style; cash flow is in.

It is never a good idea to bet the farm on being able to raise capital whenever the need arises, and yet that's exactly what many Internet companies did. Many of the companies now in the dot-com graveyard did not raise enough capital to fully execute their business plans. When the need inevitably arose to tap Wall Street for more cash, the companies found investors balking. It was like flying a plane on a too-short runway, and expecting the runway to be miraculously extended mid-takeoff.

The fact that Wall Street is being much more selective and valuing companies based on how well they handle real-world business challenges instead of their pure revolutionary potential is not necessarily a bad thing. Having the spigot of capital closed to firms that lack plausible business plans is also not a terrible thing. It allows survivor companies, those able to create both customer and shareholder value, a chance to capture a larger market share than they might have otherwise.

The silver lining
For all the negativity in the market, the Internet continues to become a larger and larger part of our lives and the economy. The underlying positive forces in the new economy remain undamaged by the dot-com meltdown. The Internet will continue growing at a breakneck rate, providing opportunities for new and unique services. It will continue putting an unthinkable amount of information at consumers' fingertips while also allowing companies to streamline their businesses and cut costs. The Internet revolution is very real, but as in every revolution, heads must roll.

There is a silver lining to the recent shakeout and Wall Street's depressed mood toward anything Internet -- the online economy will continue to grow robustly in the coming years, and thanks to the shakeout, there will be fewer fingers dipping into this ever-growing pie.

Companies are dropping from the field on a daily basis, and the market is clearly not interested in funding new upstart competitors, giving existing companies an awesome opportunity. This is because the survivors stand to gain a larger share of their respective markets. For example, if eToys (Nasdaq: ETYS) goes out of business like we expect it to, a major chunk of the online toy market will be up for grabs, and the remaining players such as the Toys R Us (NYSE: TOY)/Amazon (Nasdaq: AMZN) alliance should see growth over and above that of the overall market.

Let's look at a hypothetical example of how market-share gains may give the survivors a revenue turbo boost. Assume Company X has a 30% share of a $1 billion market, giving it annual revenues of $300 million. If the overall market grows 25% to $1.25 billion and the company can up its share from 30% to 40% thanks to competitors falling from the field, Company X will then have annual revenue of $500 million, 66% annual growth and more than twice the growth of the overall market it serves. Combining a steadily growing market with healthy share gains often gives exponential growth, which is exactly the situation we anticipate many of the Internet survivors facing.

Survivors are sitting pretty
Some survivors such as eBay (Nasdaq: EBAY) and AOL Time Warner (NYSE: AOL) (that name is going to take some getting used to) have either met or exceeded their revenue and profit estimates over the past year, and their businesses are in the best position they have ever been. However, both companies are now trading at less than half of their old highs.

Then there's Yahoo! (Nasdaq: YHOO), now trading at roughly one-tenth its previous value. While the company's short-term growth certainly was derailed a bit by the dot-com meltdown, its long-term positioning still looks quite solid. It has $1.7 billion in cash and, even with watered-down estimates, is expected to be strongly profitable in the coming years. Moreover, Yahoo! was able to dominate its market during the "melt up." It will be almost impossible to compete with now.

Mix this weeding-out process with valuations that are the cheapest they have been for some time and there seems to be a good deal of potential today for those looking to invest in the Internet survivors. The bottom line is that if you liked the companies that survived the dot-com shakeout before the shakeout began, you should love them now.

In the most recent Motley Fool Research Internet Report we looked in-depth at four of the survivors -- Amazon, AOL, eBay, and Yahoo! Pick up a copy if you want to read more about why some dot-coms died, why others survived, and why we think those survivors are now well-positioned to benefit from the shakeout.

Related Links:

  • Motley Fool Research Internet Report -- Internet Survivors 
  • Assessing Internet Stocks in 2001  
  • What's Amazon's Prognosis?  
  • How Amazon Won the War
  • The Market Hollers at Yahoo!