The last several years will go down as one of the most volatile periods to invest in stocks. Nowhere is that volatility more prevalent than in the technology-laden Nasdaq Stock Market. This index has seen stock prices rise to stratospheric levels in the late 1990’s and early 2000, driven mainly by the vast potential of the internet and technologies developed to exploit its use. But, as many investors have learned, potential does not equate to earnings, and sooner or later a lack of earnings equates to failure. This document will examine the Internet bubble and subsequent technology fallout that occurred from the late 1990’s to today. It will attempt to explain the causes that led to an abundance of e-commerce initial public offerings, ease in accessing capital, and inflated stock prices. Predictions from e-commerce executives, fund managers, and Wall street analysts during the bubble will also be provided. Furthermore, reasons why the bubble “popped” will be explored. Finally, a historical perspective draws parallels to other “revolutionary” times in American History, which will offer support why the internet and the technology sector, are by no means dead, and are poised to provide the long term economic growth engine for the world.
How did it all Start?
Arguably, it all began with Netscape in 1995. The IPO was extremely successful as the stock price rose from $28 to $71 on the first day, and ultimately cleared the way for hundreds more net companies to do IPO’s far earlier than ever before. A firm with $3 million in losses was suddenly worth $2 billion. Jim Clark, Netscape’s co-founder had been advised strongly against going public, but went ahead anyway because he had to make payment on a mega-yacht he was having built. If he missed the payment, the builder would give his slot to someone else, and he wouldn’t get his yacht for years. From such motives, among others, grew one of history’s great stock manias and a new model for venture funding.
E-Toys is a great example of a dot-com start-up with an innovative idea, great promise, and huge Wall Street backing that ultimately felt the pinch when customer demand dried up. On its first day of trading in May 1999, shares of E-Toys opened at $20, catapulted to $120, before closing at $76. Immediately it boasted a market capitalization of $7.6 billion, bigger that bricks and mortar giant Toys R Us. Chris Vroom, Internet analyst for Thomas Weisel partners initiated a strong buy on the stock, predicting that the company is likely worth $10 billion, and will continue to dominate online toy sales.
In June 2000, with losses mounting, cash dwindling and the stock price near $6, the company received another $100 million infusion from three private institutional investors. The sale was from preferred convertible stock over three years. E-Toys CFO indicates that the cash should carry the company until the fall of 2001, and that the company expects to be profitable by early 2002 at the latest.
In January 2001, the once-darling of e-commerce companies slashed its staff by 70 percent, and indicated that it will continue to search for a buyer. It also shut down all European operations. The news was no surprise as holiday sales came in at roughly half of the company’s projections. E-Toys attributes its decline to a “generally harsh retail climate and the continued disfavor of internet retailing.” At this time it’s stock traded around 16 cents. In February 2001, E-Toys was de-listed from the Nasdaq stock exchange, officially closed its doors and announced its intent to file for bankruptcy.
Another great e-commerce example is online grocer, Webvan. At the time of its IPO in November 1999, its promise was compelling, however its operational record was suspect. Yet at one point during its first day of trading the shares reached $34 giving it a market capitalization of $15 billion. Overall, the company raised more than $1 billion over its short lifetime. It has a star-studded list of venture capital backers and hired George Shaheen, former head of Anderson Consulting (now “Accenture”). For the year-ended 1999, the company reported $13 million in revenues and $144 million in losses (See CHART 1 below). But unlike many other e-companies, Webvan can lay claim to a substantive core that other e-retailers cannot. In groceries, it is offering something that every single household purchases at great trouble (2.6 visits per week), and on a grand national scale ($450 billion annually) than far dwarfs the book business that brought e-commerce into view.
CHART 1 – Webvan Income Statement Data
Webvan Income Statement
It now appears, however that its business model is also severely flawed. The costs of picking, packing and delivering most orders are likely the main cause of its sub-par financial performance. Furthermore, the company is a scale business with significant fixed costs that can only be covered with a certain amount of customers. Needless to say, they haven’t come close. Their problem, along with many other e-commerce companies also lies in the fact that they are expecting a dramatic change in consumer behavior. Instead of shopping at supermarkets, customers must opt for a more expensive, plan-ahead method of shopping for groceries. That hasn’t happened.
WebVan now has roughly $200 million in cash and at its current run rate will burn through the cash in two quarters. Furthermore, its stock price now at 13 cents, and faces imminent de-listing from the Nasdaq Stock Exchange. It’s dismal stock performance is charted below (CHART 2).
CHART 2 – WEBVAN Stock Performance
The E-Toy and Webvan stories are commonplace nowadays as more than 130 dot-coms closed their doors in 2000 and approximately one per day is shutting down this year. Nowadays the fun is gone, as executives and employees are on a grim march towards profitability, hoping to reach that elusive goal before running out of cash.
So what did the E-Commerce companies do wrong? Mostly everything, but looking back, these issues can be pointed to that contributed to their ultimate demise.
They did stupid things. Million dollar Super Bowls were run by many of these companies that ultimately produced little to the bottom line. Many dot-commers wanted branding, but “they don’t know what branding means,” says Rena Kilgannon, co founder and principal of the Ad Incubator, an Atlanta marketing firm that works closely with start-up tech companies. “Bright people run these companies but they’re clueless about low cost ways to market, the kinds of strategies start-ups should be implementing.”
They underestimated the importance of real-world know-how. Significant vertical know-how is needed to succeed in retailing and “e-tailing” is no different. Expertise is needed at sourcing and pricing products, something many dot com companies never developed. To outperform the established bricks and mortar players without this acumen turned out to be devastating for most e-commerce companies.
They overestimated consumer demand. Consumers were much slower to adapt to new technologies than most entrepreneurs had thought. Many of these companies incurred exorbitant expenses simply trying to persuade customers to shop online. A bricks and mortar start-up doesn’t have to spend one dime explaining to consumers how to shop at a local mall. But online it’s different where most consumers still haven’t made purchases. And these companies never made a strong enough case for consumers to switch from bricks and mortar store to online buying.
They never factored in customer acquisition costs in their business models. They also were not getting repeat business. Many companies eked out some sales by offering free shipping or significant discounts, but it never amounted to any kind of customer loyalty. Customers would simply move on to the next site offering the lowest price. Furthermore, when many did make sales, they failed miserably when it came to order fulfillment. Shipments were late, wrong or not made at all. That’ll hurt customer loyalty for sure.
They lacked fiscal controls. Many of these companies had no fiscal discipline. Dot- coms spend wildly on everything from office space to freebies for workers such as free massages and free yoga, and many more “non-traditional” expenditures.
They settled for unimpressive management. There was a real lack of talented top-level management during the internet boom. During the tough times, management inexperience and inadequacies became glaringly obvious.
They didn’t execute. Perhaps due partly from poor management, many start-ups were built on good ideas, but companies never executed those ideas. This seems to be true of virtually every failed dot-com.
Given these weaknesses it’s no wonder that most of these companies fell by the wayside. So who is to blame? The executives, investors, Venture Capital firms? The answer is -“D” - all of the above. While it is certainly true that executives of many of these companies drove their companies into the ground, Venture Capital investors should share much of the blame. These supposedly shrewd investors took wild plunges with these companies without doing their due diligence. There was a herd mentality and they invested irrationally.
The rest of the Technology Sector (2000 and 2001) As the e-commerce shake-out began to take hold in late 1999 and early 2000, many professional investors and analysts were still extremely bullish on the Nasdaq and most technology companies. “This time it’s different” was the mantra heard throughout Wall Street as B2B companies, PC makers, semi-conductor manufacturers, telecommunications and wireless players, and biotech firms were cruising along, boasting stratospheric stock prices and phenomenal actual and expected growth rates. The fundamentals were less important as ludicrous P/E ratios were somehow being supported by equally optimistic anticipated growth rates. At their peak, the average P/E on the Nasdsaq (excluding stocks with no earnings) approached 120, as compared to the S&P historical average of 14. At that time, the Nasdaq P/E’s traded at approximately 2.2 times the P/E on the S&P 500 (See CHART 3 below). Also at that time, technology stocks represented over 35% of the S&P 500, the highest weighting ever for any industry group (See CHART 4 below).
CHART 3 – MERRILL LYNCH TECH INDEX P/E RELATIVE TO S&P 500
CHART 4 – TECHNOLOGY STOCKS AS A PERCENTAGE OF S&P 500
Beginning in March 2000, that all started to change. As many e-commerce companies were no longer in the landscape, other technology companies that relied heavily on these big spending dot-coms to purchase their equipment, started to feel the pinch. PC companies experienced slower demand as there was no real compelling new technology to drive new PC purchases. The dot com fallout coupled with the PC slowdown also caused inventory issues and slower growth for the chip makers and server producers. The trickle down theory took effect as optical networking companies experienced slow downs as their primary customers, the telecommunication companies, were experiencing their own inventory glut. Virtually every technology sector experienced the slowdown in 2000. All of a sudden, even the mightiest of high-flying technology companies (Cisco, Sun Microsystems, Microsoft, Dell, Oracle, and countless others) started experiencing the slowdown. Investors started questioning the growth rates, P/E’s and yes, stock prices. The Nasdaq continued its decline, losing 39% in fiscal 2000 (See CHART 5 below).
To exacerbate the matter, the Federal Reserve continued in its fight against inflation and raised interest rates several times in 2000 and even held its “tightening bias” through November 2000. Not until December 2000 did the Federal Reserve “loosen” its bias and then ultimately began reducing the Fed Funds rate on January 3, 2001 and continued to reduce rates through its most recent meeting in March 2001. But it may have been too little too late, as the hiked rates in 2000, and December earnings warnings dampened the climate, squelched additional corporate borrowing and placed downward pressures on stock prices.
The interest rate declines in 2001 gave investors hope that the now economic slowdown would rebound in the second half of 2001. As a result, the Nasdaq was up more than 10% in January alone. But as profit warnings came flowing in at an alarming rate, fears of a hard landing were rampant, bleak earnings visibility, and technology spending estimates dropping through the floor, the Nasdaq plunged to a 2 ½ year low of 1619, approximately 68% off it’s all time high in March 2000. The Merrill Lynch Tech Index P/E still stands at roughly 1.5 time the P/E on the S&P 500 (See CHART 3 above). As of April 6, 2001, the Nasdaq stood at 1,719, and technology stocks now represent approximately 18% of the S&P, down from 35% in March 2000 (See CHART 4 above).