Profitability Now Matters for Net-Stock Investors

SAN FRANCISCO -- Just when loss-producing Internet stocks have fallen from favor, a new crop of Internet companies are emerging as profitable enterprises.

Only a few months ago, investors viewed profits at Net start-ups as a curse. Except for a handful that earned profits early on -- America Online (AOL Quote), Yahoo! (YHOO Quote) and eBay (EBAY Quote)) -- the mantra of Internet start-ups was simple: Spend, spend, spend. To build brand. To grow market share. And to acquire customers before they became too expensive to pry from competitors. It was all about, in the euphemistic patter of Wall Street, investing in the future.

Well, the future is arriving more quickly than most folks realized. As interest rates rise and Net IPOs flood the market, Net stocks are getting slapped upside the head. TheStreet.com Internet Sector index is down 25% since April 23, when the Internet carnage was just starting to get under way. And Amazon.com (AMZN Quote), which came to exemplify the spend-today, rule-tomorrow philosophy, is down 56% in the same period.

Now a second tier of dot-coms appears to be entering the profitability zone. And investors and analysts are starting to notice. Among the few are RealNetworks (RNWK Quote), Modem Media Poppe Tyson (MMPT Quote), InfoSpace (INSP Quote) and VeriSign (VRSN Quote).

The upshot: Profitability matters. Companies that push to profitability are more likely to see a rise in their market caps. "Two years from now, everyone will be a dot-com," says David Readerman, an analyst with Thomas Weisel Partners. "And profitability will be an important value differentiator for institutional investors."

Since Modem Media posted a surprise second-quarter profit of 5 cents a share July 29, for example, the stock has risen 11%. The company, which beat a First Call estimate of a 6-cent loss, wasn't expected to turn a profit until late 2000, according to C.E. Unterberg Towbin analyst Tara Long.

Keith Benjamin, an analyst with BancBoston Robertson Stephens, says investors are using profitability to distinguish the potential winners from the losers. "People are overwhelmed," he says. "There are too many stocks to keep track of."

When CNet (CNET Quote) said July 1 that a $100 million ad campaign could sink the company into the red for the next three quarters, its stock dropped more than 10% in a day. The stock has since slipped 44%. And since MindSpring (MSPG Quote) announced a $50 million marketing plan that will trim profits, the stock has slumped 34%.

"Unless you deliver a big revenue surprise, it's going to be harder to justify high levels of losses," says Benjamin. In the quarter ended June 30, Amazon's revenue only saw a 6% increase over the previous quarter, but its marketing costs ballooned 41%.

Does Profitability Matter? Stocks in the profitability zone
Ticker	July 1	Aug. 12	Percentage change
RNWK	77 7/8	70 3/8	-9.6%
VRSN	82 9/16	78 3/4	-4.6
INSP	47 5/16	40 13/16	-14.9
MMPT	22 3/8	23 1/2	5
Investing-in-the-Future Stocks
MSPG	46 1/4	26 3/4	-42.2%
CNET	51 3/4	32 1/2	-37.2
AMZN	122 3/8	91 3/4	-25
TSC Internet Index	640.2	506.5	-20.9
Source: ILX

Even if investors aren't pushing up the shares of profitable Internet companies, evidence suggests that these firms provide a safe haven of sorts during a market downturn. Since July 1, shares of RealNetworks, VeriSign, InfoSpace and Modem Media have all performed better than the TheStreet.com Internet Sector index. Compare that with shares of Amazon, CNet and MindSpring, which have all done worse. One primary reason may be that stocks in the profitability zone are less vulnerable to the interest-rate pressures that have been dragging down Net stocks lately.

"When rates go up, people aren't interested in waiting until 2003 for profits," says Drew Cupps, portfolio manager for the (SENTX Quote)Strong Enterprise fund. "There are better places for your money to work for today."

Of course, analysts caution that investors must look at more than one variable when judging a stock. In trying to sort out the winners from the losers in this saturated market for Net stocks, Benjamin recommends that investors think like venture capitalists and analyze the fundamentals of a company's business: the size of opportunity, strategy and management.

And sometimes it might make more sense to sacrifice profitability to guarantee the reliability of a Net company's operations. eBay, for example, has been getting pounded ever since it started to suffer an outbreak of technological glitches that have kept its Web site down for hours at a time. The company has ramped up its spending this quarter on product and development expenses to remedy the embarrassing problems. But if eBay had spent more money on technology last year, it could have dragged the online auction into the red for one quarter.

"They should have invested more no matter what impact to the bottom line," says Cupps, who is long eBay. "It was a costly mistake to not spend that $5 million to $10 million six months or a year and a half ago."