Finally, the Pot of Gold

Profits arrive for dot-com survivors with critical mass and products that need shipping only in cyberspace

Ever since Internet stocks began cratering two years ago, investors have been making mental lists of ideas they shouldn't believe in anymore: selling goods for less than they cost, for example, or companies with $2 million in sales being worth $2 billion.

But the most important Internet idea of all may be due for revisiting. As it turns out, Web companies can make money--a lot of money--once they get big enough. At least 52 of the roughly 200 public Internet companies that survived the shakeout of the past two years are profitable now under standard accounting rules, and 15 to 20 more are likely to become so by next year. Not so long ago, only online auctioneer eBay Inc. (EBAY ) and a few software and consulting firms helping dreamers build e-stores saw black ink. Now, there are money-making Internet companies in travel, finance, and a host of other industries.

Four Web companies made this year's ranking of the Info Tech 100: search engine Overture Services (OVER ) (No. 73), auctioneer eBay (83), discount-hotel broker (ROOM ) (86), and travel site Expedia (EXPE ) (87). That's up from a measly one last year. And all of them are making money.

The leaders of the Web pack are starting to show that once they turn profitable, they can quickly become big moneymakers. The reason is operating leverage. That's accounting-speak for a simple concept: Once you invest enough to build a Web site and your basic operations, you don't need to spend much money as sales rise. After you cover your fixed costs, the expense of processing each sale is so little that profits grow faster than revenues. That philosophy made for big Internet losses early on--but the payoff is at hand.

Online travel agency Expedia Inc. is a textbook example of leverage in action. In 2002's first quarter, Expedia doubled its sales, to $116 million. Yet its overhead, including administrative and marketing costs, rose only 8%, to $63 million. One big reason is that the company already had paid for the computing gear it needed to handle the higher volume of ticket sales.

"Marketing, engineering, and people--all of that scales really nicely," says Expedia CEO Richard Barton. Expedia reported net income of $5.7 million in the first quarter after losing $17.6 million in the year-earlier period.

Three years after the e-commerce IPO boom, a clear pecking order of profitability has emerged. The biggest moneymakers: online travel, software, and financial-services firms. Why did these turn profitable first? Because software, financial services, and travel reservations are pure information products, without a physical widget to store or ship. Once overhead costs are covered, the expense in providing the service to one more customer is close to zero.

Online retailers are making slower, yet tangible, progress toward the Holy Grail, profitability. What's holding Inc. (AMZN ) and other e-tailers back is simple: Every time someone buys a book on Amazon, the company has to buy a new copy from the publisher. The upshot is that Amazon's gross margins are around 26%, compared with 70% at Expedia.

Amazon, however, is getting leverage from its back-office operations. Marketing costs were 3.8% of sales in the first quarter, compared with 10.7% in 1999. Technology costs have been cut to 6.3% of sales, from 10.0% over the same period. And Amazon is running e-stores for partners like Target Corp. (TGT ) that use technology Amazon already owns.

To be sure, the same kind of operating leverage that boosts Web companies in good markets can hurt them in tougher times. In downturns, the high fixed costs of Web businesses, combined with even modest revenue declines, can whack profits. That's what happened to big Net names such as Yahoo! Inc. (YHOO ) and America Online (AOL ) (now AOL Time Warner Inc.). Last year, Yahoo slipped into the red when the company's online advertising tanked before returning to profitability in 2002.

Every year, the Web has a revised story, but now it's past the point where predictions of profitability are written in sand. Some Web businesses do work. The proof is in the black ink.

By Timothy J. Mullaney in New York, with Robert D. Hof in San Mateo, Calif.

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