Cutting Costs Fails to Lead to Profitability

Cutting costs is not helping Internet companies become profitable, according to a study by Getzler & Co., Inc., a New York-based turnaround firm, which found that cost cutting has resulted in significantly lower growth rates, which could further undermine companies’ already depressed valuations.

The study examined 213 technology and dot-com firms, and identified 57 companies that had implemented cost cuts, particularly in the area of sales and marketing. Getzler then studied the impact of these cost-cutting measures on the companies’ financial performance.

“We’ve heard time and again how dot-coms are reducing costs in order to become profitable,” said Brian Mittman, vice president, Getzler & Co. “But what we’ve learned is that, rather than help the company, cost-cutting reduces sales growth so drastically that profitability becomes nearly impossible.”

The study analyzed first- and second-quarter results of firms with more than $1 million in quarterly sales. On average, the cost-cutting Internet firms grew sales at an annual rate of only 19 percent, yet lost $1.20 for every dollar of revenue.

“At that rate, even assuming certain costs remain constant, it will take many years for these companies to become profitable,” Mittman said. “And investors aren’t likely to wait that long.”

The average growth rate for cost-cutting dot-coms trailed the growth rate for firms that increased spending — 19 percent annually vs. 149 percent annually.

“A 19-percent growth rate is typical of a healthy traditional firm, not a dot-com, which is operating deeply in the red and whose stock price has factored in expectations of several years of very high growth,” Mittman said. Amazon.com was a prime example of the study’s conclusions. Amazon reduced sales and marketing costs in the second quarter, but experienced virtually stagnant growth, according to the study.

Nearly half of the cost-cutting firms examined in the study were e-tailers. The e-tailing sector is facing particularly skeptical investor sentiment, making it increasingly difficult for these firms to attract additional funding. The result has been a wave of belt-tightening.

The study also corroborated analysts’ souring opinion of the loyalty of dot-com customers. Dot-coms have spent vast sums of money on marketing, reasoning that such expenditures were necessary to build a loyal customer base.

“But if your revenue drops as soon as the dollars stop flowing into marketing programs, you have to question customer loyalty and the wisdom of continuing to invest blindly in extravagant marketing campaigns,” Mittman said.

Not surprisingly, the study suggests that dot-coms need to make better decisions about their marketing expenditures. Mittman cited Internet firms that spent millions on short ads during the Super Bowl. In certain cases, firms spent a significant percentage of their entire annual budget on a single advertisement that generated little customer follow-through or discernible revenue.

The study did identify several exceptions, including e-tailers Pets.com and PlanetRx.com, which have managed to increase sales at a healthy clip while also reducing spending on marketing and sales.

“Clearly these companies are finding more efficient ways to spend their marketing dollars,” Mittman said. Multex.com and Priceline.com, despite the latter’s recent negative publicity, also proved to be exceptions. Both are relatively close to profitability and both have maintained healthy growth rates while reducing costs.

The news out of Europe is somewhat better, although marketing expenditures are wreaking havoc there as well. Research by PricewaterhouseCoopers found that an improvement in Internet company burn rates is heralding a healthier dot-com market throughout Europe. Despite this improvement, however, the 20 most vulnerable internet companies in Europe are at risk of running out of cash within a year, unless they take direct measures to address the issue.

The PricewaterhouseCoopers’ study found that B2C companies are most vulnerable, with an average burn rate of 15 months compared to 23 months for B2B firms. The difference stems from continued high marketing expenditures by the consumer-facing firms which, in some cases, account for more than 400 percent of gross profit. The service and e-commerce sectors are the strongest, containing the most profitable companies with no burn rate; the content and software sectors are the weakest, containing the highest number of “burning” companies. German companies are somewhat more secure than their UK counterparts, the study found.

“Against a couple of high-profile insolvencies, Internet companies are waking up to the fact that the dot-com honeymoon is long over,” said Kevin Ellis, a partner at PricewaterhouseCoopers. “What we’re witnessing is dot-coms throughout Europe beginning to take proactive steps to consolidate their position and regain the confidence of the market, including fundamental business restructuring or seeking appropriate merger partners. On the whole, the improving burn rates indicate that management teams are focusing not only on cash management but also on bringing forward their breakeven points to take control of their own destinies.”

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