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As Profits Swoon, Companies Blame
A Marked Change in Cost Structure
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
A year ago, when Inktomi Corp. was flying high, Chief Executive David Peterschmidt marveled at the nature of the software business. His company had spent more than $10
million to develop software for delivering and managing Web content and other data over corporate computer networks. But once sales had covered those costs, each additional
sale was almost pure profit.
"You have no cost of goods. We don't even ship a physical diskette anymore," he says. "Next to the federal government, this is the only business that's allowed to print money."
Now, the company is witnessing the dark side of that formula. In the past year, its development expenses doubled, as it invested the bounty from software sales in new
applications. But sales have taken a nosedive, and the company reported a staggering $58 million loss for the first quarter of this year compared with a $1 million profit in the
year-earlier period.
A Product's Value
Inktomi's reversal, seen at many other U.S. companies this year, may reflect more than just the bursting of a technology bubble. In today's economy, an increasing portion of a
product's value is the intellectual property embedded in its design, its brand or its network of users. It takes enormous fixed costs in the form of research, technological
equipment and marketing to develop such value. Moreover, intense competition and the rapid obsolescence of intellectual property mean that companies must make that heavy
investment again each time the market demands new product -- in effect, continually.
In good times, customers keep buying new products, and healthy sales more than cover the fixed costs. But in bad times, those enormous fixed costs will rapidly erode profits.
The phenomenon has hit a wide range of companies: software makers such as Inktomi, which is based in Foster City, Calif., and Microsoft Corp., of Redmond, Wash.; Internet
media companies such as Yahoo! Inc., of Santa Clara, Calif.; and semiconductor manufacturers like Intel Corp., also of Santa Clara.
The growing number and prominence of companies with this sort of cost structure could be changing the nature of the business cycle, subjecting companies and industries to
more dramatic reversals of fortune and leading to bigger swings in profits, stock prices, capital spending and hiring. This may not be enough to offset other factors making the
business cycle less volatile, nor is it clear whether the phenomenon will persist beyond the current period.
The Fed's Concern
But the sharp decline in profits is clearly a concern of Federal Reserve policy makers, who Tuesday cut their target for the benchmark federal funds interest rate half a
percentage point for the fifth time this year, taking it to 4% -- its lowest level since 1994. The Fed's moves represent an aggressive pace of easing, given that consumers are still
spending, albeit slowly, and the economy hasn't clearly entered a recession -- broadly defined as two straight quarters of declining gross domestic product.
In a statement accompanying the cut, the Fed's policy-making body, the Federal Open Market Committee, indicated it was concerned mainly with the corporate sector.
"Investment in capital equipment . . . has continued to decline. The erosion in current and prospective profitability, in combination with considerable uncertainty about the
business outlook, seems likely to hold down capital spending going forward." Falling profits and capital spending could result in rising layoffs, eventually undermining consumer
spending.
Changing Cost Structure
A year ago, profits were growing more than 20% a year, according to Thomson Financial/First Call. This quarter, they could fall almost as much. That reflects both the
suddenness of the economy's slowing and the effect of New Economy businesses' cost structure. Before they make their first sale, such companies must spend a lot developing,
designing and marketing a product. But once those fixed costs are paid, each additional sale incurs very little marginal cost. When sales were rising, that structure supercharges
profits because a high proportion of each dollar in sales flowed to the bottom line. But as the past few months have proved, the high sensitivity of profits to sales growth works in
both directions. In one quarter, Yahoo saw revenue fall 42% while expenses barely dropped. It swung to a $33 million operating loss in the first quarter of 2001 from an $87
million operating profit in the last quarter of 2000.
Richard Berner, Morgan Stanley & Co.'s chief U.S. economist, says this high sensitivity of profits to sales growth is the Achilles' heel of today's economy. It "makes a deep
contraction in earnings unavoidable, even if the economy skirts recession." Severe pressure on profit, in turn, is "producing a capital-spending bust," and "will likely force
companies to lay workers off in greater numbers than have appeared to date."
Some companies probably will be forced out of business altogether. Many economists have long predicted that the New Economy would promote a concentration of the market
in the hands of a small number of competitors. Such companies are driven to expand their market share rapidly to cover fixed costs. Once they've gotten big enough, their low
marginal costs or the benefit to new customers of joining a network of existing customers makes it possible to underprice potential competitors who may thus never get big
enough to prosper.
The current profit slump appears to be hastening that outcome in many markets, as companies such as Yahoo and Amazon.com watch their competitors give up in the face of
disappointing sales and the overwhelming expense of R&D, marketing and technology.
"You're going to have a tremendous number of failures of businesses that don't get to scale because fixed cost is so great," says Merrill Lynch & Co.'s Internet analyst, Henry
Blodget. "And it means the successful ones will be very profitable up until the time they have a major revenue shortfall, at which point they'll lose a lot of money."
One of the New Breed
Cisco Systems Inc. of San Jose, Calif., exemplifies the new breed. In its fiscal third quarter ended April 28, revenue fell 30% from the previous quarter, and operating profit
before charges plunged 95%. A drop in spending by Cisco's customers, such as small telecommunications companies, was the main reason for the decline. But almost as
important was the fact that Cisco had accumulated a lot of high fixed costs that would have been quickly absorbed in a market growing 50% a year, but not when that sales
growth disappeared. R&D costs, for example, remained at about $1 billion in both quarters.
Cisco CEO John Chambers is among those who believe such volatility is here to stay. "The speed at which this new economy moves and the associated peaks and valleys will
be much higher and lower than anyone anticipated," he says. Cisco elected to reduce or eliminate its investments in certain products, such as optical switching platforms,
concluding it would take too long and cost too much to achieve the top spot in those markets.
High fixed costs and low marginal costs have long been characteristic of some industries. Movie studios and pharmaceutical companies spend heavily on a new film or a drug. If
it's a hit, the profit potential is immense, since it costs little to sell extra film tickets or make more pills. A dud can leave the company awash in red ink. As the importance of
intellectual property has risen, more of the economy, especially in the technology sector, shows these characteristics.
To be sure, technology businesses remain a small part of the overall U.S. economy, representing 8.3% of GDP, compared with 5.8% in 1990, the Commerce Department
estimates. But the effects of the changing nature of American business are apparent in the overall statistics.
A study by Federal Reserve Bank of Philadelphia economist Leonard Nakamura estimates that R&D and advertising spending rose to 7% of corporate GDP in the 1990s from
5.2% in the 1970s.
The growing potential of information technology, in particular the Internet, also prompted many companies to spend heavily on technology gear, making their businesses more
"virtual" but at the same time more capital-intensive. Morgan Stanley strategist Steve Galbraith estimates depreciation charges have risen by a full percentage point of sales of
S&P 500 industrial companies in the last two decades. And many companies, especially in telecommunications, financed their new equipment with debt.
"Higher leverage is a primary reason why the moves up and down in earnings have become so extreme recently," Mr. Galbraith says.
While these trends have been most obvious in technology, to some extent they affect most industries that are moving online. In stock trading, Amy Butte, securities-industry
analyst at Bear Stearns & Co., says traditional brokerage firms' growth is limited by how many human brokers they have. Online brokers don't have that barrier. Instead, they
spend heavily on nationwide marketing campaigns to spur account growth and on computer systems and customer service to accommodate booming Internet transactions.
But the plunge in stock trading in the past year has also exposed the volatility of the online brokerage business. Profit at Charles Schwab Corp., San Francisco, tumbled 68% in
the first quarter from a year ago on a 30% fall in revenue.
Smaller, upstart brokers like E*Trade Group Inc. of Menlo Park, Calif., and Ameritrade Holding Corp. of Omaha, Neb., have been hit harder, in part because their smaller
revenue bases are less able to absorb the high marketing and technology costs. Ms. Butte thinks only half of today's online brokers will ultimately survive as independent entities.
"You need scale for the model to work," Ms. Butte says. "Technology and brand are becoming so important, and those are expensive things."
Squeezing Out Borders
In online bookselling, Mr. Blodget estimates it costs Amazon.com Inc. of Seattle, Wash., about $50 million to $100 million a year to develop and maintain its Web site. By
comparison, he says, it costs Barnes & Noble Inc. of New York City only $5 million to open a new store. Amazon was early to finance and establish a national presence online,
and "everybody has to fight to compete with that," he says. Small wonder Borders Group Inc. of Ann Arbor, Mich., recently said it would shutter its own money-losing online
bookstore, outsourcing Internet sales instead to Amazon.
Falling sales present these companies with unpleasant choices. They can either maintain spending on development and equipment and suffer severe pressure on profits, or they
can start cutting jobs and investment plans, at the potential cost of future growth. Morgan Stanley's Mr. Berner says that, given the pressure in boardrooms to meet earnings
targets, the choice is obvious: "Until the pressure on profits abates, chief executive officers and chief financial officers will likely tell chief information officers to shelve their
capital-spending plans." And companies will also step up layoffs, he says: "Not to do so will be to choose lower productivity growth and still more pressure on profit margins."
At Inktomi, Mr. Peterschmidt decided he had to get operating expenses down by 25%, which meant cutting 250 people from its payroll of about 1,100. The cuts were difficult
and a shock, he admits. "In some cases people talk about, 'Every year we'll get rid of the bottom 5% of the company and use it as a way to cleanse the company.' But when you
do 25%, you're cutting into really quality people."
Left relatively unscathed were Inktomi's software developers and architects who make up a third of the remaining staff. "I don't want to cost-cut our way back" to profitability,
says Mr. Peterschmidt. "It would shortchange the future of the company." But Inktomi doesn't have a forecast of when it will return to profitability.
Assessing the Trends
It isn't clear if these trends are a permanent development or a unique consequence of the recent excesses of the technology sector. Nor is it clear whether they have made the
economy more cyclical, since other factors are working in the other direction. Widespread adoption of just-in-time techniques helped counter the buildup of unwanted inventory
that often resulted in prolonged production cuts. Increased use of temporary workers and flexible pay have also given employers more options for adjusting labor costs.
But when business slumps enough, increased flexibility sometimes isn't enough. Schwab at first tried to get costs down by cutting executive pay, encouraging employees to take
time off and establishing a hiring freeze, but eventually it had to eliminate 2,750 to 3,400 full-time employees and contractors, or 11% to 13% of the total. It also said in its annual
report that it expected to cut capital expenditures by 35% to 45% in 2001 from the $705 million it spent in 2000. A spokesman says the firm is "striving to adjust our standby
ability. How much technology do we have to have plugged in to handle spikes in trading volume? How fast can we get stuff plugged in once trading volumes pick up? It's
something we're trying to fine-tune all the time."
Another choice facing New Economy businesses is whether to cut prices to keep sales volumes up. Ms. Butte says online brokers, in their scramble for account growth, drove
trading commissions down dramatically, in some cases to zero last year, though prices have since stabilized.
Semiconductor prices have fallen more this year than many industry veterans have ever seen. They have always been volatile, reflecting the very high fixed costs that are typical in
the industry and the need to run fabrication plants flat out to cover those costs. Yet if anything, these trends are deepening. A typical semiconductor plant costs $2 billion now,
four times what it did in 1995. Industry leader Intel's profit has been hit hard this year, and Intel plans to trim its world-wide labor force of 86,000 by 5,000.
But it still plans to boost its budget for capital spending and R&D this year. A lot of that is going into new manufacturing processes that spokesman Robert Manetta says should
boost efficiency, driving marginal costs even lower. In the meantime, with world-wide demand soft, Intel is introducing its 1.7-gigahertz Pentium 4 chip at $352, far below the
typical $500 to $600 at which its new microprocessors have been previously introduced. "You have high fixed costs, so you want to minimize those fixed costs and keep
factories running 24 hours a day," Mr. Manetta says.
Write to Greg Ip at greg.ip@wsj.com |
