Return to Virginia Business - April 2001

Cover Story
It really is that bad
Forget the conventional wisdom. A minority of Virginia’s public high-tech firms actually make money. Others are running out of cash. The stars are falling.

Related stories:
• Highflyers hit hard times
• Companies to watch
• The High-Tech Way of Giving
• Lessons from the Dot-Com Crash
• Chart: Tech firms and red ink
• Chart: Profitable tech firms

by Robert Burke

So far, however, the conventional wisdom about the state of high tech coming out of Northern Virginia these days has been a reassuring "Don’t worry, be happy." Recent reports point out that the region has blessedly few dot-coms and plenty of telecommunications and information technology companies, fields that are expected to do well in the long-term. Plus, there’s still plenty of the federal money that has propped up the region for decades. "As a region we’re sitting in a relatively nice place," says Roger R. Stough, director of the Mason Enterprise Center at George Mason University in Fairfax and author of a study on the region’s economic outlook.

Beneath that soothing exterior, though, hard facts suggest a crash rather than a soft landing for the high-flying region that led Virginia’s economic growth through the 1990s. A look at the last 12 months’ performance of 48 of Virginia’s leading public technology companies shows how fragile the region’s growth has been: 30 of the companies lost money in 2000. Some $5.8 billion in revenues vanished in the ozone. Compare that to the collective earnings, $192 million, of the 16 companies that were profitable, or to Silicon Valley, where the nine largest firms generated $30 billion over the last four quarters — enough to offset hundreds of dot.com losers. In Northern Virginia, 13 of the largest publicly traded tech companies surveyed by Virginia Business are trading around $1 or less, hemorrhaging red ink and making drastic cutbacks just to stay afloat. This number does not include once-promising companies like CyberCash that have been de-listed, or dozens of others launched a year or more ago in the expectation of dipping in the capital markets when their cash ran low.

The new reality has yet to sink in. Commentary remains fixated on Northern Virginia’s super-low unemployment rate and the ability of the labor market to absorb the layoffs so far. But few people seem to be focused on the profit picture: Dozens of companies are unprofitable. They’re running out of cash, and investors are in no mood to bail them out. The blood-letting has only begun. "I think a lot of people are still living in denial," says Doug Poretz, a principal with Qorvis Communications experienced in investor relations. He compares the current scenario to the collapse of the region’s real estate market a decade ago. "If you talk to a lot of people in technology at this point, you’re still hearing things like, ‘My stock’s gone down so far, how much lower can it go?’"

A lot, Poretz believes. The tech shakeout "is still working its way up the food chain. I have no doubt that relative to other markets the greater Washington area may do better, but that doesn’t mean it’s going to prosper." Tech executives ought to take a pessimistic view and just try to survive. "No matter how good your business idea is, if you’re not around in 2003, that great idea isn’t going to make you rich. The goal right now is to survive."

Former multimillionaire tech executives have become mendicants, begging for capital to keep body and soul together. With the Nasdaq in free fall, money-losing tech companies can’t tap the equity markets. Investors are treating them like toxic waste. Meanwhile, the flow of venture capital is slowing. Venture capital funding in Virginia dropped 22 percent in the fourth quarter of 2000 from the previous quarter, to $402 million, according to PricewaterhouseCoopers.

New companies can still raise money, but it’s much harder. Venture capitalists are acting like MASH units frantically patching up badly wounded troops. Diverting capital into companies in their portfolios, they are hoping to keep their existing investments afloat until earnings materialize or financial markets change. "You’re going to see a lot of them (VCs) triaging their own companies," says Kevin Burns, managing principal of Washington-based Lazard Technology Partners.

VCs are finding it harder to replenish their own capital stock. Companies they hoped would go public haven’t because the stock market has collapsed. And the ones they hoped would be acquired haven’t been because the potential buyers don’t have the cash either, Burns says. After nursing their own companies, many venture capitalists would rather lick their wounds than look for the next Big Thing. "If you spend a lot of your time cleaning up your portfolio, you’re not in the greatest mood to look for new deals."

Ironically, Northern Virginia’s success in attracting venture funding during the 1990s is a big part of what’s hurting it now. Traditionally funded companies grow slower because they borrow from banks and reinvest retained earnings. But the venture industry put a premium on growing fast, gaining the "first mover" advantage, and capturing market share regardless of short-term profitability. That strategy worked fine as long as capital was cheap and companies could raise all the money they wanted. "That probably generated some burn rates that were not sustainable," Burns says. "So you see a lot of need to right-size the expense levels and burn rates of some of the companies."

Few companies can boast of cash burn rates equal to the region’s big telecoms, which until lately had been attracting huge piles of cash. A recent Washington Post tally counted nearly $1 billion invested in telecom firms in 2000. "A year or two ago, with a handshake and a piece of paper, people could get funding," says Mike Kraft, senior vice president of marketing and communications for Teligent. The hyper-growth of the telecom sector was sparked by deregulation of the market five years ago and a flood of new technology. Now, the cash is mostly gone, and Wall Street expects only a few companies will survive. The rest will be bought up by stronger competitors or go bankrupt. "It is the most turbulent of the sectors we looked at," says Stough of the Mason study.

It’s not clear how Virginia’s telecom companies will fare, but the prospects aren’t bright. Herndon-based Network Access Solutions, a seller of high-speed Internet access, laid off 145 people in September and had to sell off 400 network operations centers to reduce debt. WorldCom in February announced it would lay off 6,000 workers, including 400 in its Washington-area offices. Vienna-based Teligent had its worst quarter ever at the end of 2000, losing $271 million despite a tripling of revenues. Unless it can find more funding, the company will run out of cash by mid-year. Still, Kraft is sure that if Teligent’s money woes are fixed the company will survive. "Core telecommunications is the lifeblood of business," he says. "It’s no longer a ‘nice to have,’ it’s a ‘have to have.’"

That’s what enables Northern Virginia tech leaders to look past all the red ink: the belief that the business world can’t get along without them. Leaders of Fairfax-based webMethods, a provider of business-to-business software, think that’s what’s behind their recent profits. Selling for about $30 in mid-March, webMethods’ stock is way off its all-time high of $308. But at least the company reported earnings, $2.7 million, in the fourth quarter of 2000. "What we’ve realized is everybody needs integration software," says Chris Barbin, vice president and general manager of the firm’s platform business unit. "[Clients] need our technology to glue applications that they’re acquiring together," he says. Even companies in financial trouble will come asking for help to squeeze savings out of their systems. "It’s been pretty positive around here because demand hasn’t slowed."

One of Northern Virginia’s advantages is the stability of its biggest customer, the federal government. Many of the players in the region’s info-tech sector perform complex systems integration work for the Defense Department and other federal agencies. Federal expenditures in the Washington region — worth nearly $70 billion in 1999, according to the Mason study — are more than twice that of second-place Silicon Valley. And the spending plan proposed by President George W. Bush would increase local spending next fiscal year. Bush’s budget calls for a $2.6 billion increase on research and development for defense systems, and much of that would go to Northern Virginia defense contractors.

Federal bucks make some observers optimistic that Northern Virginia will make it through the downturn relatively unscathed. The region has a strong core of "professional services" companies that can find clients in whatever sector is doing well, according to the George Mason study. Other recent reports by the Brookings Institution and Standard & Poor’s reach similar conclusions. "Compared to other high-tech sectors around the country the D.C. area doesn’t have as many little start-ups," says S&P analyst David Iaia. "It has AOL, WorldCom, bigger companies that are more stable. It’s been the smaller companies that have had a lot more trouble."

Federal business will buffer Virginia’s info-tech sector on the downside, but only to a limited degree. Federal contractors aren’t the companies in trouble. And the companies who are in trouble either don’t provide the services required by Uncle Sam or lack the expertise to win federal contracts. Bidding for federal business is an arcane specialty not easily mastered. Cash-starved telecom companies have little chance of resurrecting themselves by snagging a big federal contract.

What’s more, the contractors who excel in doing business with the federal government have little sex appeal to investors. They grow slowly, if steadily, and few have successfully diversified into commercial markets. Because there is so little potential for explosive growth, venture capitalists and investment bankers have displayed little interest in this sector. Indeed, it has only been Northern Virginia’s success at diversifying beyond the federal government – into the Internet and telecommunications, mostly — that attracted outside financiers to the region in the first place. The so-called Beltway Bandits may soak up pink-slipped programmers, but they aren’t likely to attract billions of dollars of investment capital, create massive wealth, or stimulate the animal spirits that made Northern Virginia so exciting in the 1990s.

Still, some observers see breaks in the clouds. The layoffs that have swept through the sector recently — 6,500 in the past five months, according to a Washtech.com tally — have lessened the competition for companies still hungry for skilled labor. By some calculations at the peak of the boom, Northern Virginia tech companies reported some 25,000 unfilled jobs. Barbin of webMethods says the layoffs have been good news. "The job market is very favorable today" for employers, he says. "It was much tighter six to nine months ago. We’re seeing a ton of resumes. My e-mail box just fills up every day, not only from job boards but just referrals. Everyone knows someone who was just let go from what they thought was a high-flying dot-com."

No longer competing with the foofoo.coms of the world, serious companies are finding it easier to find the executive and technical talent they need to grow. Diminished now are the costly perks and sign-up bonuses that drove up costs. And the reduced opportunities for job hopping also ought to reduce the extraordinary turnover, as high as 40 percent annually at some firms, that plagued productivity. That will make a difference when the financial markets revive.

Meanwhile, infotech execs can take solace in the fact that the telecommunications and Internet-infrastructure sectors have not been discredited to the same degree as e-tailing and business-to-business. Financiers are still willing to fund start-ups with strong business plans, experienced management, and a clear path to profitability. In March, Lazard Technology Partners announced it had raised a second fund of more than $300 million to invest primarily in East Coast telecommunications, software, and Internet infrastructure start-ups. Burns predicts that capital markets will loosen up by mid year. "The types of deals we do here, being more telecom infrastructure and Internet enabling and new types of software, tend to be more in favor and still look viable. ... What you see is fewer deals but better deals at attractive valuations, with … more serious and somewhat sobered entrepreneurial management teams behind them. So that’s cause for optimism."

That new-found sobriety may be the most important change of all. Humbled by the events of the past year, tech executives are getting back to basics. Presumably, Northern Virginia’s corporate leaders are spending less time managing their philanthropies and pro sports franchises and more time running their businesses. Meanwhile, businesses are rediscovering the much-maligned business virtues of the Old Economy, says Fran Craig, CEO of Unanet Technologies, a small, Fairfax-based based maker of Web-based project management software. "Prior to this change in the market, the main thing was ‘grab market share whatever the cost. Don’t worry about profitability,’" says Craig. Now, she says, everyone is focused on the bottom line.

Maybe MicroStrategy’s ‘back to basics’ approach means that even Michael Saylor has learned a thing or two. He says the company will be making money by the end of the year. While he’s lost much of his wealth, he hasn’t lost his confidence. "Our ultimate goal ... is to become the General Electric of intelligence," he says. "We are absolutely sure there is no one in the world with better technology." Saylor as Jack Welch? Maybe. But it’s just as likely that the tech crash will beat even more hyperbole out of him.

Return to Virginia Business - April 2001