The Dot-Domino Effect

Covad Communications Group Inc. has just experienced the dot-domino effect. In December, this Santa Clara, California-based high-speed Internet and network access provider announced that it would show a $180 million to $190 million fourth-quarter loss, up from a predicted $140 million to $150 million loss. It attributes the unexpected difference to the fact that 14 of its service resellers can't pay their bills. The troubled resellers account for 27 percent of Covad's 270,000 customers, according to company reports. Since November, the company has laid off 800 employees, and its stock plunged from a 52-week high of 66 to 1.25 in mid-December. (Covad executives declined to be interviewed for this story.)

Covad is only one of hundreds of companies that leaped to service the new market created by the Internet boom. With all the speed and enthusiasm of the dot-coms themselves, these suppliers rushed to grab market share. But without a tried-and-true way to evaluate the creditworthiness of this fledgling industry, many extended credit on little more than faith in the sector's ability to succeed. Today, they're paying the price. Companies as diverse as Internet consulting firm MarchFirst, AnswerThink Consulting Group, online ad seller Engage, electronic commerce software company Ariba, and Internet service providers PSINet and NorthPoint Communications are among the many that have recently announced dramatic increases in uncollectible dot-com debt.

"It's a new phenomenon," says Paul Mignini, president of the Columbia, Maryland-based National Association of Credit Management and the Credit Research Foundation, "but it's definitely a big issue with our members. The dot-coms are crashing even faster than they were rising. Now the horse has left the barn, and it all comes down to a collections matter."

When big suppliers like Lucent and Nortel lose tens of millions of dollars in bad debt write-offs, they can usually weather the storm, because their losses are a small percentage of their total revenues. But when start-ups or companies that rely heavily on dot-coms as a revenue base start writing off tens of millions of dollars in accounts receivable, bankruptcy can result.

San Francisco­based NorthPoint Communications Inc. recently filed for Chapter 11 protection after Verizon Communications Inc. backed out of a deal to buy a controlling stake. This event occurred when NorthPoint dramatically increased bad debt write-offs and the business foundered.

In its 10-Q filing in November, MarchFirst indicated that it is reserving $59.8 million of its accounts receivable for bad debt, much of which came with its March 2000 merger with USWeb/CKS. If the company continues to have trouble collecting accounts receivable, "our liquidity, financial condition, and operating results will be materially adversely affected," the filing states.

Credit-ratings agencies can't help but say, I told you so. "When the Internet bubble was still a bubble," says Bob Konefal, managing director of Moody's Investors Service, "we were already pretty focused on the percent of revenue companies got from dot-coms. We knew that a lot of these ventures were high risk by nature. We recognized that revenue from this sector wasn't certain revenue, and we were haircutting some of the growth expectations in cases where it colored our rating view of a company."

SLEEPING WITH THE DOT-COMS

That's not good news to companies like DoubleClick Inc., a New York­ based online advertising firm. Until spring 2000, its media division received 60 percent of its revenue from pure-play dot-com clients, according to Glenn Robertson, who is the vice president of finance, global media, at DoubleClick.

"For the first three years of DoubleClick," he says, "the venture capital money was flowing. If customers didn't pay, we thought, 'Who cares?' There was someone else right behind them." Even then, DoubleClick saw about 6 percent of its revenues go up in bad-debt smoke. But the March 2000 tech-stock crash was a wake-up call to tighten credit policies, or face even higher bad-debt write-offs.

The company has always employed a due-diligence process for new customers, which includes analyzing credit reports and financials for revenue and profit trajectories. "But since there's not a lot of profitability out there in the dot-coms, we also look at cash-burn rate," says Robertson. DoubleClick examines news reports, and it considers the timing and source of venture capital funds. "Even if they don't look financially viable, that's not necessarily a deal breaker," he notes. "We determine whether they have a good business model with large market and growth opportunities."

Based on these findings, a customer is classified as an "A" through a "D" credit risk, says Robertson. "A" companies are blue chips to which DoubleClick is willing to extend credit. Those companies generally pay on their own terms, although DoubleClick's standard terms are within 30 days. "B" companies also get credit, but are considered a higher credit risk. "We have the 'B' class so a company can either be upgraded to 'A' or downgraded to 'C,' which triggers a dramatic change in treatment," says Robertson.

That change, implemented in March 2000, requires "C" companies to prepay a portion of their orders. If they can't prepay the predetermined amount, DoubleClick won't take the business. "D" companies get even harsher treatment--they prepay 100 percent, or no ad. The change in policy did not go over well with DoubleClick's sales force, and caused a hit to revenues.

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