February 28, 2001, 12:00 AM

Missing the Mark

The unsinkable dot-com model had water gushing in from more leaks than it could plug this past year. But why did so many financial analysts fail to spot the ominous iceberg and fail to broadcast an S.O.S.?

In January 2000, the future of Garden.com seemed as bright as a daisy. The 4-year-old web retailer of plants and garden gear beat pundits’ projections for the quarter and its shares again garnered buy recommendations from several leading securities analysts and investment bankers.

But was Wall Street, still in the throes of its soon-to-fizzle love affair with Internet stocks, looking at Garden.com through rose-colored glasses? Though the top line was recommendations to buy the stock, a close look at details supplied in investment reports reveals thorns poking through a determined optimism. Analysts issuing positive ratings did mention, but sometimes downplayed or ignored, potential problems-problems that moved to center stage only a few months later as the dot-com engine began to run out of steam. Robertson, Stephens, for example, noted a drop-off in traffic figures for December 1999 from the previous month, but dismissed it as “consistent with historical patterns.” The same Robertson, Stephens report questioned Garden.com’s plans for a new offline advertising campaign given the saturation of dot-com ads, but concluded that offline and online content would support the campaign, driving traffic to the site. Thus glossed over were two emerging truths that would define the year for many e-retailers: first, traffic isn’t so much the point as sales, and second, continued spending on brand building isn’t necessarily the best way to get the sales.

In May, Garden.com was still generating buy recommendations-and at some firms, on into the summer. At that point, some analysts talked up concerns about the company’s cash burn rate and options for additional financing. But citing positive indicators such as new orders and web site ad revenues topping projections, some held onto buy recommendations pending the company’s announcement that it would reveal a revamped strategic focus and plans for financing in September.

Others didn’t wait. San Francisco-based W.R. Hambrecht, for example, in August downgraded its recommendation on Garden.com shares, noting doubts about the company’s yet-to-be-announced new strategy and questions about future financing. Still, it stopped short of telling investors to bail out now and instead rated the stock neutral. Three months later, Garden.com was headed for the place where it would end the year: six feet under.

Up in smoke

Garden.com’s story isn’t unique; it’s just one of the most visible. Many web retailers experienced variations on the same theme in 2000, disappearing in startling poufs for reasons that seemed obvious once the smoke had cleared. By the time the year ended, at least 210 Internet companies had shut down, according to a report from Webmergers.com, an online marketplace for buyers and sellers of Internet properties. About half of them-109-were b2c e-commerce sites. The closures put about 15,000 workers out of a job and racked up a collective loss of about $1.5 billion in investment funding.

How does a fledgling industry attract, and lose, that much money that fast? More to the point, why didn’t more web retail analysts call the biggest losses earlier in the year, or indeed at all?

For starters, the industry’s growth has been so fast that the traditional methods of evaluation didn’t seem to apply. Throw in overblown expectations, a dose of in-house investment banking politics and a stock rating system that requires a decoder ring and it’s a perfect recipe for why the big crashes among online retailers weren’t flagged earlier by more analysts. Now, a one-year-older and wiser industry-from investors to consultants to merchants-is well into 2001 with a firmer grip on what factors best predict winners and losers.

Outright sell recommendations from Wall Street analysts are as scarce as-well, let’s say they’ve been as scare as venture capital money for e-retail start-ups was in the second half of 2000. That truth extends across industries. On a five-point scale that rates stocks for investors from one as a strong buy to five as a strong sell recommendation, sell and strong sell recommendations combined constituted about 1% of the 27,000 recommendations issued by analysts for stocks of North American companies last year, according to Thomson Financial’s First Call, a provider of financial information and broker-sourced research.

“About one-third are ones [strong buy], one-third are-twos [buy] and one-third are threes [hold],” says Chuck Hill, First Call’s director of research and a former investment analyst with more than two decades of experience. “Theoretically, you should have as many sells as you do buys.”

So why isn’t that the case? Hill speculates on two reasons. One relates to analysts’ concerns about companies cutting off communication following negative recommendations, which happens rarely. A second factor is that a chunk of many analysts’ compensation today comes from their company’s investment banking business. “If you’re the investment banker or the investment banker wannabe, you want to stay on a company’s good side so hopefully the next time they have to raise money they’ll come to your firm,” Hill says.

In fairness, there are reasons for analysts to be optimistic in their ratings, Hill adds. Overall, the market does tend to go up over time, offering some justification for a positive bias-although that’s a rationalization that doesn’t hold up in the case of Garden.com or Pets.com. There’s also a built-in enthusiasm most analysts feel for the industry they’ve elected to cover.

These points aside, however, there are further complicating factors. Not all analysts use the same terms in issuing recommendations, which makes comparing recommendations difficult. For all of the above reasons, it can take a playbook to figure out what a rating really means-a fact of life understood by experienced market-watchers. “Buy can mean hold; and hold, sell and strong sell could all mean sell,” Hill says. And neutral can mean neutral, or it can mean that the company is in essence on the deck of the Titanic looking at the scenery.

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