Lessons from the Pets.com Downfall – What’s the Difference Between a Bad Idea and a Good Idea That’s Early?

As we build out our ‘This Day in Stock Market History’ archive, I like to periodically take an in depth look at notable events in history. Today’s post comes at the anniversary of the IPO of one of the most infamous dot-com names. 

The tech bubble and its bursting is the butt of a lot of jokes for investors even still today. The euphoria that swept through the market led to some incredible stories. A few of my favorites:

But perhaps nothing quite gets the same amount of laughs as the story of Pets dot com, the most famous dot-com bust.

Pets-com_sockpuppet

The Rise and Fall of Pets dot com

Originally, the Pets dot com domain was registered in 1994 by an early internet entrepreneur who was purchasing domain names that he figured would become valuable over time as the internet gained in popularity.

But to him, Pets dot com was different than other domains. He saw potential to build a business around it, and by 1998, Pets dot com was an established business and ready to serve its online customers and ship product.

After a couple rounds of financing from notable investors (more on that later!), Pets dot com had an operating budget to blitz the American public and make its self known. Their first national ad campaign was the Superbowl on January 30th, 2000:

The company paid $1.2 million to air the commercial. But this was just a fraction of the amount of money the company would spend on ads and marketing. In 1999, the company would spend $42 million on ads. In the first 9 months of 2000, it would spend over $60 million on marketing and sales.

Over that time, the company would do just $25.7 million in revenue!

m_sales_marketing_2000

That advertising budget led to the now infamous sock puppet being visible everywhere. The sock puppet would be interviewed on good morning America, and even have its own Macy’s Thanksgiving Parade float!

No doubt all this publicity helped build excitement for the company to sell its stock to investors in early 2000. And on February 11th, 2000, just one month before the Nasdaq’s tech bubble peak, Pets dot com would IPO at $11 per share, giving the company a market cap of $290 million.

And pretty much from that point on, everything went downhill.

pets.com chart

In an attempt to gain market share, the company was selling many products at a loss. For every dollar in sales, the company was losing 26 cents, (that’s before factoring in any advertising costs).

Very early on the company was able to raise cash by selling additional shares. Between the company’s IPO and its delisting 278 days later, more that 12 million additional Pets dot com shares were issued and sold that allowed the company to raise 75 million in 1999, and 60 million in early 2000.

petcom-shareissuance

But as the stock price tanked and investors’ appetites for tech dried up, so did their ability to finance their operations. In its last 9 months in operation, the company’s operations burned through $70 million in cash.

With its cash balance of $23 million to start the 4th quarter of 2000, the company did not have the money to stay alive for another quarter. It hired Merrill Lynch to help find a buyer. No one was interested.

On November 7th, 2000 the company would announce that it was closing its doors.

On August 31st, 2001 the company would approve a liquidation (the company did not technically go bankrupt) of all of the company’s assets and return the proceeds to shareholders. All the inventory was sold, office equipment sold, the web domain was sold, and even the infamous sock puppet was sold (for $125,000).

In the end, shareholders got 9 cents per share given back to them.

In total, an investor who purchased the shares at the IPO and held through to the end would lose 99.2% of their investment.

Lessons Learned From The Pets.com Downfall

Here’s the thing – Pets dot com was a pretty good idea. Maybe poorly run, maybe a little early, but they were absolutely right that buying pet supplies would trend online.

Don’t laugh at me just yet, you know who agreed with me?

Jeff Bezos, who ran a company called Amazon.

And Michael Isner, who ran a company called Disney.

Both of these companies made significant investments in Pets dot com. Amazon was a very early investor in the company, and owned as much as 50% (which was diluted to 30% after additional fundraising rounds and the IPO). Disney owned 5% of the company.

These partnerships gave Pets dot com prime real estate on Amazon’s webpage, and helped get the sock puppet featured on many of Disney’s television stations.

In fact, Bezos had this to say about Pets dot com:

“We invest only in companies that share our passion for customers. Pets.com has a leading market position, and its proven management team is dedicated to a great customer experience, whether it’s an easy-to-find product, like a ferret hammock, or help in locating a pet-friendly hotel.”

AMZN petscom investmentcropped

Fast forward to today – Pet owners spend over $32 billion per year on their pets. 40% of money that is spent online.  One of the most dominant names in the industry – Chewy.com, was purchased for $3.35 billion in 2017.

If Pets dot com was worth $3.35 billion in 2017, it would have meant that investors at the company’s IPO, when it had a market cap of just under $290 million, would have had a 15.5% compounded annual growth rate in their investment. That $11 share of Pets dot com in 2000 would have been worth $127 in 2017!

That’s triple the CAGR of the general stock market over that same time. (The Dow closed at 10,425 on the date of the Pets dot com IPO, and was at 20,412 17 years later, for a compounded annual growth rate of just over 4.0%)

Fast forward to even more recently, (as of November 2020 when I’m making this update), Chewy is worth nearly $30 billion! If Pets dot com was worth $30 billion today, investors at the IPO would have had 26% compound annual growth – Higher return than Amazon shareholders over the last 20 years!

These figures come from Statistica, if you want to verify and see other mind blowing numbers about how much money we spend on our pets every year, here’s the data: https://www.statista.com/topics/4405/online-pet-care-market/

So what exactly went wrong with Pets dot com? And more importantly, what lessons can investors today learn from the Pets dot com flop and apply to their new investments today?

Where Pets.com – and Investors – Went Wrong

 

Bezos, and other Pets dot com investors were, in a way, right – everything, including the sale of dog food, was trending towards online. If (I recognize that is a big if) Pets dot com would have been able to survive and maintain its market share, it would be worth billions of dollars today.

But of course, it isn’t.

What went wrong at Pets dot com?

Here is what the former Pets dot com CEO Julie Wainwright had to say about the company’s downfall 10 years later:

“Here is the real story behind Pets.com.

We did sell dog food for 1/2 price for 2 weeks only as a customer acquisition tool — and because the 8 other pets sites funded were doing the same. We also had an auto order feature. We did NOT go out of business because we were selling pet food for below cost. We stocked and sold over 15,000 skus of pet related items–of which less than 600 hundred were pet food. Our average order was close to $37 — only 50% of order had any food item in them.

Here is what the world looked like in 2000….there were no plug and play solutions for ecommerce/warehouse management and customer service that could scale…which means that we had to employ 40+ engineers. Cloud computing did not exist, which means that we had to have a server farm and several IT people to insure that the site did not go down. There were less than 250 Million worldwide Internet consumers in 2000- now there are 5 Billion. Amazon has reported a loss of nearly $900M in 1999…because guess what, ecommerce is a business of scale. And, the Internet bubble had burst…which meant that NO ONE was getting funded. Pets.com need(ed) a total of $260M of funding to get to breakeven. Sounds nuts now, but that was considered acceptable now. We had raised a total of $180M…and we knew that it would be hard if not impossible to raise the capital to get to break-even.

The financial market was in a tailspin and the management of Pets.com believed that the company should be shut down to return money to shareholders…not run to bankruptcy. Please note that at least 1100 Internet companies, including Webvan with losses of over $1.5B, chose to file bankruptcy.”

Wainwright deserves some blame for sure. The company spent recklessly until it was down to its last dollar.

No responsible manager should put their company in a position to fail in 3 months if they can’t get funds raised.

Pets dot com needed scale to ultimately become successful, but so did other tech companies at the time like Amazon and Priceline (now Booking Holdings). We’ll look below about how these companies structured their balance sheets to be able to survive the bursting of the tech bubble.

Pets dot com was a good idea – just poorly executed.

But unfortunately it is often these seemingly “good ideas” that are the basis for an investor deploying their savings into a new company.

What is even more important, and what investors should really be looking at – is the company’s execution of those ideas.

So what lesson can investors learn from Pets dot com and apply to tomorrow’s new investment?

Lessons For Investors:

Think you have found the next great investing idea? Here’s a few things to think about before investing.

  • New ideas take time to take hold.

New ideas are often well ahead of modern infrastructure. As Wainwright said, in the late 90’s they had no adequate warehouse management systems, no cloud computing or servers, and about 5 billion less people online than today.

All of this would be required for a company to be able to scale and operate profitably. For internet companies like Amazon, it would take a decade for these businesses to scale, and the public to become informed and educated.

I think we have seen this mistake of investors jumping on the bandwagon too early repeated a few times since the Pets dot com downfall.

From 3D printers, to electric cars, to marijuana stocks, and of course crypto currencies, over the last decade investors have jumped from hot stock to hot stock in search of the next great thing. So far, the businesses have been unable to meet their overly optimistic expectations.

Could these end up being ideas that change the world? Yes. But the time it would take to, for example, educate and convince a large portion of the world to understand and use bitcoins instead of cash is a monumental task. As we will see below, it took almost a decade for Priceline (the online travel booking site) to build out its brand name, build the online infrastructure required to run the company, and convince the world to book travel online. Bitcoin, if it catches on, will take much longer.

So with that lesson in mind, lesson 2 deals with how you can make sure the company can remain solvent long enough to see the idea take hold.

  • Even if you have the best idea in the world, if you are reliant on fund raising, you are at risk for failure.

Combine our previous lesson with this one. As mentioned, Pets dot com didn’t have the infrastructure built out to efficiently handle orders. It took companies like Amazon a decade to build out what it needed to operate like it does today.

Pets dot com had no such runway. They were constantly in need of additional funding to keep the operation going. When the dot com mania ended, if you were a tech company that needed fundraising, you were in trouble. All sorts of companies that were on the cutting edge of using the internet to do new things failed. Not (necessarily) because the idea was bad, but because they needed money just to survive.

In the tech bubble, internet search engines (you don’t think google was the first do you?!) failed, grocery deliverers failed, high speed internet providers failed, social media companies failed, computer companies failed, telecommunications companies failed.

All of these are types of businesses and industries that thrive today.  These companies did not fail because they were a “bad idea”. They failed because they ran out of money, a failure that those who read the companies’ balance sheets could see coming.

I thought it would be interesting to look at a couple companies that survived the tech bubble, and have become huge companies today and see how they were run differently than Pets dot com.

Priceline (Now, Booking Holdings – Ticker: BKNG)

The website Priceline.com was launched in 1998, bringing travel booking to the online masses.

Like Pets dot com, the company was fairly new as the tech bubble peaked. It was hardly an established company – So how was it able to survive at time that so many new companies failed?

Priceline finished up the first quarter of 2000, the peak of the tech bubble, with $110 million in working capital (current assets minus current liabilities), and $125 million in cash.

The company was burning through $5.4 million in cash per quarter, meaning that the company had about 22 quarters worth of savings in the bank.

priceline_balance_sheet priceline_cash_used

This cash cushion allowed the company to weather the bursting of the tech bubble, and continue to build its business.

Today, Priceline (known today as Booking Holdings) is worth nearly $90 billion, up 300% since its peak in 2000, and 12,000% from its lows after the tech bubble burst.

Also worth noting, and related to our first lesson above, after the excitement of the tech bubble passed it still took years for Priceline to build up a business worthy of its valuation during the tech bubble. Priceline did not surpass its tech bubble valuation until 2011!

bkng_chart_since_2000_peak

Amazon (Ticker: AMZN)

Amazon is infamous for its lack of profits over the years. And the early 2000s was no different. However, even Amazon was in better shape to weather a down market than Pets dot com

In Q1 2000, had $700 million in working capital, and had significant cash burn of $320 million!

But unlike Pets dot com, who continued to spend down to its last dollar, Amazon was able to throttle back spending 3 months later as the bottom fell out of the stock and credit markets.

By the second quarter of 2000, Amazon was burning through just $70 million per quarter, with $560 million in working capital. In total, enough to keep Amazon running for another 2 years.

amzn_q2_2000_cash_cash_burn

(and actually, Amazon was able to throttle back spending even further as the stock market collapse worsened. By Q3 2000, Amazon was burning through just $3.7 million in cash per quarter!)

Of course, the cash was able to keep Amazon alive long enough to become the household name we know today. Like Priceline, it took Amazon nearly a decade after the tech bubble to develop its business.

amzn_chart_2000_tech_bubble_peak_through_today

There are many more examples of companies that survived the tech bubble bursting to go on and thrive today. Intuit, Ebay, Adobe, and even Yahoo was able to make it through.

All of these companies were only able to make it to today because they had a cushion available to keep them afloat. Pets dot com, and countless other companies, had no such safety net, and as a result could not survive to see the day that their services would be in high demand.

Should you Take the Risk?

Ultimately, for a company without a strong balance sheet, there is no difference in being early or being wrong. The company will have the same fate regardless. So how do you determine when to take a risk on a new ideas?

Investing is all about weighing the balance of potential risk with potential return.

There is nothing wrong with using a small portion of your investment to “take a risk” on a new upstart company with a radical idea to change the world.

What is wrong is blindly assuming that that next big idea is a great investment only because of the idea.

In 2019 and 2020, a large number of IPOs will be sold to the American public. Most notably, Uber. The company is based on (what I believe at least to be) a great idea. Does that mean investors should jump in on day 1? I’m hesitant.

Although we haven’t been given insight on Uber’s financials quite yet, it has been reported that the company lost nearly 1 billion dollars in the last 3 months alone. With out a doubt, Uber will need additional fundraising in the future. As an investor, are you willing to bet your entire investment on Uber obtaining fundraising a year from now?

Compare the dependency on fundraising that Uber will have to the balance sheets of two small technology companies that I, and clients, have invested in (see Our Disclosures here) – Yelp and Ansys. Will these companies grow to become tomorrow’s large and successful companies? Of course I don’t know for sure. But I think they are built on good ideas, and these companies have zero debt and rock solid balance sheets that I know have the potential to carry them into the future, regardless of what the credit market brings tomorrow or next year.

Warren Buffett touched on this topic in his most recent letter, which I think describes this better than I can and is a great closing thought to end this post:

“We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time.

At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need”

Interested in more stock market history? Check out our previous post: “The Wisdom of Crowds – The Story of The Stock Market’s Reaction to the Challenger Explosion

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