August 8, 2001
by Jonathan Wallace firstname.lastname@example.org
"Our technology and services provide a safer, smarter and more productive Internet experience for millions of people worldwide," says censorware company N2H2 Inc. of Seattle on its web site. There the company also touts its "complex array of artificial intelligence tools that scour the Web 24 hours a day" and the "extensively trained Human Review team using sophisticated, proprietary categorization software to review results." N2H2's original product, around which the rest of its offerings are based, was the Bess censorware, which, when you attempt to reach a site blacklisted by the software, displays a page with the message "Bess won't go there."
Where will Bess go, and where is the company itself heading? This is the first in a series of articles profiling N2H2.
Why is the company worth writing about? For several reasons. Unlike some of its competitors, N2H2 has largely avoided taking an ideological public stance. Compare it, for example, with Solid Oak Software, whose Cybersitter product blocked the National Organization for Women as a "radical lesbian" page. N2H2, by comparison, is the paradigm of censorship as commerce. From the same "About N2H2" page: "As N2H2 expands into the Enterprise and Consumer markets worldwide, we're developing new, customized solutions for each market. By leveraging our advanced categorization and filtering technologies, N2H2 is able to provide our customers with tools that make browsing the Web safer, and searching the Internet more productive."
In 1999, the Censorware Project released a report on N2H2 called "Passing Porn, Banning the Bible", revealing that the Bess censorware as installed in schools blocked useful or innocuous sites like Mother Jones and Redbook magazines, the Institute of Australasian Psychiatrists, the ReWired essay site, and Feminists Against Censorship. The report also revealed that Bess wasn't successful in blocking hard-core pornography, letting through sites like HardcoreSex.com and asianslut.com. Later in this series of articles, we'll examine whether N2H2's track record has improved since 1999.
As the company announced at its third quarter investors' conference call on July 26, its software now blocks content on 165,000 student workstations in Ohio and 80,000 student computers in Utah, where it was officially selected as the state-wide censorship solution. N2H2 has achieved significant penetration of the United States K-12 market (kindergarten to 12th grade). The company has repeatedly boasted that its software governs what more than 16 million people worldwide can see.
Another reason that N2H2 is worth writing about: because it is publicly traded, much of its financial and business information is available, and it is also regulated by securities laws and SEC regulations which mandate that its statements must be truthful. By contrast, most other censorware companies are privately held, don't have to publish their results and are not subject to the same legal scrutiny of their p.r. excesses and instances of wild spin.
Finally, the passage of the Children's Internet Protection Act, mandating federally funded schools and libraries to adopt censorware, is driving new clients to purchase the technology. This article series will examine the question of whether N2H2 delivers what it promises, and whether its products are a safe bet for schools and libraries seeking to satisfy the law's requirements.
The company titled its third quarter press release, "N2H2 Announces Strong Third Quarter 2001 Financial Results." Actually, N2H2 had $9.4 million in operating expense in the third quarter against just $2.1 million in revenue, for a $7.5 million net loss (thirty-five cents a share). On the company's July 26 conference call, (a replay is still available by calling 800-642-1687, and referencing conference ID# 1160605), its chief financial officer, Paul Quinn, explained why the quarter was "strong": revenue was $300,000 better than "guidance" (the information disclosed by the company to investors and investment bankers), and the $9.4 million expense involved substantial one time charges, including write-downs of two investments in the amount of nearly two million dollars and an $809,000 charge for severance pay for terminated employees. Without the one time charges, the company claims that its actual loss came to only $3 million, compared to a loss of $4.8 million in the prior quarter.
N2H2 has only $6.2 million in cash left from its 1999 initial public offering, and spent $3.9 million to pay expenses in third quarter. This would seem to imply that N2H2 has less than six months of cash to burn before insolvency, unless it finds new capital sources or becomes profitable first. On the conference call, Quinn opined that the company has "ample time" given its run rate and about $800,000 in new sales it anticipates collecting before the end of the year.
The company's revenue projections are based on a just-concluded conversion of customers from free to paid licenses. This year, N2H2 discontinued a much-criticized approach under which schools could receive its server-based censorware for free if they tolerated advertising to their students. (The company was also caught selling the demographic data it gathered on student Internet usage to customers including the Department of Defense, another practice it then discontinued.) On the call, N2H2's new CEO, Philip Welt, a seventeen year veteran of the Microsoft sales and marketing organization, reported that the company has successfully converted about eight hundred customers (70% of the "student count", Welt said) to a fee basis. The projected revenue from these new paying customers is four million dollars, of which about $800,000 is expected to be recognized in the fourth quarter. Welt pointed out that the company had previously made only $826,000 from advertising revenue regarding these same customers.
Like other Internet-related companies in a savage market environment, N2H2 has laid people off recently, cutting 45 people to get to a headcount of 110, which the company is not planning to increase. Many of those cut were in sales and management. The company did not specifically say whether it had also cut members of its "human review" team (the employees who surf the web looking for content to blacklist). It said in a June 12 press release: "The reductions in workforce are not expected to impact N2H2's existing Internet review capabilities. The human review team, responsible for reviewing thousands of questionable Web sites a day for the Company's 16 million customers, should benefit from a streamlined management structure and rapid development of data acquisition and scanning tools that will make their work more effective and efficient."
N2H2 went public at the height of the Internet market in 1999. Its stock traded at over $30 before the end of that year. Today, the stock is at fifty one cents a share, and N2H2 attended a NASDAQ delisting hearing on August 2. The rules of the NASDAQ exchange dictate that, in order to continue to be listed, a company must meet certain criteria pertaining to market capitalization, number of shares traded, net assets and minimum bid price. N2H2's stock first dropped below $1.00, the minimum bid price, last November and, except for two brief resurgences in the winter and spring of this year, has stayed there. On March 26, NASDAQ sent the company a delisting notice.
On the July 26 call, CFO Paul Quinn acknowledged that the company's chances of dodging the bullet were not very good. The main recourse, he said, would be to do a reverse stock split (decrease the number of shares outstanding until each share was worth $1 or more). He said the company did not believe a reverse split would be in the best interests of shareholders, and has decided not to do it. (In fact, many companies who do reverse splits to avoid delisting find that the newly combined shares soon sink to less than $1 apiece, and they get delisted anyway.)
If N2H2 gets booted off of NASDAQ, its stock will still trade as an over the counter stock, but the liquidity of the shares will be much reduced, the upside far smaller, and the company's ability to do further offerings will be harmed. No-one wants to be ejected from NASDAQ, and when it does happen, it usually represents the end of a dream of huge market value and lucrative follow-on offerings.
N2H2, even if its burn rate decreases after the one-time charges, is going to need more money soon (unless sudden profitability relieves it of this need, but even companies that are profitable on paper need cash to operate while they collect their revenue). A company that cannot raise capital in the public markets can get it in a variety of other places: in private placements, by borrowing it from banks, by turning to venture capitalists, or by selling itself to a larger company with the cash to finance future growth.
However, the fact remains that N2H2 is a small, unprofitable company, losing millions against projected revenues of only about $9 million for this year. Sinking to a fifty-one cent stock price, and being delisted, give the company a further stigma which may be hard to overcome in private capital markets. It doesn't help that two insider shareholders declared their intention in July to sell almost two hundred thousand shares while the company is still public. N2H2 has an average daily trading volume of only thirty seven thousand shares.
As for borrowing more money from the bank, the company's second quarter 10Q filing with SEC (its third quarter is not yet available online) contained the chilling news that Imperial Bank had called in N2H2's $2.5 million line of credit for the violation of certain covenants. The company said in that filing that it did not agree with the bank's determination and was negotiating a resolution. CEO Welt and CFO Quinn did not report the outcome on the July 26 conference call. The company failed to respond to several emails I sent (to the P.R. director, the CFO and the outside public relations agency) asking for clarification.
On the conference call, Welt disclosed that N2H2 sales and marketing expense had dropped by $1.2 million over prior periods. Sales and marketing is one area where typically the market does not want to see a product company cut expenses. Welt went to some lengths to reassure his audience that this cost-cutting reflected the shift from a direct to an indirect sales model. In other words, instead of having salespeople calling directly on school districts, libraries and corporate customers, N2H2 will refocus its efforts on finding resellers such as integrators or product companies who will bundle its censorware with other products and services. Welt said that five new corporate resellers had been recently recruited. He also highlighted another recent win: N2H2 had signed a contract with Excite@Home to sell censorware to its 3.2 million customers.
At the end of an investor call, the CEO usually solicits questions. The number he gets, and their substance, is a pretty good indication of the level of public interest in the stock. At the end of the N2H2 call, Welt had only a single question, from George Lee of SDI. This was not surprising, given the fact that (according to Yahoo) N2H2 is not followed by any industry analysts (who usually line up to lob a few softball questions apiece at a conference call).
Lee wanted to know about the Excite@Home deal: what were the financial terms? Paul Quinn answered that any Excite@Home user who requested could obtain a six month free trial of the N2H2 client-based censorware. Afterwards, if satisfied, they would pay a one-time charge of $39.95, part of which N2H2 would then pay back to Excite@Home as a commission. "Our ISP partners are having a tough time making price increases stick," Welt added.
There was a difference, as usual, between the dry, realistic language of the company's filings and the CEO's optimism on the conference call. The second quarter filing warned that, "If we are unable to raise additional funds on acceptable terms when needed"--which the company, in the prior sentence, acknowledged "would be very difficult to obtain"-- then "our business, financial position and results of operations would be seriously harmed." Contrast the scripted words with which Phil Welt ended the call: "N2H2 is sailing ahead and will weather the storm."
N2H2 is a technology company, and the quality of its technology is now (in today's harsher, more realistic Internet marketplace) a necessary (though possibly not a sufficient) condition for its success. In order to stay in the game, N2H2 will have to prove the efficacy of its "complex array of artificial intelligence tools". Have these tools improved N2H2's blocking capabilities, clearly both over- and under-inclusive last time we examined them? This will be the subject of the next installment of this series.