A Lust for Profits

(LAS VEGAS, NV) — The cartoonishly proportioned women of Bare Breasted Cat Fight are boinging across a computer screen. Perched atop a table littered with CD-ROMs like Naughty Housewives 3, the monitor enraptures passersby with images of seminude combatants tugging ponytails. But attention spans are short at AdultDex, an online adult-entertainment expo held amid the tacky chinoiserie of Las Vegas’s Imperial Palace hotel. Quickly bored by erotic mayhem, some viewers drift off to booths extolling various Web-hosting services. Others pause to hear a sunglassed free-speech advocate shout with revival-worthy zeal, “If you knock out X, every other letter in the alphabet is endangered!” The rest shuffle over to Comdex, the world’s largest computer trade show, being held a few hundred yards away at the city’s mammoth convention center.

Vendors of explicit material were once welcome at the annual Comdex show. The owners of ultravixen.com set up shop just around the corner from Microsoft, for example. But Comdex ejected the adult community in 1995, fearful that merchants hawking Bra Bustin’ Babes 2 would tarnish the event. The exiles went on to found AdultDex, now a refuge for techies eager to study the latest innovations and business models of what has been dubbed the Internet’s “dirty little secret.”

The nickname is a partial misnomer, for E-porn is anything but little and certainly no secret. Raunchy pictures were the bread and butter of the Internet’s early days, and pornographers pioneered several technical wonders, from streaming video to shopping-cart software. Just a few years ago, Web pundits predicted that erotica would recede into the shadows once “legitimate” E-commerce blossomed. But with the dot-comming of America near complete, salacious fare remains a huge-and growing-cyberspace draw. According to Nielsen NetRatings, 17.5 million surfers visited porn sites from their homes in January, a 40 percent increase compared with four months earlier. The top E-Porn site-PornCity.net-boasted more unique visitors in January than ESPN.com, CDNOW, or barnesandnoble.com.

Flush with profits. By both online and offline standards, E-porn is also a massive moneymaker. While behemoths like Amazon.com and eToys struggle with losses running into eight figures, adult-entertainment companies like Voice Media and WebPower are flush with profits. “A large, mainstream E-commerce company needs to go out of its way to create demand, [to] explain why it is important,” says Keith Condon, vice president of Atlas Multimedia, whose holdings include Live Porn.com. “We don’t. We work on filling demand that’s already there.”

Overall, Web surfers spent $970 million on access to adult-content sites in 1998, according to the research firm Datamonitor, and that figure could rise to more than $3 billion by 2003. A Forrester Research report estimates that cyberporn sales-including videos and accessories ordered online-accounted for 8 percent of last year’s $18 billion E-commerce pie. That’s about the same as the amount spent online for books ($1.3 billion in 1999) and a good deal more than plane tickets (less than $800 million). With low advertising and labor costs, adult sites typically enjoy profit margins of 30 percent or more. Online brokerages, among the few Internet ventures to rival adult sites in popularity, are far less lucrative; the 1998 profit margin for Ameritrade, for example, was just 0.2 percent.

But as Martha Stewart and countless wunderkinder became overnight tycoons despite unproven products and massive amounts of red ink, pornographers were excluded from Wall Street’s party. The industry has been shut out of the dot-com initial-public-offering blitz, which last year yielded an eye-popping $702 billion in equity value.

Now tech-smitten investors may finally have the chance to put their money where their browsers are. E-porn insiders will pay close attention to the fortunes of softcore stalwart Playboy.com, which makes its Nasdaq debut next week. If the IPO succeeds, companies that rely on such indelicate slogans as “Young teen lesbians get nasty!” could be the latest beneficiaries of Wall Street’s Internet infatuation.

Early adopters. Pornographers’ mastery of the online universe shouldn’t be surprising. The industry has never passed up the chance to manipulate new media. “The first thing printed after the Bible was probably porn,” jokes David Card, director of consumer-content strategies at Jupiter Communications, who calls adult entertainment an “early adopter market.” The adult industry’s decision in the early 1980s to release their videos in the VHS format, for example, is credited with dooming Sony’s rival Betamax machine. As soon as Americans learned to dial into primitive electronic bulletin board systems, scores of them began swapping naughty pictures. It wasn’t long before surfers were paying monthly fees of $30 and up for the privilege of viewing X-rated material, as well as ordering their erotic needs-steamy videos, “marital aids,” latex corsets-in the comfortable anonymity of cyberspace.

In the early to mid-1990s, up to 80 percent of all Internet traffic was adult related, and service providers smelled money. Larry Bell, chief operations officer for Florida-based ISP Strictly Hosting.com, notes that his company was not created to cater to adult clients. “But it went that direction because of demand,” he says. “We all know the adult entertainment industry drives the Internet.” Eighty percent of Strictly Hosting’s business comes from adult sites, which require the highest-speed connections to transmit their bandwidth-gulping material.

Even America Online, which tirelessly promotes itself as family friendly, owes a great deal to sex; its early survival depended on E-porn and spicy chat, the latter of which brought in an estimated $7 million per month at one point. The company is the provider of choice for porn-site visitors-nearly 16 percent of the Internet’s racy material is still accessed via AOL.

With the exception of the Wall Street Journal’s interactive edition and a few other ventures, porn sites are still the only ones able to generate sizable revenue via subscriptions. Most of the millions of individuals who regularly visit adult sites settle for free “teasers,” but enough surfers pay access fees to make porn the king of online content. Adult material accounts for 69 percent of the $1.4 billion pay-to-view online-content market, far outpacing video games (4 percent) and sports (less than 2 percent).

“The great thing for [online] pornographers is that they can digitize their product, and then their delivery cost goes essentially to zero,” says Frederick S. Lane III, an Internet lawyer and author of Obscene Profits: The Entrepreneurs of Pornography in the Cyber Age. The sites enjoy another revenue stream in the form of advertising; adult pages feature multiple banners for online casinos, phone-sex numbers, even rival sites.

Instant entry. Success breeds imitation, and the market has been diluted by a slew of minor players-there are now at least 40,000 sex-oriented sites on the Web, and probably thousands more. No one has been able to count them all. Running an adult-entertainment business requires little expertise or capital. “All you need to do is know a little bit of HTML and scan some dirty pictures,” says Malcolm Maclachlan, a media E-commerce analyst at International Data Corp.

There are even “starter kits,” prepackaged collections of pictures and video clips that can turn anyone into a budding Larry Flynt. American Sex Inc., for example, sells a $200 beginner’s kit containing 32 minutes of video and 312 images. Low-quality sites featuring canned content often earn money as “click-through farms,” enticing visitors with free smut. Their revenue is derived exclusively from ad banners for pay sites, which dole out a few pennies each time a surfer is sent their way.

The number of porn sites has also skyrocketed because original content is easier than ever to produce. Webcams, which retail for under $100, allow exhibitionists to create mom and pop sites with $20 worth of shareware and a few grainy seconds of bedroom footage. Nicki Sacks of Maryland, for example, makes several hundred dollars a night doing live strip shows via streaming video. “The mom-and-pop player can bring a level of intimacy and personal service,” says Jim Duvall, co-founder of Jane’s Guide, which rates and reviews adult content.

Most E-pornographers run these minor sites as sideline businesses, though a few become blockbusters. After losing his job as a cemetery administrator in 1996, Maryland resident Jon-David Messner began posting nude pictures of his wife on the Internet. “The surfers felt that she was real, as opposed to a mammary-enhanced blond bimbo,” says Messner. His site, wetlands.net, grossed over $3 million last year. He spends over $40,000 a month on high-speed phone lines to handle the demand.

The increased competition is buffeting the industry. Midlevel E-porn businesses are struggling, and smaller sites are being forced to lower their subscription fees to $10 or less. All but the biggest players have problems dealing with rampant credit card fraud. “We have a lot of what’s called friendly fraud,” says Karen Campbell, sales manager for Netbilling Services. “Somebody will join a membership site, and then it’s very easy for them just to call their issuing bank and do a chargeback”-that is, deny they ever made the purchase. Visa and MasterCard both impose sizable penalties on vendors when chargebacks occur too often.

Industry watchers predict that the end result will be a major shakeout among smaller outfits, and the rise of E-porn conglomerates. “As it’s become more and more difficult, a lot of the midsize sites are selling out to the big sites,” says Mark Tiarra, head of United Adult Sites, a 500-member trade group. “You can pretty much figure out that the top 10 are the ones who will likely be around a long time.”

Mark Kreloff, chief executive officer of New Frontier Media, a Colorado-based adult cable programmer, foresees the leading players operating a wide range of sites, from soft core to every conceivable fetish. “We may own 10,000 Web sites, but the viewer won’t know that,” he says. “Every site will have its own personality, its own identity.” Particularly in demand will be sites associated with brick-and-mortar brands, bearing the names of popular porn stars, video producers, or strip clubs-brands that can only be licensed and marketed by industry leaders. A good example is Vivid Entertainment, whose roster of female stars, the Vivid Girls-frequent guests on Howard Stern’s radio show-are among the industry’s most high-visibility assets.

As in the mainstream entertainment sector, the ultimate dream is the delivery of picture-perfect content to every living room, thanks to broadband technology. “We sort of foresee a day when you turn on your television, and you’re looking at the Internet,” says Kreloff. “We’ll give the viewer the opportunity to cull through 100,000 adult videos. They’ll be able to order by star, by studio, by theme, and create their own interactive experience. True video on demand is being pioneered by the adult business.” At Vivid’s Web site, for example, subscribers can watch any full-length feature the company has ever produced for a $40 monthly fee. Pornographers think that AOL’s recent merger with Time-Warner, a marriage made with broadband in mind, validates their strategy.

With consolidation roiling the industry, more and more porn heavyweights are examining the benefits of going public. High stock prices could help them finance empire building, especially if they can achieve market valuations anywhere near those of mainstream dot coms. “When you take a price-to-earnings ratio and you can turn it into 100 rather than 3, you can leverage that money for a lot more acquisitions,” says Andrew Edmond, CEO of Flying Crocodile, an ISP dedicated to adult sites. Companies also could use that capital to integrate vertically, buying up associated businesses such as credit-card processors, adult verification services, or ISPs.

“You’d have to be brain-dead not to think about it,” says Bill Asher, president of Vivid On Demand, Vivid’s new media wing. “People always talk about traffic, traffic, traffic. If you look at the top adult sites, they’ve got a phenomenal amount of traffic, and people want that.” After witnessing nascent dot coms garner multimillion-dollar valuations, many adult companies ache for paper wealth-and the respect that comes with it. “With a lot of these [nonadult] start-ups, people are throwing money at them before they really figure things out,” says Danni Ashe, founder of Danni’s Hard Drive, one of the Web’s most popular female-operated adult sites. “I run a lean business that works.”

Online pharmacies, toy stores, and software outlets have all navigated the IPO process with ease, but adult companies who have tested the waters have so far been discouraged. Most investment banks are loath to back porn-based ventures, and institutional investors are reluctant to bet on companies pandering to lust. “Even if you can find someone to underwrite you, the big institutional buyers won’t buy because it’s adult, and that’ll hurt their reputation,” says Ashe.

Chest hair. Adult-site operators blame a few shady characters for perpetuating stereotypes that harm the industry’s Wall Street standing. “Just getting somebody to pick up the phone and talk to you is difficult,” says UAS’s Tiarra. “When people learn you’re working in the adult market, they automatically think you have a lot of chest hair and that you’re working in the mob.” Vivid’s Asher argues that the adult business is hardly the hedonistic playground of adolescent fantasy. “If you come by my office, it’s disappointing,” he says. “There’s no girls lying on the floor naked.”

Another turnoff has been the fly-by-night nature of E-porn entrepreneurs. “Most companies want to be profitable now, for the quick score; their five-year plan is nonexistent,” says Duvall of Jane’s Guide. “They have a five-year dream, which is to cash out and go to Barbados.”

Aside from the stigma, potential investors are wary of a moral backlash. As more and more homes get wired, and thus porn ready, “it raises more and more concerns among religious groups, among conservatives, among parents,” says Lane. “That’s why you’ve got this constant threat from Congress.” There is also growing concern over the number of “cybersex compulsives”; a recent study by researchers at Stanford and Duquesne universities claims at least 200,000 Americans are hopelessly addicted to E-porn. Congress has already passed two bills to regulate adult content on the Internet, though both were tossed out by federal courts. The most recent attempt, the Child Online Protection Act of 1998, would have made it a federal crime to operate sexually explicit Web sites unless access was restricted to adults. The law was overturned on free-speech grounds last February, but an appeal is pending.

A few adult companies have made the foray onto Wall Street, with generally lackluster results. Most went public via “reverse mergers,” purchasing shell companies that were already publicly traded in lieu of finding underwriters. Starfest Inc. was a failed concert producer when Michael Huemmer bought it last March and opened an adult site. Though Starfest.com attracted an impressive 450,000 hits per month, Huemmer found it nearly impossible to find takers for his over-the-counter stock. “The brokers wanted a [porn] CD to show their clients, then they’d come back and say, ‘There’s no way, it just won’t fit into our portfolio,’ ” he grumbles. “I think the brokers just wanted the CD.” With the stock trading at 27 cents this past January-unchanged for four months-he sold Starfest to a nonadult software start-up eager for public status.

Ivy investment. Metro Global Media enjoyed modest Nasdaq success until a series of setbacks last year. First listed in 1996, the company has a strong background in video and magazine sales, and the company recently branched onto the Internet with its debut commercial site, amazingdirect.com. It even attracted a few prominent institutional investors, including Harvard College, which once owned 6,400 shares. (Harvard dumped its investment last year.)

But trouble began last June when Metro Global Media’s accounting firm, Boston’s Grant Thornton, charged that alleged mobster Kenneth Guarino was the company’s behind-the-scenes decision maker. (Metro Global Media denies that allegation.) In November, a class action suit was filed against the company, alleging “a series of false and misleading statements” in reported financial results. Two weeks later, Metro Global Media was delisted from Nasdaq because of “lack of public interest,” according to a Nasdaq spokesman.

For some time, Seth Warshavsky’s Internet Entertainment Group seemed certain to reverse E-porn’s fortunes in the public sphere. A media-savvy 26-year-old notorious for posting the X-rated home movies of Baywatch siren Pamela Anderson Lee, Warshavsky has been widely lauded as the “Bill Gates of smut.” He claims annual revenue of nearly $50 million, much of it derived from his flagship site, clublove.com. An SEC filing was in the works when the company’s legal situation suddenly became very sticky this past fall. Several ex-employees charged Warshavsky with ordering them to double-bill customers or charge credit cards for serv- ices never rendered. They also contested the company’s stated revenue as being grossly inflated. Warshavsky denies the allegations, but they have sidetracked his IPO plans for the time being.

Adult companies believe a breakthrough is at hand, however. The industry is abuzz with hope over Playboy.com‘s impending IPO, which is being underwritten by top-tier investment bank Credit Suisse First Boston (box, Page 43). “With First Boston underwriting the Playboy.com deal, it validates that this is a real industry, that there’s real revenue,” says Warshavsky, who has reshuffled IEG’s management and would like to attract Goldman Sachs for his next crack at an IPO.

If Playboy.com is a hit, Wall Street may start taking a closer look at the last dot-com niche it has yet to invade. “If there’s a company that has strong fundamentals in an area that is continuing to grow, I think the market would end up accepting them,” says Craig Gould, vice president of corporate finance at National Securities Corp. Good candidates, he adds, would be film or magazine producers like Vivid and Zane Entertainment, which have built strong brand-name recognition among connoisseurs before branching into cyberspace.

Normal guy. As for moral qualms, they may be of secondary importance to financiers in the grip of dot-com madness. “I’m not a weirdo or a pervert, it’s not my deal,” says Bruce Biddick of Centex Securities, a microcap underwriter in La Jolla, Calif. “I’ve got kids and a family. But if I can see as an underwriter going out and making bucks on people being weird, hey, dollars are dollars. I’m not selling drugs. It’s Wall Street.”

Porn’s stock-market fate may ultimately depend on whether small investors raise a stink. “People really pay attention to what’s in their mutual fund,” says IDC’s Maclachlan. “A certain percentage of investors don’t want to invest in companies that support certain causes, or harm animals, or whatever.” Many prominent “sin stocks,” however, continue to perform despite heaps of negative press. “People are still buying Philip Morris,” says Joel Isaacson, head of the financial planning firm Joel Isaacson & Co., “and I think a lot of people might say tobacco is worse than pornography.”