(MONEY Magazine) – A year ago, Beyond.com was a New Economy success story. The company had the smart idea of selling software over the Web--a perfect example of using the Internet to eliminate warehouses and lower costs. Microsoft co-founder Paul Allen loved the company and bankrolled it. Regular investors adored it too, and the stock soared from $9 to $40 in six months.

But last quarter the company failed miserably to meet analysts' revenue expectations. Today it's barely alive. The CEO has resigned; the company is laying off a fifth of its workers. The stock languishes at $5.

Beyond.com isn't alone. Everywhere you look there's carnage among Net stocks (see the chart on page 38). Since last year's highs, Amazon is down 36%, Charles Schwab 50%, TheStreet.com 80%, Net.Bank 80%, eToys 82% and iVillage 84%. Internet IPOs that would have dazzled last spring are now flopping, with Pets.com and Webvan sinking well below their offering prices. The papers are filled with news of embarrassing snafus in the formerly idyllic Internet world: Value America fires its CEO and slashes its work force; Toys R Us blows its Christmas delivery dates; cyberthieves get hold of credit-card numbers at CD Universe; and mysterious hackers disable the websites of AOL, E*Trade and Yahoo!.

Amid all this misery, important investing lessons are emerging from the first phase of the Internet frenzy.

Lesson No. 1. There's still loads of money to be made off Net stocks, but it'll be a wildly volatile ride. And if you're not a discerning investor, you'll get savaged. Gone are the days when stocks like Amazon and eToys could keep soaring without ever showing much promise of making money. Investors are finally starting to care just how much red ink gets spilled.

Lesson No. 2. E-tailing is a hard, thin-margin business. To survive on "very skinny margins," companies must have "the scale and ability to execute flawlessly," says Charlie Finnie, a partner at CMGI at Ventures. Sellers of commodities like compact disks and toys are particularly vulnerable because stiff competition forces them to price their products so low. Nor is luring customers online by selling electronics at deep discounts a sustainable business model--bad news for Buy.com, which sells products such as stereos and computers below cost. In the long run, a firm like Autoweb, with its 90% gross margins, is a far better bet than Drugstore.com, with gross margins of 16%.

Lesson No. 3. Pricey advertising doesn't always pay off. Some e-tailers rang up record sales in the fourth quarter, but they spent so heavily on all those wry TV and radio ads over Christmas that profitability looked further away than ever. Ameritrade spent an astonishing 76% of its revenues on advertising in the fourth quarter, vs. 26% in the same period in 1998. Not surprisingly, the stock has tumbled 73% from its April 1999 high of $58.

Lesson No. 4. Advertisers will pay up only for highly targeted audiences. This favors a company like The Knot, which we'd currently recommend over any other ad-dependent Net stock. Its website, devoted to the $45 billion wedding market, targets engaged couples. Lise Buyer, a Credit Suisse First Boston analyst, says couples spend more lavishly during the six months before and after their weddings--think dresses, honeymoons, setting up house--than in any other 12-month period: "Advertisers are, of course, very anxious to get these people's attention." Result: The Knot can charge rates of $30 and up for a thousand viewings of an ad, while many other e-tailers charge less than $10. The stock made its debut in a tough market in December and it's down 34% to $7. But with its rich revenue stream, it's Buyer's favorite e-tail stock.

Lesson No. 5. Size matters. Established gorillas like Amazon, eBay and Yahoo! have a mighty edge over smaller upstarts. Given its revenues, Amazon still spends exorbitantly on marketing. But it's got a much better shot at long-term success than most other e-tailers: It's got heft, a great brand and a slick distribution system that punier rivals like CDnow can't hope to match. Amazon already makes money off books, and that division helps to fund its rapid expansion into new areas like electronics. Amazon also has a giant customer base, giving it the power to cut sweet deals with other companies. Small firms like Greenlight.com and Living.com have ponied up millions for access to Amazon's eyeballs.

Lesson No. 6. Follow the smart money. With business-to-consumer, or B2C, stocks getting smashed, savvy investors are zeroing in on an emerging sector that's barely out of diapers--business-to-business, or B2B, stocks. "Sentiment has clearly shifted. Investors are gravitating to infrastructure, Web-enablers and the pure B2B--and away from e-tailers," says Pam Cutrell, a fund manager at Essex Investment Management, which scored huge gains as an early investor in Amazon. CMGI's Finnie agrees: "B2B is clearly all the rage among sophisticated investors." So where should you place your B2B bets?

THE BEAUTY OF B2B

It's not hard to see why analysts and money managers wax lyrical about the promise of B2B. Forrester Research says the markets that B2B companies are targeting will be 12 times larger in 2002 than those addressed by e-tailers. The untapped opportunities are vast. For example, Goldman Sachs estimates that a mere 6% of electronics sales to corporations were made via the Internet last year. By 2004, Goldman expects that figure to approach 25%.

Another attraction of B2B companies is the relative juiciness of their profit margins. "Typically, business customers' first concern isn't price," explains Finnie. "It's quality of product, service availability, timeliness...and other criteria like that."

The vision of this high-margin nirvana is so intoxicating that even some e-tailers are now racing to reinvent themselves as B2B players. One of the most promising of these B2B wannabes is Ask Jeeves, a natural-language search engine that started out as a pure B2C player. Visitors to Ask Jeeves' site can type a question in plain English--instead of using keywords joined by "and" or "not"--and they'll be sent to the exact website page that contains the answer.

That's a pretty nifty consumer service, and well-heeled companies like Dell, Fidelity and Microsoft have inked deals with Ask Jeeves to exploit its technology. Dell's website now features a service called Ask Dudley that allows consumers to pose questions about various products and services. Thanks to Ask Jeeves, Dell's database actually "learns" from these queries, enabling it to provide smart answers to frequently asked questions.

Despite morphing into a B2B stock, Ask Jeeves has slumped 68% from its peak of $186. "That's clearly an overreaction on the downside," says Essex's Cutrell. Carolyn Trabuco, an analyst at First Union Securities, expects Ask Jeeves to hit $230 this year. She thinks its budding B2B business could help boost revenues by 100% a year for the next three years.

Tim Getz, an Internet analyst at Prudential Volpe, is similarly bullish about e-marketplaces, which bring together corporate buyers and sellers over the Web, just as eBay introduces far-flung collectors of Beanie Babies to one another. Industries such as steel, water processing, and chemicals are particularly fragmented, with numerous suppliers dotted around the country. Companies like Chemdex and VerticalNet introduce them electronically to potential buyers, pocketing a matchmaker's fee in return. Getz predicts that such Web-based exchanges could eventually account for as much as 40% of all online B2B transactions.

Our favorite of these "infomediaries" is Ariba, which links buyers and sellers of office equipment and supplies. Using its technology, "what took a hundred people now takes one," says Quint Slattery of PBHG New Opportunities (see The Ledger at right.) We recommended Ariba in December, and it's since soared 226% to $239. At 393 times sales, this fireball isn't for the risk-averse, but it's worth buying on its inevitable dips. Ariba now sells its software platform to companies in other businesses, enabling them to set up e-marketplaces in fields like oil and telecom. This array of partnerships should help to drive the stock higher.

Meanwhile, even poor Beyond.com is angling for its piece of the B2B action. The company recently promised to reduce its consumer business, focusing instead on selling software to corporations and government agencies. Neat idea? Maybe. But as Internet investors are finally starting to discover, it's a Darwinian world out there--and some of these weaklings are destined to die.