The wolves of tech street
Tech start-ups are big investment news again, but is a second bubble preparing to pop?
with billion-dollar market valuations fuelling a second dotcom boom, but profits failing to live up to the hype, is tech about to lose its trousers?
tepping out of the trading floor’s frenzy, the reverberations of the stock market bell still ringing, reality sets in. Taking in the madness around him, a cocky, twentysomething web entrepreneur has just seen his company, a simple service that allows you to connect with friends, chat and share photos, go public to become a billionaire-dollar enterprise, making him one of the richest men under 30 in the world. The value of his shares has risen by a stunning 606 per cent in just 24 hours, the largest opening day “pop” in a company’s share price in the history of the stock market.
Yet this isn’t the exciting new tale of WhatsApp, and Facebook’s billions are yet to be made – it’s November 1998 and Stephan Paternot, founder of TheGlobe.com, has joined thousands of other pimpled millionaires enjoying overnight wealth at the height of the first dotcom boom. Much like The Wolf of Wall Street’s real-life anti-hero Jordan Belfort, Paternot became the symbol of the excess and profligacy of the time, famously filmed in a New York nightclub exclaiming that he’d “got the girl, got the money, now I’m ready to live a disgusting, frivolous life”.
Little over a year later, it all turned to rubble, and his bright idea had become the digital emperor with no clothes. By 2001, after three years of making absolutely no money for its profit-hungry new owners, TheGlobe.com’s shares were worth just ten cents, Paternot’s $78 million fortune fading away.
While this dotcom boom had been building up to its catastrophic bust, a total of 369 tech companies had “gone public” through what’s known as an initial public offering (IPO), which hands everyday punters a chance to buy a little slice of their favoured firm. But as soon as the bubble popped, IPO activity lay dormant and the hangover of the early millennium lasted a decade.
Now, however, the wolves are again circling Silicon Valley. In fact, the murmurs of a new tech bubble have almost become a din over the past three years, with some 329 tech firms trading on the stock market since 2010 and investors pumping in an incredible US$68 billion in the process. But while tech stocks may be today’s hot market picks, is it all a case of history repeating?
There are two common themes among this new generation of public tech companies: mind-bogglingly high valuations and next-to-no profits. Of the five largest US IPOs last year, just one company actually turned a profit. The firm with the highest valuation? Twitter, the social networking platform that raised US$1.8 billion when it went public in 2010 but has lost money every single year since. In fact, in 2013 it lost US$645 million, an 816 per cent increase on the previous year’s losses. Has that deterred investors? It’s a resounding, “Hell no!” from Wall Street. Twitter’s share price has ballooned by 20 per cent since it listed and its market capitalisation – the size of the company calculated by multiplying all of its outstanding shares by their price – has grown by 62 per cent to US$29 billion. This makes the value of Twitter greater than the gross domestic product of Bolivia, which isn’t bad going for a company that’s never made a profit.
Why Wall Street really loves tech
If this sounds worrying to you, it doesn’t seem to bother the stock market’s money men. With interest rates in the Western world at rock bottom, investors have been struggling to find companies with the potential to grow their wealth to even more obscene levels. Today’s tech firms offer that tantalising potential, so traditional means of valuing businesses are discarded in the hope of what these young upstarts can become in the future.
This is the concept of “story stock”, companies that have the potential to revolutionise their sector or, in the cases of Google, Apple and Amazon, the world. The
current wisdom is that almost any tech firm is on the verge of joining these behemoths, the positivity fuelling massive growth in their valuations. It can be seductive: buying ten shares in Google when it first listed in 2004 cost under US$850; now, you’d be sitting on over US$10,000.
“What US investors are looking for when investing in these types of companies is the total addressable market that they have if they’re successful,” explains Jeremy Gleeson, a professional fund manager who invests exclusively in tech. “They’re not necessarily looking at their earnings this year or next year. Traditional
ten shares in google would have set you back US $850 in 2004; today they are wort h US$10,000
profitability metrics aren’t appropriate for companies when they’re at such a high growth stage.”
These metrics are called the fundamentals, or “multiples”, of a business. Professional investors use a number of these complex formulae to assess the value of a firm. The price to earnings (P/E) ratio is one such metric, which divides the share price by how much each share has earned over the past year; the higher the figure, the greater perceived potential for growth (above 25 is good).
Facebook’s ratio, at the time of writing, is 99 but, like a short-price favourite in betting, requires heavy investment to realise any return (in this case, $99 for $100 back). Gleeson’s invested four per cent of his fund in The Zuck.
“I’m paying a premium for it,” he admits, “but I get a premium return. Facebook’s earnings per share are forecast to grow at around 35 per cent, which is significantly above the market growth rate.” Indeed, Gleeson sees value in the way Mark Zuckerberg’s firm has monetised the huge traffic visiting its site. While the stock may be pricey, the company pocketed a cool US$1.5 billion profit last year.
The disparity in tech stocks is startling, though, with on-the-rise on-demand firm Netflix rocking a 310 P/E ratio and LinkedIn’s untapped potential/low-share-price combo seeing it slapped with a huge 887. When you compare these to Apple and Google – offering 13 and 31 respectively – it’s clear how expensive it can be to buy the very top tech firms for, currently, not much return at all.
Blowing more air into the bubble
Twitter’s valuation has no doubt benefitted vicariously from Facebook’s success, as investors expect it to achieve the same ad revenue. Lou Kerner, a venture capitalist who invests in tech start-ups and was the first social media analyst on Wall Street, believes that while conditions are right for social media companies to snag even bigger slices of cash pie from advertisers, Twitter is likely to struggle.
“You know who marketers want to reach? People,” Kerner enlightens us. “The reason that Facebook is doing so well is because that’s where the people are. The question regarding Twitter is, ‘Are people going to go there in such large numbers?’ Right now they’re not.”
Indeed, Twitter’s latest quarterly figures – a calculation that advertisers pay close attention to – showed a total of 241 million active monthly users, a disappointing 3.8 per cent increase on the last quarter, suggesting growth is slowing (#worrying). “The path Twitter’s on is not reflective of the valuation it has today,” adds Kerner.
There are echoes of the tech industry’s haunted stock market past in statements like Kerner’s. Do all of these many companies going public have sustainable business models? At the very height of the ’90s boom, Webvan, a grocery delivery service, was valued at US$1.2 billion when it went public, but the razor-thin margins on offer saw it flop just 18 months later. There are signs that some of today’s tech titans are beginning to flounder in a very similar way.
A dangerous game to play
Zynga, Californian creator of the irritatingly addictive FarmVille and Mafia Wars, has seen its stock price tumble since its 2011 IPO. When it listed on the stock exchange at a valuation of US$7 billion, Zynga was generating revenues of over US$1 billion a year, yet its IPO now appears cursed.
Since then, gamer numbers have fallen from 300 million at their peak to 133 million, revenues have dropped by 36 per cent over the past year, and its disastrous US$180 million takeover of Words with Friends maker OMGPop resulted in its closure and a US$95 million write-off. Oh, and there’s still no sniff of an actual profit.
This is a particular danger in the gaming industry – one minute you’re all the rage, the next you’re Streets of Rage. More recently, King, creator of blister-causing mobile hit Candy Crush Saga, launched a US$500 million IPO, valuing the company at a staggering US$7.1 billion, quadruple the value of Grand Theft Auto maker Rockstar Games.
Yet the rot may be setting in before the worm has even turned: in its IPO filing, King revealed that use of its games is already slowing. In the first quarter of this year, the average number of times its titles were played fell by around 20 million, while the average number of people succumbing to the temptation of in-app purchases in any given month dropped by seven per cent. Kerner’s stock market voice of doom thinks that there’s only one way King can go: the Zynga way.
“These are hit-driven businesses and they tend to go public when the hits are peaking,” he explains. “Historically, they’ve proved to be horrific investments.”
In the run-up to its listing, King has been taking particularly aggressive action to protect its prized game, Candy Crush Saga, which earned the company US$1.5 billion last year alone and 78 per cent of the total amount spent across all of its titles. In the US, it’s even been trying to register trademarks on individual, everyday words, such as “candy” and, you guessed it, “saga” to prevent an explosion of clones cannibalising its business model, like the recent abundance of Flappy Bird cash-ins.
So why go public if the risks are seemingly so great? Well, there can be huge advantages for the business and
after the first dotcomcrash the nasda q stock market fortech fell by 80% in just two short years
the entrepreneurs that built them, other than making them disgustingly wealthy, of course. It means they are able to raise more capital to invest in, and grow, their business. But the blessings of becoming a stock market listed company can run out rather quickly.
“It sucks to be public,” says Kerner. “It takes a lot of mind sharing. If you’re sitting around thinking about the problems of being public, you’re not thinking about your business. And if you’re not thinking about the issues of being public, you’re doing a disservice to shareholders.”
Predicting the future: boom or bust?
Once you open up the doors of your business’s ownership to the wider world, you truly let the wolves in, and even the biggest companies can fall foul of their claws. Apple is an extreme case, where a perceived lack of innovation has led to almost surreal drops in its share price. In January 2014, nine per cent was wiped from Apple’s value in one day, in the face of record iPhone sales. It was simply the knee-jerk reaction of investors paranoid about the iDream evaporating, desperate for the next iPad or iPhone.
The past few years has seen a doubling in the level of shareholder activism, too, as super-wealthy hedge funders with large stakes in tech firms hound the management for changes in the way the companies are run.
Carl Ichan is one of the more famous activists. Despite investing over $1 billion in Apple, he’s waged war against the Cupertino firm, demanding that it buys back some of its shares and distributes a portion of its enormous $160 billion cash pile to its shareholders. Elsewhere, Daniel Loeb, who runs the Third Point LLC hedge fund, campaigned to get Sony to effectively break up its business and sell off its under-performing Vaio PC arm, which it duly did just this February.
Gleeson believes that while activism can be a good thing for a business and its shareholders, activists are naturally short-termist. “Are they doing things that are beneficial to long-term shareholders or striving to get cash returns that benefit themselves, now?” he asks.
Short-termism is an image the technology sector will want to leave to its troubled past. In 1999, at the height of the dotcom boom, tech companies were listing on the stock market before they had even got to the stage of making any money, each one a billion-dollar daydream.
Indeed, TheGlobe.com is an illuminating example of the manic euphoria around tech shares at the time. A 24-year-old Paternot listed his site at nine dollars and the very next day shares had swollen to $97, turning him into an overnight celebrity and multi-millionaire. But when the bubble popped and he, alongside thousands of Wall Street bankers, lost their fortunes, the US economy sunk into recession. As the Nasdaq tech market fell by 80 per cent in just two years, scores of small investors who’d bet everything they had on hype saw their savings decimated.
“There are, of course, massive differences between where we are today and where we were 14 years ago,” Gleeson assures us. “Technology wasn’t at the heart of our everyday lives in the way that it is now. Back then, we didn’t have the infrastructure in place to turn concepts into anything more than an idea. Now, the infrastructure is very much in place.”
And while investors may be losing their heads, the companies themselves are keen to avoid the mistakes of the past. The average age of a company going to IPO was three years old in 1999; today it’s nine. While many of them have yet to generate a profit, they’re already doing something their forefathers failed to do: generate revenue.
So, if it’s not bad business models that could bring the tech upsurge to a grinding holt, what could? Our friend Kerner believes it will be old-fashioned capitalism.
“Markets like saying everybody’s great and that’s what we’re seeing today,” he explains, “but then something happens, that no one sees coming, and the market turns, saying everyone sucks. Fact is, when the bubble finally bursts, it will be just as catastrophic as 2000.”