The wolves of tech street

Australian T3 - - CONTENTS -

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.”

Words: Jeff Har­ris Il­lus­tra­tion: Sam Tay­lor

Tech stocks are the flavour of the month, but when record prof­its can see your shares fall, who’d go pub­lic?

Boo! One minute you’re a ‘net poster boy, the next an­other failed tech cau­tion­ary tale

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