Tech Bubble? Or Can Software Eat Bubbles Too?


village mobile
Cell phones bring empowerment to Nepalese women – bubble or breakthrough?
Source: Khabar South Asia

Summary: Valuations of public and private technology companies have been quite high in recent months, and many have asked whether we are in a tech bubble. Certainly, general optimism about the promise of tech has driven up prices for many undeserving companies. But while we must all think critically about valuations and have financial discipline, let’s not mistake uncertainty about how to price fundamentally new products and business models – and the accompanying volatility – with speculative excess. 

 

“For how much?

This is a common question in the tech world these days. Even those of us that lived and worked through 1999, who know the key role that technology plays in the economy and in people’s lives, have been raising our eyebrows at recent  valuations in both the private and public sphere:

  • Funding rounds of private companies like Dropbox, AirBnB, and Uber (rumored) that valued those companies at $10 billion each
  • Facebook recent acquisitions of WhatsApp for $19 billion and Oculus for $2 billion, both companies with very little to no revenue
  • Twitter’s $13 billion, and FireEye’s and Tablueau’s ~$2 billion IPO valuations which all jumped 70%+ higher in their first trading day, even though none of these companies was or still is profitable

So, are we in a tech bubble?


Bubbles Defined

According to Dr. Jean-Paul Rodrigue of Hofstra University, market bubbles exist when people stop even trying to justify why prices are where they are, and they simply buy, buy, buy to ensure that they get in on the market momentum. Bubbles go through three stages: “Stage One is the Stealth Phase, when the “smart money” enters. Stage Two is the Awareness Phase, when institutions begin to invest. Stage Three is the Mania Phase, when the media broadcasts it to the general public who, in turn, begin to invest. It is during this phase that speculation rises, investors buy on margin, and prices soar… The paradigm is that prices will always rise, which is reinforced by a surge of excess and superfluous optimism.”

Four-Phases-of-a-Bubble-Graph

Was Stage One back when AirBnB and Oculus took their initial rounds of “smart money”? Was Stage Two when Dropbox raised their last round of $350 million in private capital back in February? And did we enter serious bubble-mania when the general public bid up Twitter’s IPO valuation 73% last fall to roughly $25 billion on its first trading day? The main test of a bubble is this unreasonable optimism that prices will always rise, leading to speculative excess. However, as seen in the chart above, there are pauses along the way. Is the recent market pull-back in April and May a return to rationality or simply a “bear trap?”

 

Some Data …

No one can predict, but I would argue that, in fact, the market has become choosier in 2014, with rotations in and out of classes of tech companies. And, valuation is at least partly, being based on some semblance of financial accountability vs. pure speculation. First, the S&P 500 index over the last 6 months shows stock prices rising roughly 7%. This is very healthy, but no where close to the index’s 20% rise in the 6 months leading up to March 2000, the dot-com bubble’s peak.

More important are the relative valuation metrics, like price to earnings (P/E) ratios. A recent New York Times article suggests that the S&P 500 is still “tethered to reality, at least compared with the stratospheric prices that investors routinely paid in the market bubble that burst in 2000.” For example, in 2000, the average P/E ratio for the 10 largest market cap stocks in the S.&P 500 was 62.6. Of those 10, the 2 highest P/E’s were 196.2 (Cisco) and 148.4 (Oracle). As of May 16, the P/E of the top 10 S&P companies is around 16.5. The two highest P/E stocks of those are Berkshire Hathaway at 16.2 and Apple at 14.3. There are certain Nasdaq stocks like Amazon that trade at unthinkable P/Es like 464.4, but the overall Nasdaq index P/E is only at 23.1. The point is that “even if prices are high in the overall market, they are being backed up by earnings to a much larger extent than in 2000.”

Furthermore, we see differentiation in the types of stocks that are commanding high relative valuations, and there have been rotations in and out of different classes of equities. If one looks at simple price performance over the last 9 months of so-called tech momentum stocks like Amazon, Splunk and Workday vs. traditional large cap technology companies like Microsoft, Oracle and Vmware, one can draw the following conclusions:

stocksSource: Yahoo Finance

  1. The market was trading largely in tandem in the fall of 2013. Momentum stocks like Splunk were yielding the same returns as large cap Microsoft, and Workday and Oracle were similarly neck and neck
  2. Jan to March of 2014 saw momentum stocks accelerate significantly, with companies like Splunk achieving 80% returns for the measured period vs Microsoft’s 20% returns
  3. The seeming “bubble” burst for momentum stocks and today, Microsoft and Oracle have outperformed Workday and Splunk for the 9 months ended May 6, 2014

Finally, we have seen some pause even in the private technology markets. Certain  “hot” companies hoping to ride the IPO momentum wave but lacking basic fundamentals are, in fact, being punished immediately in the public markets or are being forced to delay their IPO altogether:

  • Shares of mobile gaming company King Digital Entertainment PLC (makers of the very popular Candy Crush Saga) lost 16 percent of their IPO price in their first day of trading on April 26, 2014
  • Three of the four software IPOs that have debuted since April 1—Paycom Software Inc., Sabre Corp. and Five9 Inc.—priced their shares below their projected ranges, according to Dealogic and the Wall Street Journal. The fourth, Opower Inc., a software provider to energy utilities apparently did manage to price at the top of its projected range. But its shares are down 21% from where they closed on their first day of trading.
  • Square, the super hot mobile payments company co-founded by Twitter co-founder Jack Dorsey, backed out of a planned 2014 IPO in February and is now delaying going public “indefinitely.” Some speculate that Square’s financials are not really supportive of it’s $5 billion private valuation
  • Box, the poster child of the cloud storage craze, just announced it is delaying its plans for an IPO. Public market tolerance for its questionable path to profitability  (Box spends about $1.38 on sales personnel, marketing and related costs for every dollar in revenue) – and high cash burn rate (It did  $124.2 million in revenue for the year ending Jan. 31, 2014, but its total net loss was $168.6 million) are in focus. The private markets valued Box at $2 billion back in December 2013, and the company had IPO aspirations as high as $5 billion.

 

If Not A Bubble …

It would seem that we are not in a 1999-style tech bubble. However, it is clear that there is still froth in certain parts of the technology markets. And even though stocks like Twitter have fallen significantly in the last month, the real question remains: should the company have ever been valued at just under $42bn on December 26, 2013? The answer is connected to the age-old question in tech of “is there really something different this time?”

I believe that there is a fundamental shift occurring in the world economy which is as momentous as the evolution from agricultural to manufacturing economies in the 1920s and 1930s. Steve Dunning and others have called it the shift to Creative Economies. A creative economy is “an economy in which the driving force is innovation. It is an economy in which organizations are nimble and agile and continually offering new value to customers and delivering it sooner. The Creative Economy is an economy in which firms focus not on short-term financial returns but rather on creating long-term customer value based on trust.” Creative economies take into account, manufacturing and services, not either/or, and most importantly, turn information and ideas into value.

I believe that this transition to creative economies will be one of the only true drivers of growth in an otherwise low growth, low-yield macroeconomy where, as Former Treasury Secretary Larry Summers states, “declining levels of investment, spending, consumption and growth are the “new normal.” It will require new ways of thinking which people will have to learn. Nobel Prize-winning economist Joe Stiglitz states that “The problem today is … rooted in the kinds of jobs we have, the kind we need, and the kind we’re losing, and rooted as well in the kind of workers we want and the kind we don’t know what to do with.”

 

Tech’s Role in Creative Economies

In my opinion, technology companies, and their often outspoken but dynamic leaders, are and will continue to be the main driver of creative economies. As I argue recently, we are now in an era where technology is the primary source of productivity gains and competitive advantage for every company in every industry.  A recent report by the Economist likens the digital innovation explosion to the Cambrian explosion of the animal kingdom, “Digital startups are bubbling up in an astonishing variety of services and products, penetrating every nook and cranny of the economy. They are reshaping entire industries and even changing the very notion of the firm.” As Marc Andreessen famously wrote, “software is eating the world.” And it is not just product innovation that disrupts and spurs growth, but the new cultures, business models and work forces currently being spawned by today’s breed of tech businesses. Roger Marin, Dean of the Rotman School of Management argues that, in fact, it is the “Fortune 500 that must master the management principles needed for continuous innovation that delights customers… the command-and-control management of hierarchical bureaucracy is inherently unable to delight anyone–it was never intended to.”

This type of creative innovation and management is exactly what companies like Google, Amazon and Apple have long stood for in every aspect of their business. And some of the newer companies that have the “frothy” valuations mentioned earlier, are taking this innovation to the next level. For example, AirBnB has singlehandedly created a brand new market that enables new income streams for all stakeholders by using technology to facilitate the information flow about a new type of “landlord” and a new type of “hotel” or “rental,”  and thus allocate spare housing capacity to disrupt traditional hoteliers worldwide. Companies like Uber and Lyft have had similar impact on the transportation industry, and, not unimportantly, put a number of unemployed to work as in flexible jobs as drivers. And finally, companies like Twitter and Facebook, have fundamentally changed the way and cost of communicating, truly connecting the world in a way that empowers the disenfranchised.

Yes, all of these new companies and products can be exploited and abused. And I agree with Om Malik that the expectation by many founders in Silicon Valley is “that even if they don’t build an interesting product, they deserve a nice exit for trying anyway,” is indeed troubling along with other forms of egoism and entitlement that seem more common these days. But many of these companies and technologies are in fact leveling the economic playing field in a way that governments have fought in vain to do. New types of technology-based retailing, financial services, healthcare and education platforms are emerging that will improve not only efficiency, but the quality of people’s lives.

I personally believe that we must all think critically about valuations and have financial discipline – folks who invested in Twitter back in December have, in fact, lost money. But let’s not mistake uncertainty about how to price fundamentally new products and business models – and the accompanying volatility – with speculative excess. From time to time, the appetite for growth and innovation will throw the market out of whack. But, I can’t think of a better place to bet my fortune and future, and, in fact, have put my money where my mouth is. So, instead of asking whether we are in a bubble, we should perhaps look for what industry software will eat next, and bet as big as we can.

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