There are no runners-up in this tech boom; Business models are more profitable but competition is rampant

March 14, 2014 8:33 am

There are no runners-up in this tech boom

By Henny Sender

Business models are more profitable but competition is rampant

Silicon Valley is known for its paranoia. It is understandable that the entrepreneurs and venture capitalists who finance business there are looking over their shoulders wondering who next is going to marginalise their companies and their investments. Tech companies can have an incredibly short life – the definition of cool can change in a nanosecond.

But when it comes to whether valuations of tech companies are artificially inflated an informal survey at an FT conference in Palo Alto revealed that few attendees are paranoid. Indeed, they believe that today’s generation of tech companies, especially those in the cloud, social media and software and services areas, are in bubble territory.

The new tech world has been robust for years now. In 2013, tech IPOs were up 80 per cent on average, a performance exceeded only by healthcare listings which returned 93 per cent. Year to date things are even better, tech company listings have returned 88 per cent, leaving healthcare a distant second at 48 per cent, according to data from Dealogic.

At the same time, however, the old line tech companies, the ones with market caps of more than $50bn are trading at 10 to 12 times price to earnings, a ratio that is more modest than the 15 times average for companies in the Standard & Poor’s 500 index.

There are many arguments for why it may be different this time around, though in some ways little has changed since the new economy bubble burst over a decade ago.

The metric by which tech companies are judged still has little to do with hard cash earnings. The sceptics say these new companies will struggle to yield anything close to the future earnings their present valuations suggest.

Moreover, corporate spending on technology has been sluggish, a function of slow economic growth in the US. Real spending on high tech equipment was up less than 2 per cent over the past year and barely over 2 per cent for the last three years, according to data from JPMorgan. Finally, as more money pours into the stock market due to low yields everywhere else, demand for the shares of growth companies becomes inflated, the doubters add.

To the denizens of Silicon Valley, however, this time around is nothing like the previous tech bubble – a whole generation ago in their collective view. Broadband has created a myriad opportunities for companies that did not exist 15 years ago, when there was no mobile access to the internet.

Today, the number of people with access to mobile internet has exploded. “It is less about selling products than about providing services,” says one tech investor. “The business models are more profitable” – at least some of them. That means there are more opportunities.

During the last boom technology bankers thought it took at least $100m to launch a start-up. Today, the cost has dropped to a small fraction of that, which means the barriers to entry are lower than ever, making the competition far more intense than ever. The company that is about to marginalise you could be located across the planet and you cannot even pronounce its name, let alone understand what the name actually means. In addition, the winner-take-all dynamic means being runner up is not good enough.

To invest in new tech requires a totally different mindset than to invest in traditional industrial companies. This past week Blackstone, for example, bought Accuvant, a cyber security company, valuing it at about $250m – a tiny amount for the giant buyout firm. “The price that Blackstone paid was not a typical Blackstone multiple,” says one person familiar with the deal. “It was far higher.”

To people looking on the transaction from the east coast, the deal was about buying a business service that has huge growth potential. To people on the west coast, though, it was a pure tech deal, a vindication of their view that tech is where the growth is and that more traditional investors like the private equity firms have to get used both to paying up and looking at different metrics. Never mind that many young firms have no income.

They also believe these traditional investors also need to pay attention to tech because it is about to marginalise both their existing portfolios as well as the core business of old line tech companies such as the Ciscos and Jupiters and IBMs of this world that are increasingly yesterday’s story. That is because it is not enough to build better or cheaper boxes when software can do what the boxes used to do.

To be sure, the old companies could buy their newer competitors but few entrepreneurs wish to sell out. “Why wouldn’t they want to ride the listing wave?” asks one tech banker. Clearly, they believe the wave has some room to go before it crests.