Lazard Insights
Are Silicon Valley Valuations in the Clouds? Bret Miller, CFA, Vice President, Research Analyst
Summary • Media coverage and investor appetite for growth in the technology sector has intensified, leading some individuals to reflect on bubble-like developments. • Some signals of enthusiasm include the steady increase in the number of merger-and-acquisition (M&A) transactions within the software and internet industry since 2009, a recent upturn in venture capital investment in 2014, and stong IPO performance. • On the other hand, many indicators are nowhere near the extreme activity of the prior tech bubble in the late 1990s/early 2000s, while fundamentals and valuations of the technology sector remain healthy in the aggregate. • We are in the middle of a generational platform shift toward the mobile/cloud era. Many investors are seeking to capitalize on opportunities related to this trend, thereby driving some valuations up. While we continue to evaluate these disruptive players, we are still finding many compelling opportunities in other technology companies, primarily those with strong balance sheets, profitability, and consistent revenue growth. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The presentation can be accessed via www.LazardNet.com.
The Current Landscape in the Technology Sector—Evidence and Narratives on the Bubble Debate Recent headlines and quotes from key market participants, including US Federal Reserve Chair Janet Yellen, suggest that many in the investment community believe we are once again in a technology bubble. It seems like there is a story every other day about Silicon Valley’s latest startup that is going to change the world. We are constantly reminded about the quintessential twenty-something-year-old entrepreneur that started his company in his dorm room and became instantly rich through an IPO or by selling to Facebook or Google. Do the concerns of a tech bubble have merit? There are certain market indicators that give some credibility to the discussion of a tech bubble. The availability and deployment of venture capital investment has increased significantly over the last year. The number of M&A transactions within the software and internet industry has steadily increased since the market bottomed in 2009, as larger technology companies have used their balance sheets and cash flow to invest and acquire growth and innovation (Exhibit 1). For the most part, post-IPO performance has been solid as investors have purchased many of the newer high-growth companies, even if they have yet to execute on delivering profitability, cash flow, or even market leadership.
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Exhibit 1 Renewed M&A Activity in Internet and Software Industries
Exhibit 3 Startup and IPO Valuations, 2014 Transactions
Deal Count 300
($B) 168 30 IPOs 238
240
Capital Raise
24
Acquisition 18
Internet
194 12
180
2012
2013
2014
Airwatch
Trulia
Oculus
GrubHub
GoPro
Square
Palantir
Dropbox
Airbnb
OpenTable
2011
Nest Labs
2010
Pinterest Arista Networks Cloudera
2009
Snapchat
60 2008
Uber
0
120
Alibaba
6
Software
As of 19 September 2014
As of 31 July 2014
The securities mentioned are not necessarily held by Lazard for all client portfolios, and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable.
Source: Bloomberg, Lazard
Source: Bloomberg, Deutsche Bank, company filings
Exhibit 2 The Valuation Gap Appears to Be Widening in the Technology Sector Valuation and Revenue Growth, Russell 3000 Index Technology Sector EV/Sales
(%)
20
60
15
40
10 20 5 0
0 2009
2010
2011
2012
2013
2014
Median EV/Sales of Top 15 Most Expensive Tech Stocks [LHS] Median EV/Sales of All Tech Stocks in the Russell 3000 Index [LHS] Median Revenue Growth of Top 15 Most Expensive Tech Stocks [RHS] As of 26 August 2014 Source: Bloomberg
Valuation multiples, for a narrow part of the technology market, may appear stretched. For example, the median enterprise-value-to-sales (EV/sales) multiple for the fifteen most expensive tech stocks in the Russell 3000 Index has expanded significantly over the last few years, going from just over 5 times EV/sales in the depths of the recession in 2008 to over 14 times today. Relying on this same multiple, we observe the gap between the fifteen most expensive stocks and the median of all technology stocks in the Russell 3000 Index continues to widen. Clearly investors are paying a significant premium for this cohort of companies. However, one reason that may explain why multiples have expanded is that the revenue growth rate for the most
expensive companies has steadily accelerated from the 20% to 30% range a few years ago, and has now ramped up growth to the 50% to 60% range (Exhibit 2). This year, many tech startups have gone public or have received venture capital infusions, while others have been acquired, and many of these transactions have resulted in multi-billion dollar valuations (Exhibit 3). Some of the highest profile deals, including Uber’s recent capital raise at an $18 billion valuation and Facebook’s acquisition of WhatsApp for roughly $18 billion, both of which have limited, if any, profitability, are examples of where valuations may have become somewhat excessive. In the current macro environment, where GDP growth remains rather tepid, some investors may be paying up for exposure to disruptive and high-growth companies because they have large market opportunities and are driving high levels of revenue and user growth. In addition, many investors have an appetite for the option value if these companies can execute on their vision.
Today’s Technology Environment Stands in Stark Contrast to the Prior Bubble Despite the aforementioned indicators, we believe today’s environment is drastically different than the time before the dot-com bubble burst in the late 1990s/early 2000s. Current levels of venture capital and IPO activity are well below those during the last bubble (Exhibit 4). While valuations for private and recently-public high-growth, innovative companies have picked up, we are nowhere near the excess exuberance of the past. Companies that are going public today are more mature. On average, companies in recent IPOs are also much larger in terms of revenues and profitability. The median sales level for
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Exhibit 4 Venture Capital Financing and Global Technology IPO Issuance Are Well Below 1999–2000 Levels Number of US Companies receiving VC Financing
6000
5,476 50% Lower
4000 2,746
2000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Number of Global IPOs 400 310
300
87% Lower
200 100
41
0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Thomson ONE, Morgan Stanley Equity Capital Markets. Data per Dealogic, Bloomberg, and Capital IQ
Exhibit 5 Comparison of IPO Characteristics, 1999–2000 versus 2013
Median Company Age (years) Median Sales ($M)
1999–2000
2013
5
12
17
91
28
63
4
18
77
49
Percentage of Companies Earning Revenuesa Over $50 million (%) Over $1 billion (%) Percentage of Companies with Negative EPS
Exhibit 6 Technology Fundamentals Are Attractive in the Aggregate S&P 500 Index Technology Sector December December 1999 2007
S&P 500 Index
August 2014
August 2014
Valuation
a Revenues adjusted to 2005 purchasing power Source: US IPO database of Dr. Jay Ritter, Cordell Professor of Finance, University of Florida
P/E , CY Gross Margin (%)
When evaluating the fundamentals and valuations of the broader technology industry in aggregate, the sector remains very healthy and attractive relative to prior cycles and the rest of the market. Exhibit 6 shows the price-to-earnings (P/E) multiples, profitability, and balance sheet strength of the technology companies within the S&P 500 Index today and at prior peaks. Clearly, all of these metrics are much more attractive currently than in past environments. As one can see, today’s technology sector generates higher levels of profitability, as measured by margins and return on equity (ROE), and has stronger balance sheets holding more cash and less debt. In addition, when compared
22.2
16.7
16.7
40
43
52
42
Profitability and Returns EBITDA Margin (%)
20
20
31
20
ROE (%)
21
18
24
15
Balance Sheet Cash/Market Cap (%)
recent IPOs has been $91 million, more than 5 times the size of the median sales of IPOs in 1999–2000. Other key metrics highlighting this divergence are shown in Exhibit 5.
64.7
Debt/EBITDA
3
11
13
9
0.9
0.9
0.8
1.9
As of 28 August 2014 Source: Lazard, Bloomberg
to the S&P 500 Index as a whole, the valuations of the broader technology sector are currently in line with the benchmark. While there may be some signs of stretched valuations within the startup market and recent IPOs, we believe the data show that any potential froth in the market would be narrow in scope, as the broader investable technology universe remains solid with attractive valuations and strong fundamentals.
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What Secular Forces Potentially Justify the Higher Startup Valuations? A Paradigm Shift Toward Mobile and Cloud We believe we are in the midst of a generational shift in technology platforms. To put this change in context, note that the computing and application architectures have only shifted a few times over the last fifty to sixty years. Computing began with the mainframe. Then the client– server model gave birth to the personal computer (PC) which expanded the availability and affordability of computing to hundreds of millions of people and thousands of packaged software applications. Companies like Intel and Microsoft built tremendous businesses on this client–server model and during the PC era. Now, we are in the middle of a platform shift to the mobile and cloud era (Exhibit 7). Mobile and the cloud are expanding the accessibility of computing and connecting billions of people—disrupting the information technology (IT) landscape. We believe the next Microsofts and Intels are being built during this transition.
Why Does Mobile Matter? The adoption rate of mobile has made it one of the most pervasive technologies ever invented. There are more than 6 billion mobile handsets in use across the world, which is a staggering number when compared to the number of people who live in homes with electricity (5.9 billion), or have bank accounts (3.5 billion) or PCs (1.5 billion). Today just about 2 billion of those 6 billion handsets in use are smartphones with internet connectivity.1 Over time, however, the vast majority of handsets will become smartphones. The growth of smartphones is expanding internet access and enabling new types of mobile services and applications. Among the early beneficiaries of this mobile transition has been the smartphone hardware market. As smartphone suppliers have rode down the cost curves on components, the price of low-end smartphones has moved well below $100. This has driven the smartphone market to over 1 billion units a year, an unmatched scale against any other hardware segment. To provide a sense of that scale, the 1 billion plus smartphone shipments per year compares to the PC market’s less than 400 million units.2
Apple, Samsung, and Google’s Android dominate the profit pools within the smartphone market, as these are the companies with the most scale, as well as control over the two leading operating systems and app stores on which smartphones rely. Along with all the value they have created over the last five years, the companies have indirectly destroyed a lot of the value from historical players in the handset industry like Nokia, and threaten much of the value in the PC industry. The internet is literally in people’s pockets for the first time, and therefore application developers are shifting their focus and innovation towards mobile, and away from PCs. Mobile is enabling new types of applications and services that were previously not possible and this is transforming business models across many industries. For example, location-based services have created the opportunity for companies like Uber to disrupt transportation business models, and the information security industry has been forced to evolve and create new solutions to deal with the new types of risks and threats with mobile devices. The emergence of the casual smartphone “gamer” has expanded the total addressable market for the video game software industry by a multiple of more than 5 times. However, mobile has also introduced many new competitors with much lower barriers to entry and partially cannibalized the core console-based gaming market. And in the financials industry, the entire payments ecosystem is now changing with the mobile wallet. The digital advertising industry is seeing some of the largest expansion opportunities driven by mobile. For years, it has been discussed that, in theory, internet advertising expenditures should grow rapidly to catch up with how much time consumers were spending with internet media. This is exactly what has happened as roughly 25% of consumers’ media time spent now occurs on the PC-based internet closely matching the 22% of total advertising expenditure. This framework also applies to mobile, where consumers currently spend 20% of their time, and yet where only 4% of advertising budgets have shifted (Exhibit 8). This dynamic has created opportunities for companies like Facebook, Twitter, Google, and Yelp among many others to capture and grow those advertising dollars.
Exhibit 7 A Generational Shift in Technology Platforms
Mainframe
Client-Server
Thousands of Users Hundreds of Apps
Millions of Users Thousands of Apps
This information is for illustrative purposes only. Source: VMWare
Mobile-Cloud
Billions of Users Millions of Apps
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private data centers given the sensitivity of data and years of historical investment in their own infrastructure.
Exhibit 8 The Mobile Advertising Gap (% of Total) 50
Time Spent Ad Spend
40 30 20 10 0
Radio
TV
Internet
Mobile
As of 31 December 2013 Data are for the United States only. Source: KPCB
The Cloud Is Transforming IT Infrastructure The cloud is a fundamentally different method to host, deliver, and pay for IT. Using the cloud makes IT akin to buying a service, instead of enterprises having to build, operate, and manage their own physical data centers. Traditionally, an enterprise would own and operate all the pieces of the technology stack within their data center. Today, with the public cloud, companies have the option of outsourcing their whole technology stack to a cloud vendor. The vendor will host the company’s applications along with other customers’ applications in their massive virtualized data center. These applications are delivered and accessed over the internet, in a pay-as-you-go model. In reality, most companies will likely use a hybrid approach, putting some applications in the cloud, while keeping others in their
So why are we seeing such strong adoption of cloud-based IT? We believe the cloud is an improved IT model for most businesses. With the cloud, applications are faster to implement and easier to use. Cloud vendors are able to provide continuous innovation and feature improvements instead of forcing users to go through difficult upgrades. The economics are more favorable; instead of large upfront purchases of servers and software, IT becomes a flexible variable cost based on cloud usage. Importantly, the cloud allows companies to focus on running their core business, rather than dealing with the distractions of operating IT departments. The market opportunity for cloud vendors is massive. Over $900 billion a year is spent on hardware, software, and IT implementation and outsourcing services. This pool of expenditures represents the latent opportunity for cloud vendors to capture and disrupt the transition from traditional IT to cloud-based solutions. According to a survey of Chief Information Officers, 10% of their application workloads run in the cloud today, and are expected to grow to 18% by the end of 2015.3
Evaluating High-Growth, but Optically Expensive Companies As discussed earlier, some of these high-growth, recently public technology companies appear expensive according to traditional valuation metrics. However, we believe many of these young companies are investing significantly to drive growth, which obscures the underlying profitability of their existing installed customer base. Therefore, when we value these companies, we separate the analysis into two parts. We first evaluate the existing customer base on their underlying contribution margin and renewal rates. Then we value future growth by examining the growth of new business and new customers, the
Exhibit 9
Analyzing the Drivers of Underlying Operating Margin A Hypothetical Cloud Software Company, Margin Profile
Analyze the Business in Two Parts: Existing Customer Base Underlying Margin and Customer Acquisition Costs
Figures as Share of Total Revenue (%)
Figures as Share of Total Revenue (%)
Revenue
100
Revenue
100
COGS
25
COGS
20
Gross Margin
75
S&M
40
R&D G&A Operating Margin
Gross Margin
80
S&M
5
15
R&D
10
G&A
10
Underlying Operating Margin
Figures as Share of Total Revenue (%)
Revenue, year one
0
COGS
5
Gross Margin
-5
S&M
35
15
R&D
0
10
G&A
50
Customer Acquisition Costs
0 -40
A portion of COGS is tied to implementation costs of new customers. The majority of S&M is tied to customer acquisition costs, with limited S&M needed to renew existing customers.
This information is for illustrative purposes only. Source: Lazard
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sales and marketing cost to acquire those customers, and the ultimate contribution margin of the customers after they have been acquired. Finally, we use scenario analysis to understand the sensitivity of valuation to key metrics such as renewal rates, underlying contribution margin, new customer growth, and the cost to acquire those new customers. Exhibit 9 illustrates the philosophy behind this valuation framework. A hypothetical cloud software company might only have 10% operating margins today, and therefore looks expensive on any valuation multiple of their earnings. But once we separate that income statement into two parts, the existing customer base and customer-acquisition costs, we can then see that the underlying contribution margin of the existing business is often much higher at 50%. This example shows that the majority of the sales and marketing (S&M) costs and some of the cost of goods sold (COGS) are used to drive new customer acquisition, and actually do not support the existing business. This analysis allows us to evaluate the entire customer lifetime value, giving us more confidence in the long-term future profitability of a business.
Conclusion Technology fundamentals are compelling and appear favorable when compared to the market as a whole. These valuations are nowhere near the extremes of the late 1990s. However, we are in the middle of a powerful platform shift from a PC and client–server era, to a mobile/ cloud era. To the extent a bubble exists, it would be much narrower in scope, as some investors are aggressively seeking companies that are taking advantage of these new secular trends, which will only grow in size and importance over time. There will be some winners, as well as many losers who are not able to execute on the opportunity in this highly innovative but competitive space. We believe investors recognize this opportunity and are paying a premium to place option-like bets on potential winners. We continue to gain a broad and deep understanding of mobile and cloud trends in order to appreciate industry implications. We plan to continue evaluating the full range of technology investment opportunities using our investment process, which focuses on future returns, valuation, and scenario analysis. While we have currently found some opportunities in pure plays levered to the mobile and cloud trends, we are also seeing very good risk/reward in many technology companies that feature sustainable recurring revenue growth, high levels of profitability, strong balance sheets, improving capital allocation, and attractive valuation.
Notes 1 Source: Mobile Future Forward. As of September 2012. 2 Source: Gartner (analysts: Mikako Kitagawa, et al.) “Market Share: Devices, All Countries, 1Q14.” 23 May 2014 3 Source: Gartner (analysts: Ken Newbury, et al.) “Gartner Market Databook, 2Q14 Update.” 23 June 2014; Morgan Stanley January 2014 CIO Survey.
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