Equities

Each day brings more news of another huge technology IPO, often by businesses that have never made a profit – and perhaps never will. But there are new signs that this latest tech bubble could be coming to an end.

For some time now we have been warning that the line of unicorns racing to IPO was evidence that private equity (PE) and venture capital (VC) owners were worried about the sustainability of their model.

Could a negative feedback loop be developing where public market losses put pressure on the willingness of PE and VC firms to do deals at elevated prices, ultimately heaping pressure on revenue multiples?

For a long time, growth has trumped profits. Since the GFC, the best performing stocks have been those that prioritized revenue growth over profits fueled by an ideological winner-takes-all pursuit of the network effect. Of course, the race to win requires reinvestment of all and any margin, as well as additional capital.

All busts are preceded by a bubble, and all bubbles are preceded by a boom. Importantly, all booms are founded on a legitimate basis for expecting future growth.

But what the smart money does at the beginning the fool does at the end.

Recently we heard that Aussie web design business Canva received another dose of capital at a valuation of $3.7 billion. Less than 18 months ago, in January 2018, Canva raised $40 million in a Series A round at a valuation of $1 billion. The company’s revenue for the six months ending December was reported to be $25 million, on which it generated profit of just over $1 million for the same period.

In January 2018, Canva’s founder, Melanie Perkins, was interviewed by the ABC and was asked how she could objectively confirm Canva’s new valuation. Ms Perkins said: “That’s exactly how venture capital works — the investors determine the price of the company that they believe it’s worth.” At $3.7 billion the company is trading on an historic price-to-sales multiple of 74 times.

Over in the US, the VC world is finding massive piles of cash are easier to come by than ever. Consequently, valuations are being skewed upwards. Start-up DoorDash offers to get your breakfast, lunch and dinner delivered from your favorite restaurants right to your doorstep with one easy click. It makes a small profit on the hundreds of millions in revenue it generates but only if you exclude salaries and rent. Just over a year ago the food delivery company was ‘valued’ at US$1.4 billion. It raised US$250 million at a US$4 billion valuation in August, US$400 million more at a US$7.1 billion valuation in February. And last week it raised US$600 million. In other words, its valuation has soared by US$11.2 billion in a mere 14 months.

This isn’t normal and as the economist Herb Stein once observed, “if something cannot go on forever, it must stop”.

In the case of DoorDash it’s probably worth noting the Singaporean Sovereign Wealth Fund, Temasek, was one of the February Series F round investors. Why is that relevant? Temasek invested in ABC Learning Centres at $7.40 per share when I valued the company at less than 50 cents. ABC Learning ultimately collapsed.

I think this bubble will collapse too. But I don’t propose to suggest this Tech Bubble is like the one I experienced first-hand in 1999. That bubble was fueled by enthusiasm for internet companies that, it was hoped, would eventually work out how to generate revenue.

This bubble is not the same. Growing revenue from zero to billions of dollars is hard work and requires dedication. Many of the current crop of stock market and private equity stars have indeed achieved billions in revenue. This time however the hope is that the cost base can eventually be tweaked, or the scale will eventually be so great, that profits will ultimately flow.

Where the two bubbles are identical however is that investors are betting on ‘potential’ rather than ‘proof’.

We are today living in another bubble, so caution is warranted. I have never in my career seen so many massive-loss-making, revenue-growth-chasing companies go public and trade at such lofty, nay absurd, valuations. And the pile of red-ink at the profit line has never been higher either.

Young fund managers, those who were still in school when the last bust occurred, think it’s normal to pay almost anything for a company that must scale enormously to eventually (hopefully) generate an economic return. But excitement has always been the preserve of the young. Sadly, they have sucked in a whole bunch of old heads who should know better.

For old-fashioned value investors – those who prefer profits over promises – it’s better to now sit this one out.

Figure 1. The state of play

Source: Crunchbase

I had great fun poking holes in Uber’s prospectus. At one point the company notes its Total Addressable Market (TAM) is US$12 trillion. Take China out of the equation, which is 15 per cent of the global economy – because Uber is banned there – and Uber’s TAM is equivalent to almost 20 per cent of Earth’s GDP. Let me assure you, Uber will never, ever, ever reach that potential!

Gloss Fading – watch out for negative feedback loops

Since 2009, global private equity capital raised annually has risen from US$315 billion to over US$800 billion in 2018. Consequently, uncalled capital held by private equity firms globally now sits at $US1.7 trillion, up from US$800 billion prior to the GFC. Similarly, deal volume has exploded. At the bottom of the GFC in 2009 ‘just’ US$300 billion of deals were conducted. In 2017, more than $US1.3 trillion of deals were done.

Perhaps most tellingly, the number of Private Equity firms around the world has mushroomed from just over 4000 firms globally in 2008 to nearly eight thousand in 2017. The world’s population grows at roughly 1.1 per cent per year, so it probably doesn’t require eight per cent growth in the number of PE firms!

With so much money looking for an alternative to the punitive rates offered by cash since the GFC, it’s not surprising so many PE firms have hung the shingle up to ‘help’. It then follows, that with so many PE firms all looking to park record amounts of cash in new opportunities, revenue and EBITDA multiples (where there is EBITDA) have all expanded too. By way of example US Leveraged Buy Out (LBO) transaction EBITDA multiples have expanded from an average 7.7 times in 2009 to over 11.2 times today.

But all that may be about to change.

According to University of Florida finance professor Jay Ritter, and despite a handful of winners, 83 per cent of IPOs in the first three quarters of 2018 “lost money in the 12 months leading up to their debut.” The previous record for that stat was 81 per cent.

In Australia, Israeli-based Afterpay-wannabe, Splitit, issued a prospectus for its IPO at 20 cents per share. By March of this year, and within two months of listing, it was 1000 per cent higher at $2.00, giving it a market cap of $534 million or 1069 times its revenue. Since March, however, Splitit shares have fallen 57 per cent.

Over in the US, Uber’s shares have fallen such that anyone who invested privately in the company over the last three years has lost money. And according to Bloomberg, investors who bought Uber’s stock at the listing price of $45 lost $655 million in the first day of trading, more than any other IPO in U.S. history.

More broadly, Pitchbook’s latest report reveals that in 2018 the CAGR, since 2010, for investors who purchased shares in the first trade after an IPO, turned negative.

These changes mark the beginning of the end for unbridled enthusiastic sentiment that buying technology IPOs are a free ticket to financial freedom. And the shift in sentiment may be significant.

If retail investors begin to notice the bad taste being left in their mouths from buying recent IPOs after they float, it won’t be too long before the exit window for private equity firms looking to foist their loss-making love children, those with no clear path to profitability, on an unsuspecting public begins to close.

Nobody left to buy

Moreover, with all the money raised by Private Equity, the deals they invest in must necessarily be larger, which explains why so many companies have been in private equity hands for so long. By way of an admittedly extreme example, Uber raised US$24.7 billion over 23 funding rounds spread over a decade (and it still only generated two percent penetration (and arguably the low hanging fruit, which means it only gets harder from here)). Larger deals must be followed by larger exits but with most of the world’s institutions, endowments, high net worth and ultra-high net worth investors already backing the IPOs, there are only retail investors left to buy them after listing.

Remember, what smart money does in the beginning…

Obviously, there will always be winners. Companies with best-in-class products and services, and those able to leverage large user databases to expand and improve collaboration tools or platforms will always have a market and/or generate improving margins from the ‘network’ effect.

But the belief that all companies, especially the 83 per cent that lost money, are worth owning because they will all be winners, is a fundamentally flawed proposition that has defined many past bubbles.

Cheap and abundant money has once again precipitated a misallocation of capital and we wonder whether the declining aggregate returns from buying loss making IPOs after listing may shift sentiment in favour of a reversal of multiples for high-risk unicorns.

Unicorns are start-ups with a market valuation of more than a billion dollars. Only revenue multiples are relevant in these times as many don’t earn any profits.



Comments

Please sign in to comment on this wire.

James Marlay

Good article Rog, really enjoyed this and some mind boggling numbers.

Roger Montgomery

Thanks James, the combined valuation of the two listings for Uber and Lyft at IPO was >US$100bn (Uber $82bn, Lyft $24bn), a higher valuation than every company on the ASX aside from the mighty BHP.

Bruce Henderson

The Dotcom boom was about an idea, this one about growth! Does that imply the next tech boom will be about bottom line?

Caroline Hardy

Roger as many other people have pointed out, your eschewing of tech shares has led to substantial underperformance. To take one example from a comment on a recent Australian article- "On 10 October 2018 he said "While you may not be compelled to buy RIO, the point we and others are making is that you should be very cautious about buying CSL at these prices. And the same goes for Appen, Wisetech, Afterpay and friends." Since then: RIO has gone from $79.19 to $100.30 (up 26.7%) CSL has gone from $191.80 to $205.49 (up 7.1%) Appen has gone from $12.54 to $26.03 (up 107.6%) Wisetech has gone from $18.35 to $24.36 (up 32.8%) Afterpay has gone from $15.47 to $24.15 (up 56.1%) On average, the shares he was warning against buying have gone up 46.1%. In the same period the ASX200 has gone up 5.7%. His funds including the Montgomery Private Fund and the Montgomery Alpha Plus Fund have consistently underperformed the market for years, with the latter losing 11.94% of it's money. It's little wonder with the investment approach he advocates." At what point do you acknowledge the investment principles you're trying to hold to are the direct reason for your underperformance?

william frederick roberts

Today's news mentioned the likelihood of further QE in the US as rates continue to fall. Is it possible that Lower rates + more QE = more crazy valuations = longer and bigger bubbles?

Nathan Manzi

Hi Roger, WeWork is another company not built on sound economics, rather the hope of easy capital raising and an exit at an IPO for the original investors. There are other companies out there with steady growth as they value shareholder's returns, companies like JustCo and ClubCo (disclaimer here i am involved in this one). I continue to be amazed at the lack of common sense out there. Keep up the great insights, Nathan

Sean Rapley

In my opinion, Roger's analysis is not comparing apples to apples. Many of the tech companies referred to, such as Elastic, have a high percentage of recurring revenue, high gross margins (over 70%), and have a load of cash in the bank. Think about that for a minute. 70c of every dollar revenue goes to the business. Then, every year, the customer will spend, in Elastic's case, 30 % more than they did the previous year on elastic's services. The reason why they are loss making is because, in Elastic's case, they spend over 50% of revenue on sales and marketing, and over 35% on R & D. So, 85% of Elastic's expenditure is discrectionary, and is geared towards maintaining stellar revenue growth rates, and to increase/protect its total addressable market. You can't just look at the bottom line of a SAAS business. Sales & marketing spend is more akin to capital expenditure in a traditional capital intensive business, but with higher returns. Payback on SAAS S & M spend is typically less than 18 months, vs 5-10 years for your miners. The big diference is S & M spend is fully expensed at the time, whilst capital expenditure is depreciated over the life of the asset. My 2 cents.

Roger Montgomery

Dear Caroline Hardy, You have made some fair and largely accurate points. Before I respond, let me first clarify a couple of observations. You say our funds have consistently outperformed for years. In fact all our funds are beating the market since inception. You are correct our domestic funds have underperfromed over recent years but our global funds have beaten the market and our Montgomery Global Fund has beaten all but one other global fund available in Australia since its inception. The single fund you highlighted with a negative return is 1) The only fund we have that has produced a negative return since its inception - a very short time frame, and 2) is a purely quant fund that operates differently to all the other funds in our suite in terms of philosophy and process. It is a little unfair to attribute its performance to the disparity in returns between momentum and value or to anything our team of analysts has done. Humans have no input into its stock selections, which are purely run by AI. Finally, its worth noting that the changes that were made to the quant model that drives MAPF, and switching it to a global universe, has seen it add 5.30% alpha last month alone. Seeing businesses that we won't own rise by triple digits is extremely frustrating and it is tempting to throw in the towel on value investing. But over the very long run value investing has successfully shepherded its followers through many market and economic cycles. As painful as it is to sit on the sidelines, we will continue to do so. We firmly believe that prices for many companies are bordering on insanity. Xero is on 370 times 2021 earnings. Wisetech is on the same market cap as Qantas but QAN generates $16bn of revenue and Wisetech just $355m. Appen, Altium and Afterpay all have a higher market caps than JB Hi-Fi, Air NZ and Metcash who in aggregate generate $23bn of revenue. Appen, Altium and Afterpay generate just $1.1bn. Looking at a high quality company like CSL we find it generated $1.7bn of NPAT last year. If you decided to quarantine that profit so that it could never grow again and if you accepted a measley 5% return for owning the business (ignoring the risk of owning a business), you could pay $34bn for it. It's on a market cap of almost $100bn which means investors are willing to buy almost three of today's CSLs to own one with some growth. Perhaps investors believe its growth last year of 29% in NPAT will be repeated into perpetuity without interruption. If you thinks that's reasonable, go right ahead. The share prices of those 'growthy' SaaS companies with momentum on their side might be tearing a hole in the sides of value investors right now but that doesn't mean they are supported by fundamentals. And that's the bottom line. History is littered with periods when investors thought 'this time is different'. Thinking that interest rates will stay lower for longer, that debt doesn't matter, that companies can continue to prosper indefinitely even without producing a profit are all examples of 'this time its different' thinking. We are in one of those periods again and while the domestic team here at Montgomery might look very wrong right now (keep in mind our global funds are doing very well indeed), we aren't going to switch to momentum investing anytime soon. During the Oct-Dec sell off last year, The domestic Montgomery Funds were two of the top performing Aussie equity funds in our peer group. Granted it's a very short time frame but our clients saw only a 4 per cent decline, versus more than 20% for some other funds intramonth. We are positioned for a different market circumstance than the one you are currently experiencing and while your observations might be accurate I wonder whether they might also be temporary.

Ben Gussey

"Roger as many other people have pointed out, your eschewing of tech shares has led to substantial underperformance." I hold Appen, Altium, Nearmap, Xero and previously held Wisetech, which is why I actually decided to invest in one of Roger's funds. Even as a holder, I can recognise how absurd the valuations have become and at some point, we will revert to the mean and the geniuses now will be left with their pants down. It's certainly been a golden time for the growth investor but the age of easy money won't last forever.

Tim Mountjoy

So if Roger is right and he probably will be then should we be shorting any of these stocks ? I would love to see a "short" list by best odds from Roger. I ask cos I went short Uber on listing and am from this week short WiseTech. The problem I have is I'll probably be right but timing it is hard and another flood of cheap central bank money could see me long term right but on the losing side of the ledger due to timing. C'mon Roger share with us your top 10 shorts in order in the Australian tech market. Thx

David James

Good discussion. We should be wary of why VCs have rapidly started offloading their darling performers. One of Uber's mantras is that it will remove one of its biggest cost lines, drivers, with the introduction autonomous cars. It also likes to promote that it is an asset lite business. So who is going to fund the capex for the autonomous vehicle roll out? They burn endless amount of cash now ($1.2bn in operational cash in 2018?). Every customer interaction now costs them more then the transaction revenue - maddening. Without cars, others (VW, GM, Ford etc) will roll out autonomous cars themselves and charge consumers per usage. Uber's cash burn would skyrocket if they try to deploy their own cars to streets. I think they are in trouble.

Roger Montgomery

Thanks for sharing your thoughts on Uber David. You ask who will fund the rollout of autonomous vehicles? Keep in mind the company raised US$24.7bn to secure 2% penetration, which took a decade and stock market investors will probably be much less patient than their PE owners were (they knew they would be offloading it in an IPO one day). I personally believe Uber will be the last company able to roll out a fleet of AVs. Why? Because they would have to disrupt their own drivers who would protest by joining other firms and thereby destroying the very revenue streams that Uber would require to fund the next stage.

Roger Montgomery

Hi Tim, Thanks for suggesting a list of shorts. We tend not to discuss our shorts in the Aussie market. Its also worth keeping in mind that a successful short needs to have more going for it than just being expensive. As you quite rightly point out, timing is essential and that's why other factors need to be part of the framework.