Are Silicon Valley Valuations in The Clouds Lazard Insights
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Lazard Insights
Are Silicon Valley Valuations in Valuations in the Clouds? Bret Miller, CFA, Vice President, Research Analyst
Summary • Media coverage and investor appetite or growth in the technology sector has intensied, leading some individuals to refect on bubble-like developments. developments. • Some signals o enthusiasm include the steady increase in the number o merger-and-acquisition merger-and-acquisition (M&A) transactions within the sotware and internet industry since 2009, a recent upturn in venture capital investment in 2014, and stong IPO perormance. • On the other hand, many indicators are nowhere near the extreme activity o the prior tech bubble in the late 1990s/early 2000s, while undamentals and valuations o the technology sector remain healthy in the aggregate. • We are in the middle o a generational platorm shit 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 nding many compelling opportunities in other technology companies, primarily those with strong balance sheets, protability, and consistent revenue growth.
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The Current Landscape in the Technology Sector—Evidence and Narratives on the Bubble Debate Recent headlines and quotes rom 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 o a tech bubble have merit? Tere are certain market indicators that give some credibility to the discussion o a tech bubble. Te availability and deployment o venture capital investment has increased signicantly over the last year. Te number o M&A transactions within the sotware and internet industry has steadily increased since the market bottomed in 2009, as larger technology companies have used their balance sheets and cash ow to invest and acquire growth and innovation (Exhibit 1). For the most part, post-IPO perormance has been solid as investors have purchased many o the newer high-growth companies, even i they have yet to execute on delivering protability, cash ow, or even market leadership.
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Exhibit 1 Renewed M&A Activity in Internet and Sotware Industries
Exhibit 3 Startup and IPO Valuations, 2014 Transactions
Deal Count
($B) 168 16 8
300 30
238
240
IPOs Capital Raise
24
Acquisition 18
Internet
194 12
180
6
Software 120
0
60 2008
2009
2010
2011
2012
2013
2014
a r b e p b p n a b A b r b U i s i l t a A A h W
x t o a b h p c p o r a n D S
r i t n a l a P
e r a u q S
t a s r a o r s t k r e e s P r r o d o e i A w u G t o n t i e l C P N
s b l a e i l b u a u b a r L H T T t b n u s r e e G p N O
s h u t c l u a c w r O i A
As o 19 September 2014
As o 31 July 2014
The securities mentioned are not necessarily held by Lazard or all client portolios, 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, protable.
Source: Bloomberg, Lazard
Source: Bloomberg, Deutsche Bank, company lings
Exhibit 2 The Valuation Gap Appears to Be Widening in the Technology Sector Valuation and Revenue Growth, Russell 3000 Index Technology Sector EV/Sales
(%) 60
20
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 R ussell 3000 Index [LHS] Median Revenue Growth of Top 15 Most Expensive Tech Stocks [RHS] As o 26 August 2014 Source: Bloomberg
Valuation multiples, or a narrow part o the technology market, may appear stretched. For example, the median enterprise-value-to-sales (EV/sales) multiple or the teen most expensive tech stocks in the Russell 3000 Index has expanded signicantly over the last ew years, going rom just over 5 times EV/sales in the depths o the recession in 2008 to over 14 times today. Relying on this same multiple, we observe the gap between the teen most expensive stocks and the median o all technology stocks in the Russell 3000 Index continues to widen. Clearly investors are paying a signicant premium or this cohort o companies. However, one reason that may explain why multiples have expanded is that the revenue growth rate or the most
expensive companies has steadily accelerated rom the 20% to 30% range a ew years ago, and has now ramped up growth to the 50% to 60% range (Exhibit 2). Tis year, many tech startups have gone public or have received venture capital inusions, while others have been acquired, and many o these transactions have resulted in multi-billion dollar valuations (Exhibit 3). Some o the highest prole deals, including Uber’s recent capital raise at an $18 billion valuation and Facebook’s acquisition o WhatsApp or roughly $18 billion, both o which have limited, i any, protability, are examples o where valuations may have become somewhat excessive. In the current macro environment, where GDP growth remains rather tepid, some investors may be paying up or exposure to disruptive and high-growth companies because they have large market opportunities and are driving high levels o revenue and user growth. In addition, many investors have an appetite or the option value i these companies can execute on their vision.
Today’s Technology Environment Stands in Stark Contrast to the Prior Bubble Despite the aorementioned indicators, we believe today’s environment is drastically dierent than the time beore the dot-com bubble burst in the late 1990s/early 2000s. Current levels o venture capital and IPO activity are well below those during the last bubble (Exhibit 4). While valuations or private and recently-public high-growth, innovative companies have picked up, we are nowhere near the excess exuberance o the past. Companies that are going public today are more mature. On average, companies in recent IPOs are also much larger in terms o revenues and protability. Te median sales level or
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Exhibit 4 Venture Capital Financing and Global Technology IPO Issuance Are Well Below 1999–2000 Levels Number o US Companies receiving VC Financing 6000
5,476 50% Lower
4000 2,746 2000
0 1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Number o Global IPOs 400 310
300 87% Lower
200 100
41
0 1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008 2009
2010
2011
2012
2013
Source: Thomson ONE, Morgan Stanley Equity Capital Markets. Data per Dealogic, Bloomberg, and Capital IQ
Exhibit 5 Comparison o IPO Characteristics Characteristics,, 1999–2000 versus 2013
Median Company Age (years) Median Sales ($M)
1999–2000
2013
5
12
17
91
28
63
P/E , CY
4
18
Gross Margin (%)
77
49
Percentage o Companies Earning Revenuesa Over $50 million (%) Over $1 billion (%) Percentage o 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 o Dr. Jay Ritter, Cordell Proessor o Finance, University o Florida
64.7
22.2
16.7
16.7
40
43
52
42
EBITDA Margin (%)
20
20
31
20
ROE (%)
21
18
24
15
3
11
13
9
0.9
0.9
0.8
1.9
Proftability and Returns
Balance Sheet Cash/Market Cap (%)
recent IPOs has been $91 million, more than 5 times the size o the median sales o IPOs in 1999–2000. Other key metrics highlighting this divergence are shown in Exhibit 5. When evaluating the undamentals undamentals and valuations o the broader technology industry in aggregate, the sector remains very healthy and attractive relative to prior cycles and the rest o the market. Exhibit 6 shows the price-to-earnings (P/E) multiples, protability, and balance ba lance sheet strength o the technology companies within the S&P 500 Index today and at prior peaks. Clearly, all o these metrics are much more attractive than in past environments. As one canassee, today’s technologycurrently sector generates higher levels o protability, measured by margins and return on equity (ROE), and has stronger balance sheets holding more cash and less debt. In addition, when compared
Debt/EBITDA As o 28 August 2014 Source: Lazard, Bloomberg
to the S&P 500 Index as a whole, the valuations o the broader technology sector are currently in line with the benchmark. While there may be some signs o stretched valuations within the startup market and recent IPOs, we believe the data show that any potential rothtechnology in the market wouldremains be narrow in with scope, as the broader investable universe solid attractive valuations and strong undamentals.
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What Secular Forces Potentially Justiy the Higher Startup Valuations? A Paradigm Shit Toward Mobile and Cloud We believe believe we are are in the midst o a gener generationa ationall shit shit in techno technology logy platorms. o put this change in context, note that the computing and application architectures have only shited a ew times over the last ty to sixty years. Computing began with the mainrame. Ten the client– server model gave birth to the personal computer (PC) which expanded the availability and aordability o computing to hundreds o millions o people and thousands o packaged sotware applications. Companies like Intel and Microsot built tremendous businesses on this client–server model and during the PC era. Now, we are in the middle o a platorm shit to the mobile and cloud era (Exhibit 7). Mobile and the cloud are expanding the accessibility o computing and connecting billions o people—disrupting the inormation technology (I) landscape. We believe the next Microso Microsots ts and and Intels are are being built during this transition.
Why Does Mobile Matter? Te adoptionever rateinvented. o mobileTere has made it onethan o the most pervasive technologies are more 6 billion mobile handsets in use across the world, which is a staggering number when compared to the number o people who live in homes with electricity (5.9 billion), or have bank accounts (3.5 billion) or PCs (1.5 billion). oday just about 2 billion o those 6 billion handsets in use are smartphones with internet connectivity. 1 Over time, however, the vast majority o handsets will become smartphones. Te growth o smartphones is expanding internet access and enabling new types o mobile services and applications. Among the early beneciaries o this mobile transition has been the smartphone hardware market. As smartphone suppliers have rode down the cost curves on components, the price o low-end smartphones has moved well below $100. Tis has driven the smartphone market to over 1 billion units a year, an unmatched scale against any other hardware segment. o provide a sense o 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 and Google’s Android dominate dominate the the prot pools within the the smartphone smartphone market, as these are the companies with the most scale, as well as control over the two leading operating systems systems and app stores on which smartphones rely. Along with all the value they have created over the last ve years, the companies have indirectly destroyed a lot o the value rom historical players in the handset industry like Nokia, and threaten much o the value in the PC industry. Te internet is literally in people’s pockets or the rst time, and thereore application developers are shiting their ocus and innovation towards mobile, and away rom PCs. Mobile is enabling new types o applications and services that were previously not possible and this is transorming business models across many industries. For example, location-based services have created the opportunity or companies like Uber to disrupt transportation business models, and the inormation security industry has been orced to evolve and create new solutions to deal with the new types o risks and threats with mobile devices. Te emergence o the casual smartphone “gamer” has expanded the total addressable market or the video game sotware industry by a multiple o more than 5 times. However, mobile has also introduced new competitors with much lower barriers to entry and partiallymany cannibalized the core console-based gaming market. And in the nancials industry, the entire payments payments ecosystem is now changing with the mobile wallet. Te digital advertising industry is seeing some o 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. Tis is exactly what has happened as roughly 25% o consumers’ media time spent now occurs on the PC-based internet closely matching the 22% o total advertising expenditure. Tis ramework also applies to mobile, where consumers currently spend 20% o their time, and yet where only 4% o advertising budgets have shited (Exhibit 8). Tis dynamic has created opportunities or companies like Facebook, witter, Google, and Yelp among many others to capture and grow those advertising dollars.
Exhibit 7 A Generational Shit in Technology Platorms
Mainframe
Client-Server
Thousands of Users Hundreds of Apps
Millions of Users Thousands of Apps
This inormation is or illustrative purposes only. Source: VMWare
Mobile-Cloud
Billions of Users Millions of Apps
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private data centers given the sensitivity o data and years o historical investment in their own inrastructure.
Exhibit 8 The Mobile Advertising Gap (% of Total) 50
Time Spent Ad Spend
40
30
20
So why are we seeing such strong adoption o cloud-based I? We believe the cloud is an improved I model or most businesses. With the cloud, applications are aster to implement and easier to use. Cloud vendors are able to provide continuous innovation and eature improvements instead o orcing users to go through difcult upgrades. Te economics are more avorable; instead o large upront purchases o servers and sotware, I becomes a exible variable cost based on cloud usage. Importantly, the cloud allows companies to ocus on running their core business, rather than dealing with the distractions o operating I departments.
10
0
Radio
TV
Internet
Mobile
As o 31 December 2013 Data are or the United States only. Source: KPCB
Te market opportunity or cloud vendors is massive. Over $900 billion a year is spent on hardware, sotware, and I implementation and outsourcing services. Tis pool o expenditures represents the latent opportunity or cloud vendors to capture and disrupt the transition rom traditional I to cloud-based solutions. According to a survey o Chie Inormation Ofcers, 10% o their application workloads run in the cloud today, and are expected to grow to 18%
The Cloud Is Transorming IT Inrastructure
by the end o 2015. 3
Te cloud is a undamentally dierent method to host, deliver, and pay or I. Using the cloud makes I akin to buying a service, instead o enterprises having to build, operate, and manage their own physical data centers. raditionally, an enterprise would own and operate all the pieces o the technology stack within their data center. oday, with the public cloud, companies have the option o outsourcing their whole technology stack to a cloud vendor. Te vendor will host the company’s applications along with other customers’ custo mers’ applications in their massive virtualized data center. Tese 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
Evaluating High-Growth, but Optically Expensive Companies As discussed earlier, some o these these high-growth, recently public technology companies appear expensive according to traditional valuation metrics. However, we believe many o these young companies are investing signicantly to drive growth, which obscures the underlying protability o their existing installed customer base. Tereore, when we value these companies, companies, we separate the analysis into two parts. We rst evaluate the existing customer base on their underlying contribution margin and renewal rates. Ten we value uture growth by examining the growth o new business and new customers, the
Exhibit 9
Analyzing the Drivers o Underlying Operating Margin A Hypothetical Cloud Sotware Company, Margin Prole
Analyze the Business in Two Parts: Existing Customer Base Underlying Margin and Customer Acquisition Costs
Figures as Share o Total Revenue (%)
Figures as Share o Total Revenue (%)
Revenue
100
Revenue
100
COGS
25
COGS
20
Gross Margin
75
Gross Margin
80
Figures as Share o Total Revenue (%)
Revenue, year one
0
COGS
5
Gross Margin
-5
S&M
40
S&M
5
S&M
35
R&D
15
R&D
15
R&D
0
G&A
10
G&A
10
G&A
0
Operating Margin
10
Underlying Operating Margin
50
Customer Acquisition
-40
Costs
A portion o COGS is tied to implementat ion costs o new customers. The majority o S&M is tied to customer acquisition costs, with limited S&M needed to renew existing customers.
This inormation is or illustrative purposes only. Source: Lazard
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sales and marketing cost to acquire a cquire those customers, and the ultimate contribution margin o the customers ater they have been acquired. Finally, we use scenario analysis to understand the sensitivity o 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 ramework. A hypothetical hypothetic al cloud sotware company might only have 10% operating margins today, and thereore looks expensive on any valuation multiple o 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 contribution margin o the existing business is oten much higher at 50%. Tis example shows that the majority o the sales and marketing (S&M) costs and some o the cost o goods sold (COGS) are used to drive new customer acquisition, acquisition, and actually do not support the existing business. Tis analysis allows us to evaluate the entire customer lietime value, giving us more condence in the long-term uture protability o a business.
Conclusion echnology undamentals are compelling and appear avorable when compared to the market as a whole. Tese valuations are nowhere near the extremes o the late 1990s. However, we are in the middle o a powerul platorm shit rom a PC and client–server era, to a mobile/ cloud era. o the extent a bubble exists, it would be much narrower in scope, as some investors are aggressively seeking companies that are taking advantage o these new secular trends, which will only grow in size and importance over time. Tere 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 opportunity and are paying a premium to place option-like bets on potential winners. We continue to gain a broad and deep understanding o mobile and cloud trends in order to appreciate industry implications. implications. We plan to continue evaluating the ull range o technology investment opportunities using our investment process, which ocuses on uture returns, valuation, and scenario analysis. While we have hav e currently ound 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 eature sustainable recurring revenue growth, high levels o protability, strong balance sheets, improving capital allocation, and attractive valuation.
Notes 1 Source: Mobile Future Forward. As o 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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