Rise of New Tech Companies: Unicorns, FANGs, and the Nifty Nine
by the Curmudgeon
The last several years have seen the rise of a “new” information economy based on services, mobile apps, social networking, e-commerce, and cloud computing or storage. The “old” IT driven economy, based on engineering design, development and manufacturing, has effectively been outsourced to Asia (China and Taiwan Original Development Manufacturers (ODMs) and smart phone/tablet vendors).
Here's proof: considering that Apple makes all of its smart phones (and tablets) in China, 8 of the top 9 smart phone vendors are in China or South Korea. Microsoft, which acquired Nokia's phone division in 2014 is the only non-Asian vendor in the top 10.
Both the private and public equity markets have stupendously driven up the values of “new tech” companies, creating huge mega-bubbles that have inflated to extremes that rival the dot com boom (and subsequent bust). We examine both private and public “new tech” in this post.
Unicorns: Sky High Valuations vs Exit Price?
Business Insider reports that the number of private tech companies valued at $1 billion or more (so called “unicorns”) has surged so much this year that on average 1.3 unicorn companies have been created every week in 2015. In spite of Silicon Valley insiders' fears of a tech bubble, that number doesn't seem to be declining. The number of new unicorns doubled in the 3rd quarter of 2015 compared to the same quarter last year. There were seven new U.S. unicorns and three new Asian ones in Q3-2015.
CB Insights provides a real time list. There are now 144 unicorns, which have a cumulative valuation of $505B.
However, all is not wine and roses in unicorn land. As noted in a previous Curmudgeon post, a Financial Times article titled “Unicorns face end of the ‘steroid era’”, said that Silicon Valley unicorn valuations may be seen as ‘marketing numbers’ in the face of the reality of an IPO.
CB Insights recently released a global tech exits report for Q3-2015, which tracks M&A and IPO activity among tech companies. Q3 saw a slowdown and one of the first quarters in a long time with no billion dollar exits. Corporate M&A clients say that Silicon Valley valuations for tech companies have them slowing down while they wait for things to come back to reality. In Q3'15 exits declined 18% quarter-over-quarter to 833 M&A and IPO exits. There were only 9 IPOs in Q3’15, including 5 IPOs outside the US, including IPOs in Singapore, Japan, and New Zealand.
Chart Courtesy of CB Insights
As a wave of tech companies prepare to launch IPOs over the next two years, these headline valuations are starting to intersect with reality — a process likely to be both painful and disappointing. Today’s “tech” bubble may not burst violently, like the dot com boom in 2000. But many observers expect that headline valuations, along with private share prices, will deflate over the next 18 months.
This week, the Economist weighed in with the following:
“Valuations for private technology firms are rising at a slower clip than they were six months ago. On November 24th Jet, an e-commerce competitor to Amazon, announced that it had raised $350m (valuing the firm at $1.5 billion), a big sum for a loss-making startup, but a lower one than it had first hoped for. Airbnb, a fast-growing room-rental firm, recently raised $100m, but reportedly stayed at its recent valuation of $25 billion, instead of rising further. Fred Giuffrida of Horsley Bridge, a firm that invests in private-equity funds, reckons that the valuations in late-stage rounds of financing have declined by around 25% in the past six to eight months. These rounds are also taking slightly longer to complete.
In the last quarter several mutual funds, including Fidelity, have marked down the value of some of their unicorn holdings in unlisted tech firms. Fidelity wrote down Dropbox, a cloud-storage firm, by 20%; Snapchat, a messaging app, by 25%; and Zenefits (software) and MongoDB (data bases) by around 50% each.
Many investors in unicorns had bet that a new generation of technology firms would unsettle the old guard, but that has not happened as quickly as they had predicted. Tech giants like Amazon, Google and Facebook (see section on FANGs below) have continued to grow impressively, especially considering their already large size; and they have been adept at entering new markets that start-ups might otherwise have claimed. For example, Facebook has bought and built messaging apps that compete with Snapchat, and Dropbox has a rival in Amazon, whose cloud computing and storage business (Amazon Web Services or AWS) is large and growing quickly.
With investors, until recently, throwing money at them, the unicorns have got into the habit of burning through their cash in an attempt to buy market share. Lyft, a taxi-hailing firm that is a rival of Uber, reportedly suffered losses of nearly $130m in the first half of this year, on less than $50m in revenue. Instacart, a food-delivery firm, is rumored to lose around $10 on each order it fulfills. Such practices are only likely to stop when the funding for these firms dries up, or investors whip them into shape.”
The tech industry’s herd of unicorns contains many that look very similar to each other, and/or to longer-established firms (e.g. Jet vs Amazon). Yet many are being valued -in as much as the valuations are believable - as if they were guaranteed to be among the long-term winners in their line of business. In fact, not all can survive. Weaker firms have been able to keep going because money has been so easy to raise1. Their spendthrift ways have made it harder for stronger rivals to control their own costs and make a decent profit.
Note 1. In an April 16th interview with the New York Times, Slack CEO Scott Butterfield said: “This is the best time to raise money ever. It might be the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians. It’s certainly the best time for late-stage start-ups to raise money from venture capitalists since this dynamic has been around.”
What most observers seem to have missed is that there are much fewer exits. 2015 tech IPOs as a percentage of all IPOs have been the lowest level in seven years. Also, high flyers like Zynga, Box, GoPro and Twitter are all trading below their IPO price of one or more years ago!
A recent example of a down round exit was mobile payment darling Square (SQ), which had to price its recent IPO much lower than late stage private equity investors paid. The stock popped 45% on its first day of trading November 19th to close at $13.07. However, that was its high close to date (Friday's close was $12.05).
It seems that raising money to obtain a billion plus dollar private equity valuation (i.e. becoming a unicorn) and exiting or remaining at the same or higher valuation (via IPO or acquisition) are two very different things.
FANGS and Nifty Nine vs. Nifty Fifty (1970s) and Four Horsemen of the Internet (late 1990s):
John Authers weekend FT column (on-line subscription required) called attention to the FANG stocks - Facebook, Amazon, Netflix and Google – while Ned Davis refers to a Nifty Nine (Note that Apple isn't included). If made into indexes, research by the FT statistics group shows that either group of stocks would have gained about 60 per cent this year.
“The success of the FANGs is a symptom of the rise of a new (information) model for the economy that revolves around services rather than manufacturing. But it is best not to get carried away. All these companies are richly valued (Ned Davis puts the Nifty Nine’s collective price/earnings ratio at 45, double that of the S&P 500). They also look expensive when compared with their sales.
Hype and excitement around a few big companies, and eclipse for riskier small companies, are classic symptoms of the top of a bull market. For comparison, look at the “Nifty Fifty” companies of the early 1970s, or the first wave of web companies during the dot com boom of the late 1990s — when it was fashionable to talk of a new economic paradigm.” That's illustrated in the chart below:
Chart courtesy of the Financial Times
In a Zero Hedge Post titled: “Diversification Is For Dummies - The Nifty Nine Never Mattered More,”
“From the 4-horsemen of the dot com exuberance (and apocalypse), to today's so-called FANG and NOSH stocks, and now 'Nifty Nine', investors could be forgiven for ignoring the benefits of stock market diversification that every commission-taking, fee-gathering asset-collector promotes and going all-in on a few 'easy to select' stocks to make the quick buck that everyone believes is their right as an American taxpayer. While the S&P languishes unchanged in 2015, these small groups of overwhelmingly propagandized stocks are up on average over 60%, but with a collective P/E of 45, they are not cheap….”
The exuberant upside of the FANGs or Nifty Nines is always obvious after the matter, as shown by the chart below:
The Curmudgeon has been watching the U.S. stock market for over 53 years- since July 1962. We have never seen such a total disconnect from reality than today's “new tech” unicorns and mega-cap tech stocks [the FANGs + LinkedIn, Apple, Microsoft (via its Azure cloud computing services)].
What very few realize is that they're all about software (web + mobile apps) and information services, rather than real engineering technology. Yes, Apple does the industrial design of its iPhone and iPad in the U.S., but they outsource the detailed engineering design and manufacturing to several Chinese companies. That was first disclosed in 2012, but few paid attention.
While Amazon, Google, Facebook, Netflix, LinkedIn, et al are all viable “new tech” companies, they are much overvalued compared to the rest of the stock market.
As for the “new tech” unicorns, we predict that 80% or more will be wiped out in the next five years causing use damage to the VC's, hedge and mutual funds that were looking to make big money “investing” in them. Most depend on advertising to monetize their services, but advertising dries up in a severe recession. You read it here first!
Good luck and till next time...
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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