Tech Bubble 2.0 Will End Badly Just Like the First Tech Bubble

by the Curmudgeon and Victor Sperandeo

Introduction:

Does anyone remember the excesses of the late 1990's tech stock bubble and the price declines that followed? Apparently not. Many seem to have forgotten that earnings growth really matters for stocks. Today, we see two areas of extreme overvaluation: publicly traded Internet commerce and social media stocks and private Internet companies. We examine each of these in this article, but first a bit of recent market history.

An Internet Echo-Bubble?

Remember the Four Horseman of the Internet? From 1998-2000, there were four companies that could do no wrong on Wall Street: Cisco, EMC, Sun Microsystems and Oracle. Yet after the Internet bubble burst, orders dried up as large corporate customers stopped buying products. Earnings collapsed and, in Sun Micro's case, disappeared. Sun was later taken over by Oracle and hasn't made any money since.

Today we have the equivalent: a small group of technology stocks trade at a huge premium of ~ 700% above market valuation. Amazon, Netflix, LinkedIn, Twitter, Pandora Media and Yelp are the big names. The newcomers include: FireEye, Splunk, and Workday (see chart below). There's also Rocket Fuel - an online advertising company- which is trading at about $66 a share with a market valuation of more than $2 billion, even though the company has never made a profit.

These Internet stocks have very inflated valuations which are based on a perception of enormous earnings growth which has yet to be realized. It is like a new bubble within an old bubble sometimes referred to as Tech Bubble 2.0 or an "echo-bubble."

YELP, Pandora and Facebook all broke up out of their respective short-term ranges in the last week and are approximately 30% overextended relative to their respective 200-day MAs. Twitter has steadied following a pullback and is trading on the order of 68x trailing Enterprise Value/Sales, which is a much higher multiple than the peak multiple of either Google or Facebook. Amazon is approximately 20% overextended relative to its trend mean as it pauses in the region of $400. LinkedIn is basing in the $220-$250 range, after more than doubling in the past year.

Buying (or even holding) these stretched multiple (P/E) stocks offers a very poor risk/reward ratio. It's questionable whether such "investors" have the discipline to exit before the inevitable price declines take place. We continue to ponder whether there will be anyone to sell to in a fast moving down market - especially for overvalued/overextended issues.

Up until recently, the CURMUDGEON had never heard of FireEye (FEYE-cloud based advanced malware security), Splunk (SPLK-big data analytics software) and Workday (WDAY-cloud based human resources and financial management software). These newbies are trading at very high valuations and a very short history as can be seen by the chart below:

Company	Current EV/Sales Valuation	Current Market Cap	Trailing 1 Year Revenues
FEYE	49x	$8.7B	$136M
SPLK	29x	$8.5B	$268M
WDAY	36x	$16.1B	$409M

Internet darling stocks are not restricted to the U.S. In Europe, Asos, the London-listed fashion portal, is trading at almost 100 times forecast earnings. Ocado, an online grocer that has yet to turn a clean profit in 13 years, has been re-rated as a tech company, quickly doubling its value to more than £3bn. Moncler, an upmarket Italian ski jacket maker, surged 44% when it listed recently in Milan.

Example Valuations for Privately held Internet and Social Media Stocks:

Facebook’s $3 billion cash offer for Snapchat, declined by its 23-year-old founder (who said the company was worth a lot more), shows how exuberance has grown to new levels in the social media space. Snapchat has zero revenue and only one product- a photo messaging app. Snapchat does not have a business model or a timeframe in which to make money or become profitable. Yet it was valued at $4 billion shortly after it spurned Facebook's buy-out offer.

Surprise: Snapchat's entire value proposition of user privacy has been severely compromised! Users of the Snapchat app take photos and send them to a controlled list of recipients. Users set a time limit for how long recipients can view their Snaps (as of December 2013, the range is from 1 to 10 seconds), after which they will be hidden from the recipient's device and deleted from Snapchat's servers. But there was a huge data breach in December which saw 4.6 million usernames and phone numbers leaked. To add insult to injury, Snapchat has recently been the target of Snap Spam which sent unwanted photos and videos to Snapchat users.

“We’ve heard some complaints over the weekend about an increase in Snap Spam on our service. We want to apologize for any unwanted Snaps and let you know our team is working on resolving the issue,” Snapchat wrote in a blog post today. However, the company said the issue appeared to be unrelated to the user data breach. That's a huge worry for the 4.6M users who were compromised. Spammers could be attempting to send spam Snaps to every username they can find. Many people only allow Snaps from friends, but others accept them from anyone with their user name, opting for privacy by obscurity.

Last week, Google agreed to pay $3.2bn for Nest, a privately owned four-year-old start-up that has only sold one product- a Wi-Fi-enabled smart thermostat that might cut heating and cooling bills. The company has recently introduced a smoke and carbon monoxide detector for homes, but hasn't indicated whether there've been any sales of that product.

Square, the on-line payments start-up led by Twitter co-founder Jack Dorsey, received a private investment last week that valued the company at $5 billion. That permitted existing investors and employees to cash out $135 million worth of equity. In 2012, Square was valued at $3.25 billion, when it raised $200 million in a round led by Rizvi Traverse Management, which also led this month’s tender offer alongside François-Henri Pinault’s Artemis. Square began by allowing small businesses to accept credit-card payments through a smartphone widget, which plugged into a headphone jack. The company has since expanded to provide a range of other payment and business-management software, moving into new markets as it has done so. But is that worth $5 billion?

Then there's Dropbox - a very viable on-line storage provider (occasionally used by the CURMUDGEON) that has just closed on approximately $250 million in a funding round that values the company at close to $10 billion - one of the most highly valued companies backed by venture capitalists.

Dropbox's valuation has more than doubled since late 2011, when investors valued the San Francisco-based company at $4 billion. The company also got a higher price than expected when it approached investors as recently as November. People familiar with Dropbox’s finances told the FT last year that its 2012 revenues reached around $110m. According to the WSJ, Dropbox had expected sales of more than $200 million in 2013. But the company has not said that it was profitable or when it might be.

The elite club of companies with multibillion-dollar valuations is growing. At the end of 2013, Palantir Technologies was valued at $9 billion; Spotify was worth $4 billion; and Uber Technologies was valued at $3.76 billion. VCs and institutional investors are putting tons of money into these companies in anticipation of a huge profit after their IPOs. And there was definitely a resurgent appetite for IPOs last year.

IPOs Trump Stock Buy-Backs:

While many large corporations have been buying back stock in order to raise their earnings per share, the market for IPOs has been surging. There've been several sky-high valuation companies (e.g. Twitter) listed in the last few months and a number more in the pipeline. The net effect is that the total supply of outstanding shares on the NYSE increased in the first half of last year despite the robust pace of stock buybacks.

Apparently, there still is stupendous demand for tech IPOs, which we think is based on perceptions, stories and momentum, rather than earnings growth or sustainable business models (e.g. Snapchat).

Is this all rational or plain nuts?

In this weekend's FT, Paul Murphy asks:

"Is this a sane approach to business investment? While macro strategists tell us that US companies in particular are over-investing in the face of sharp deflationary pressures and shrinking margins, is it really too cloddish to ask again whether, in a world awash with easy money, a combination of tech-fever and feverish greed has caused investors to lose touch with reality? Fifteen years have passed since the Great Dot Comedy. The era has been mocked ever since, yet many specific instances of craziness have been forgotten or brushed away."

"15 years (after the dotcom bust), it is considered dull, stupid or both to question the $40bn valuation afforded Twitter. As the tech analysis team at London brokerage Aviate told clients at the time of the initial public offering: “The opportunity for Twitter is to become the largest real-time delivery system, large enough and pervasive enough to exert noticeable ‘pressure’ on the overall internet itself.” Twitter is “all about now,” they said.

Since the Twitter joined the New York Stock Exchange in November 2013, Silicon Valley has continued in its role as a seemingly magical valuation creation machine. This week Square, the mobile payments business, was valued at $5bn after a private placement that allowed a number of insiders to cash out $135m of stock. There is no discussion of profitability anywhere near this. Revenues might get a mention but only as a secondary matter to market share.

It's clear to us that the reason for all of the above is the Fed's quantitative easing. "Cheap money has given us a period of wild abandon,” says Andrew Lapthorne of Société Générale.

Victor's Closing Comments:

Experienced stock market professionals have witnessed over valuations (bubbles) over and over again. Like a villian /good guy movie, the bad guys always lose in the end. There are different names (and symbols) associated with each bubble, but the sequence and endgame is always the same.

In the late 1960's, when I began trading and managing money, the "conglomerates" were the kings. Gulf and Western was my favorite (my firm was a market maker in GW options on the CBOE). Citi Investing, RW Grace, Ogden, Litton Industries, LTV, to name a few. All of them died a terrible death. Buying companies was easy with credit, but managing them became impossible at some point.

In 1977 I sold my company to Weeden - a 'third market firm'- and became a market maker in the large cap "glamour stocks" (AKA the "nifty fifty"). Those included: IBM, Xerox, Polaroid, Eastman Kodak, Avon Products, American Home Products, and many others. P/E's ranged from 2.2 to 28 times those of the S & P 500. The rationale for those high multiples was that it did not matter what you paid for those companies, because they were "all weather" stocks. They could never go down because earnings would always increase! They came to be known as "one decision" stocks, because you only had to decide if earnings would grow to the sky in order to buy 'em.

The long bear market from January 1973 to August 1982 caused valuations of the nifty fifty to fall to low levels, with most of those stocks under-performing the broader market averages. Some of the glamour stocks became defunct and disappeared. As a result, they are often cited as an example of unrealistic investor expectations for growth stocks. We wonder if active money managers that have bought today's Internet names are aware of that. Or do they even remember the dotcom boom and bust?

Today, Amazon has a P/E of 560. Amazon is a wonderful company from the consumer’s point of view, but it is a very overvalued stock. So too are the other big Internet companies the CURMUDGEON has listed in this article.

This is what markets are all about- emotions. And the built-in bias to "buy" what's currently in vogue. The investment industry pays fees to asset managers to make money, and in most cases to outperform the S&P 500. Risks with "other people’s money" are on the backburner and mostly neglected. It's only about what can I (the asset manager) buy that is hot and has momentum in order to look good (when compared to other money managers).

Analyzing fundamentals is a waste of time when money is being printed, e.g. QE. The only concern is when will it end and cause the buying to stop? As a result, analyzing stocks is replaced with anticipating what is going on in "the minds of men at the Fed." What will Ben and now Janet do next? This is a true monopoly game, and few win when the game ends.

The fallout will be like all other market crashes/steep declines. The U.S. federal government will blame business, the Wall Street banks, and capitalism. It's ironic that the Bernanke led Fed saved Bear Stearns from bankruptcy (by orchestrating its takeover by JP Morgan) in the Spring of 2008, yet some of Bear's financial assets are still on the Fed's books. But the Fed and Treasury Dept. claimed they could not save Lehman Brothers (a much bigger investment bank) in September of 2008, because they "did not have the tools?"

The inevitable stock market decline (timing of which is uncertain) will sadly make many market participants look very red- like a bad sunburn from a beach vacation.

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

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 1979) to profit in the ever changing and arcane world of markets, economies and government policies. As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas 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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