By Ben Strubel of Strubel Investment Management
LinkedIn (LNKD) went public and began trading on May 19th. The stock almost doubled in its first day trading with a valuation reaching almost $10B. But it’s not just retail investors willing to pay sky high prices. On May 11, Microsoft announced it intended to acquire Skype for $8.5B. Individual and institutional investors have been assigning sky high multiples to a select group of private social networking stocks for awhile but Microsoft’s acquisition might signal that things are beginning to get out of control. Though many investors roundly trashed Microsoft’s acquisition of Skype, excitement around the new breed of tech companies seems to be taking hold among investors and in the media as well.
I recently came across this article at TechInsidr.com, trashing Whitney Tilson’s short bet on Salesforce.com (CRM). The article reads like a piece written in 1999 and talks about how traditional valuation metrics like cash flow can’t be used to value high flying tech companies. The absurd valuation of LinkedIn was also vigorously defended in an article on DealBook.
The following quote by Scott McNealy, founder of Sun Microsystems, shows just how silly the valuation at the height of the original tech bubble was:
“But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
Investors today certainly aren’t going to pay 10x sales for Sun since it was bought out by Oracle, but they have found some shiny new companies to exercise the same lack of judgment that they exhibited during the 1999 tech bubble. A new tech bubble seems to contain three loose groups: (1) social media and crowd-focused companies; (2) cloud and mobile computing companies; and (3) assorted hangers-on.
Social Media and Crowd-Focused Companies
Social networking or social media darlings, like Facebook in the US or RenRen (RENN) in China, are hot right now. This group also includes companies that have a social or “crowd” component to them, such as Groupon. Many of these companies are not yet publicly traded but are expected to eventually become public (and at ever increasing valuations it seems). Many of these companies suffer from the same flaws as the first tech bubble, notably lack of any income. Instead, alternative valuation metrics are trotted out. When talking about the Skype acquisition, Steve Ballmer dusted off his 1999 playbook and frequently mentioned the number of users Skype had, reminiscent of the halcyon days at the beginning of the last decade when companies were valued on “clicks” and “eyeballs.”
Notes: Facebook valued at $50B and $2B in revenues, Groupon at $20B and 2010 revenues, LinkedIn at $9B and 2010Q4 revenue annualized. All other valuations from the week of May 9th.
Cloud and Mobile Computing Companies
The second group contains cloud and mobile computing companies, like Salesforce.com (CRM), ARM Holdings (ARMH), and include companies that make networking equipment that supports the cloud, such as Riverbed (RVBD). Again, the parallels between 1999 are astounding. In 1999, the obsession was any company laying fiber optic cable and building the backbone of the internet. Now the obsession is over all things “cloud.”
Notes: Valuations from the week of May 9th.
The third group is a catchall group that contains companies that have some sort of “new” new economy component attached to them, like OpenTable (OPEN) or Travelzoo (TZOO).
Notes: Valuations from the week of May 9th.
Of course, the big difference between the bubble now and the bubble in 1999 is size. The 1999 tech bubble was large and broad enough to lift the entire market. Today’s bubble seems to be contained in just a few names. No doubt some great companies will emerge from the wreckage of the new bubble, but the odds are against investors in any space with nosebleed valuations. By 2003 investors had learned the hard way that valuations matter. It looks like the first lesson didn’t stick and they are setting themselves up for heartbreak a few years from now.
Disclosure: No positions