Pando

The tech industry's faith is starting to look a lot like denial

By Kevin Kelleher , written on February 9, 2016

From The Economics Desk

Say this for Silicon Valley: The blithe resilience built up after decades of booms and busts is as strong as ever.

Even if, for the past week, the can-do faith that the tech industry has in its own future growth has started to take on an aspect of blind denial.

And so San Francisco celebrated itself all last week with the security clusterfuck that was Super Bowl City, while the market cap of companies like Twitter continued a slow meltdown. And, following yet another day of tech carnage Monday, the Crunchies were handed out in the city's Opera House, where the evening began with a man holding a BB-8 toy while serenading nominees like Zenefits. This on a day when the CEO of Zenefits resigned amid reports about compliance issues.

There has not been much to celebrate in tech finance of late, especially in the public markets. Look around for reasons why markets everywhere are in freefall, and few if any of them have to do with the kind of tech recklessness that led to the dot-com bust: The growing risk in China's black-box economy, the spread of negative interest rates around the world, the toll that low oil prices are taking on energy junk bonds, the re-emergence of default rumors in Europe, and the stress that all of this is putting on big banks.

Some will point out that, just as the rising tech valuations of recent years was very unlike the insanity of the dot-com bubble, the plunge in tech valuations right now is different from the dot-com bust. And those views are right. But they overlook the simple fact that many companies, public and private, were still valued way, way higher than they deserved to be through the lens of fundamental analysis. And now those valuations are coming back toward earth – fast.

Tech is falling because these global factors have spoiled any investors appetite for risk – even, and especially, in tech shares with high PE ratios. Because hidden inside all the stories spun for years about the long-term promise of social/mobile/cloud/big data/VR/AI is a very real, shorter-term risk. Public investors aren't just recalibrating the values of their tech investments. They're rethinking how they look at the risk they embody right now.

The idea that tech companies are growth oriented – that is, investing many profits today into revenue growth in coming years - is falling out of favor. Instead, there's a mindset emerging that's closer to a “new normal” way of thinking. Sure, Amazon and Netflix may for years be able to keep plowing profits into growth and investors won't rebel. But for many smaller, more niche companies, this simply won't be the case anymore.

The strongest evidence of this shift can be seen in LinkedIn. For years, the company had a triple-digit PE ratio. The stock has lost more than half its value so far this year, largely on the back of an earnings report that left analysts and investors wondering whether its long-term growth thesis would hold up. Even after the plunge, LinkedIn is still trading at a rich PE ratio of 37, more than double the market's average.

LinkedIn is hardly alone. Tableau Software also warned last week about slower revenue, driving its stock down 60 percent below where it was at the end of 2015. Even after that pummeling, Tableau's stock is still valued at 60 times its earnings. And on Monday, Yelp's prematurely released earnings report drove the stock down 10 percent on the day and to a 44-percent decline this year. Yelp has a 43 PE ratio after that decline. (These PE's are based on non-GAAP results; both companies posted GAAP net losses.)

In short, investors are bailing out of tech stocks that promised strong growth for years but are having trouble delivering on that growth now. The selling isn't even leaving them at bargain prices, because most are still trading at expensive valuations. If bad news keeps emerging elsewhere that adds to concerns about a global recession, they could fall further.

This is especially bad news for IPO candidates. Only two companies - both biotech, both last week - have gone public since mid-December, the longest IPO drought since September 2011. Tech companies that did go public in the recent past aren't faring well either. Square is down 36 percent in 2016, Match Group down 32 percent, New Relic down 40 percent and Hortonworks 64 percent.

In time, the dust will settle and private tech companies looking for an IPO exit will try to move forward. But companies like Square that went public last year did so at a sizable discount to their private valuations, and those that make it out this year may faced with a grim choice – go public at even bigger discounts to their recent private rounds or withdraw from the IPO queue altogether.

Even the stronger tech stocks have taken a beating. The so-called FANG stocks are all down this year – Facebook down 5 percent, Amazon down 28 percent, Netflix down 27 percent and Google down 10 percent - with only Facebook outperforming the S&P 500 Index. Apple as well is down 9 percent.

Taken together, those five companies have lost an aggregate $280 billion in market value so far this year, a period of less than six weeks. More than half of that lost value came from Amazon and Netflix alone – two companies that convinced investors to accept high PE's in exchange for high growth. Now that they've lost more than a quarter of their value this year, they're still precariously valued: Amazon at 105 times this year's expected earnings, Netflix at 333.

Clearly, an appetite for risk still exists for some privileged tech companies. That includes Uber, which is reportedly having no trouble raising $500 million from wealthy investors who “are effectively handing over their money with their eyes closed.”

And why not? Investing with eyes open doesn't seem to have prevented many people from overpaying for public tech companies that are better at promising future growth than delivering on that promise in 2016. As long as that kind of blind investing in risk endures, so does the possibility of volatile declines. So far this year, it's been more than a possibility.