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If this week's earnings are any indication, the IPO window is staying closed

By Kevin Kelleher , written on April 22, 2016

From The Money Desk

To get an idea of how investors in the public stock market are feeling about private companies planning an IPO, just take a look at how they are treating tech stocks already in the market.

This week, Intel and Netflix delivered earnings reports that included disappointingly weak outlooks for the coming quarters. Investors quickly sold off their stocks on the news. In Netflix's case, the stock fell 13 percent in a single day. Yesterday, Alphabet and Microsoft reported first-quarter numbers that came in shy of Wall Street expectations. The immediate response was to send Alphabet's stock down as much as 7 percent -- equal to a $38 billion loss in market value -- and Microsoft stock down as much as 6 percent -- or $22billion of its market cap.

All four of these companies have growth in recent quarters. All have been trading in the stock market for years, offering the public a much more intimate look at their financials than private companies have ever allowed. Most notably, all have a steady track record of profitability. And yet all have declined on any hints of weakness in either their most recent quarter on quarters to come.

Now consider how such a gimlet eye would view a company with no profits and a history of private rounds that were either overvalued or that included provisions like ratchets that guaranteed early investors rich payouts when an IPO happens. It's not very encouraging.

The IPO of SecureWorks offers a telling example. A spinoff from Dell as it plans to merge with EMC, SecureWorks had filed to sell 9 million shares between $15.50 a share and $17.50 a share. Early reports suggested the IPO would happen last week. It didn't, despite a lack of volatility in the stock market. Last night, SecureWorks said it would instead sell 8 million shares at $14 a share. As we wrote last week, SecureWorks saw increased losses last year and included a guaranteed payout of $28 million to holders of the company's convertible debt.

If SecureWorks was the canary that investment banks were sending into the coal mine, that canary has come back looking rather ill. And between the lower-than-hoped-for pricing of the SecureWorks IPO and the selloffs in established tech companies that have so farposted first-quarter earnings, this week is offering ample evidence that the stock market remains unfriendly to tech IPO candidates.

This is especially interesting since Alphabet and Microsoft have been regarded by investors as two of the stronger and healthier standard bearers in the tech industry. Microsoft, for example, is continuing to see strong gains in its cloud computing business, which now boasts an annualized revenue run rate above $10 billion. Its Azure cloud services business alone saw a 120 percent growth rate.

Not everything at Microsoft is doing well. Sales related to the ailing PC business declined as expected, but Microsoft's transition to new businesses like the cloud are far from disappointing. The company missed its earnings target of 64 cents a share by two cents, and officials said that the miss was caused by an unexpected rise in its tax rate rather than weakness in its core operations.

Alphabet faced a bigger miss, with revenue rising 17 percent to $20.3 billion but coming in $110 million below analyst estimates. Earnings per share of $7.50 fell 47 cents short of forecasts. But here again, the reasons for the disappointment had less to do with any overall deterioration in Alphabet's businesses – whether in Google's ads or the moonshots -- than with three separate factors. The first is simply that Alphabet refuses to give any kind of guidance, leaving analysts and investors to shoot for estimates that often miss the mark.

The other two reasons have to do with the short-term effects that Alphabet must endure if it wants to keep growing. In the case of Google, traffic acquisition costs increased by 13 percent to $3.8 billion. CFO Ruth Porat said that these costs rose because of a rise in mobile ads.

She argued that the growth in mobile ads is encouraging -- this is exactly what Google and its investors have long hoped for -- noting that search was the “primary driver” of Google's revenue, which was up 23 percent when forex rates are factored out. In its network ads, Google is also seeing growth in programmatic ads, which helped drive up traffic-acquisition costs.

Many mobile ads have long brought in lower ad rates than their desktop counterparts. On top of that, as ad inventories and clicks increase, the cost per click can drop. Google's cost per click fell 9 percent last quarter, not great but also not as bad in the previous three quarters, when they fell between 11 percent and 13 percent.

Secondly, the so-called "Other Bets" segment that includes non-search businesses such as Nest, Verily and Fiber is seeing both revenue and losses grow. The segment's revenue more than doubled to $166 million, while operating loss rose to $802 million from $633 million a year ago.

But unlike an independent startup with a history of losses approaching the stock market, Alphabet's money-losing businesses are shielded inside a long-profitable search company. The Bets' operating losses is equal to an eighth of Google's core operating profit.

Alphabet is investing in newer areas like Fiber that are not expected to contribute to profits for some time. Capital spending these initiatives totaled $280 million last quarter, or 14 percent of Alphabet's total spending. The rest is going into data centers, device launches, content deals for YouTube.

Overall hiring grew 16 percent to 64,000, but most of this went to areas like the cloud and AI, which the company sees as its best chance to maintain growth. “In the long run, we will evolve in computing from a mobile-first to an AI-first world,” said Sundar Pichai, CEO of Google. “I do think we are at the forefront of the development.”

Like Microsoft, Alphabet is positioning itself for years of future growth by hiring in and investing in emerging businesses. That the growth is not manifesting itself as quickly as investors were expecting will probably result in a short-term blip in their longer-term trajectories.

For now, the market is more willing to focus on the short-term disappointment than the long-term promise isn't great news for the likes of Microsoft and Alphabet. But for private companies that have big losses as well as hopes of joining the public stock market, it's much more worrisome news.