Tech sector focus: Forever blowing bubbles

HERD MENTALITY never ends well. Just look at lemmings. When population density becomes too great, they are driven to migrate in large groups and, if popular myth is to be believed, end up plunging headlong over a cliff edge to a watery doom.

The same propensity to go along unquestioningly with popular opinion, eventually leading to deluded mutual self-destruction, also exists in human beings. The dot com bubble that so dramatically burst in the last years of the 20th century left investors – so certain that they were on to the next big thing – grievously out of pocket.

So it was with interest, not to mention no little amount of hype, that investors and tech market observers waited for Facebook, the social media darling, to come to market with the largest company initial public offering in history for a technology or internet company.

Valued at about 26 times sales in its 18 May IPO, Facebook appeared to provide confirmation for supporters of the markets that stratospheric valuations could be achieved and would subsequently spawn a wave of tech market IPOs. The more cautious observers could warn that the listing was symptomatic of a new tech bubble forming. No one needs reminding how the last one turned out.

The outcome, however, managed to catch everyone cold. Mark Zuckerberg, Facebook’s founder, perhaps most of all. Zuckerberg’s wedding to college sweetheart Priscilla Chan the day after the company’s initial public offering was no doubt a happy affair. His honeymoon gift was not. The IPO tanked as shares plunged as much as 32% since their debut.

Finger-pointing and recriminations quickly followed: NASDAQ and lead underwriter Morgan Stanley both came in for some stinging criticism over how the botched listing was handled. The performance of Facebook’s shares may have been the result of mismanagement of the deal – stock market glitches and an over-supply of shares that were materially overpriced – but that did not prevent the stocks of other tech market high fliers from taking a nosedive.

Shares in voucher company Groupon, valued at about $12bn (£7.7bn) at the time of its listing in November 2011, fell 13.5% between the day of Facebook’s IPO and the end of May, while LinkedIn closed the month 14.1% down on its $112 share price on the day Facebook went to market, though LinkedIn’s stock has since recovered.

Bubble-pausing

As of close on 26 June, Facebook was trading with a market cap of $77.8bn, according to Yahoo Finance, which is a far cry from the $110bn plus valuation on the day it came to market. Prior to Facebook’s IPO, many thought that it would unleash a wave of internet mania akin to that which followed Netscape’s 1995 offering. Facebook’s frankly horrendous debut brought the bubble’s expansion to a halt. But has it outright burst that bubble?

According to Jass Sarai, UK technology leader at Big Four accountants PwC, it is more likely that the market is just taking a deep breath.

“I look at it as a pausing, rather than a bubble bursting. Tech companies have always had issues around valuations. Good tech companies will continue to come to the fore and list,” says Sarai. “In some ways, the timing is good. It coincides with the summer break. By the end of the year, there will be companies that investors target. You will always find people willing to invest in tech because of the opportunity for good returns.”

Jon Coker, a tech specialist who heads the investment team at MMC Ventures – albeit not in the social media space – is also of the mind that Facebook’s botched listing doesn’t signal the end of the tech boom.

“The valuation hasn’t fallen off a cliff, which you would expect to see when a bubble bursts,” he says, and adds that public markets just aren’t cut out to invest at the level of valuations being bandied about prior to Facebook hitting the street.

“Facebook’s valuation reflects a potential that is still a long way off. There are always going to be big bumps in the road to achieve that potential. In the private market, we are more likely to hang on. We are used to seeing big ups and downs as companies grow,” he continues.

Believe the hype

Two finance directors who are more interested than most in whether Facebook has damaged the prospects of upcoming tech IPOs are Nilesh Pandya, FD of online payments service Skrill, and Divinia Knowles, FD of Mind Candy, the company behind Moshi Monsters, the children-focused social network.

Turnover at Mind Candy, which boasts 50 million children registered for its Moshi Monsters network, leapt to £7.6m for the year ending December 2010, up from £1.9m a year earlier, and the company has garnered a £250m valuation, according to press reports. Skrill’s growth has been even more impressive.

In joining Skrill, which re-branded from Moneybookers in the spring of 2011, Pandya came to a company experiencing its own rapid rise. Profits grew by 89% a year, from £2.1m in 2006 to £14.4m in 2009. Between 2009 and 2010, revenues increased from £40.2m to £55.5m, demonstrating a compound annual growth rate of 40% over the prior two years – supported by a growth in its customer base of 48%, which now stands at more than 21 million account holders.

More important, however, is that both Pandya and Knowles are looking to take private companies public.

Pandya is probably more patient than most when it comes to going public. He has had to be. Skrill has already had to abort a listing attempt in the past because of adverse market conditions. He concedes that the appetite in Europe is not good, yet he is strangely optimistic about the chances for the tech sector.

“For IPOs, the whole of Europe is still shut and I can’t see it opening up until the back end of the year. There is a general risk aversion among funds. But I expect to see a number of tech companies coming to market [in the US] in the coming weeks,” says Pandya.

Knowles hasn’t had the tempering experiences of Pandya, but nor is Mind Candy in any rush to go public. Yet she is open about the company’s intentions and has been looking with a great deal of interest at how tech companies that have come to market have performed in the past. Listening to Knowles, you could be forgiven for thinking that a hype bubble is indeed inflating.

“I don’t really believe in tech bubbles. When you look at big tech companies trading at good price-to-earnings ratios, there is a stable tech base there,” she says.

“When you look at series A round of investments [a class of preferred stock sold to investors], you might think they have been overinflated, but they have come in at fair valuations. You have to take that into consideration.”

And there are success stories of non-social media internet companies going public from which Pandya and Knowles can take heart. Online travel site TripAdvisor is one such company. Originally part of Expedia – with which it still enjoys a fruitful relationship – the company was spun out and listed on NASDAQ in December last year.

The figures are impressive. Since its listing on 7 December, the site’s share price has appreciated by 37.5%. For Julie Bradley, CFO of TripAdvisor, the volatility inherent in the internet space has been a plus.

“We’ve been rewarded with a kind of upward volatility. Our trend line has gone up since we spun out from Expedia,” explains Bradley. “TripAdvisor is a little bit different from some of the IPOs that we’ve seen. We’re definitely a high-revenue grower. We’re in the social media community space, but we are very profitable. We don’t have any peers that have the same kind of profit profile.”

$100bn question

Battered and bruised Facebook may be, but its valuation, which still tops $70bn, is not bad by any stretch, particularly given that it has yet to nail how to effectively monetise the undoubtedly vast potential of its massive customer base.

With more than 850 million active monthly users worldwide, Facebook’s valuation would start looking like a very good value bet for any investor if only these users’ wallets could be prized open.

“The reason they get such a huge valuation is they have so many customers. All you need to do is sell them stuff. It’s like having a high-street shop that can guarantee 10,000 customers coming through the door,” says PwC’s Sarai.

The problem for Facebook is making sure these customers leave with something. With 80% of its revenues derived from advertising sales, the concern is that advertisers haven’t yet decided whether they can make money from buying ads on the site. More worrying is the fact that Facebook’s advertising on a per-user basis is shrinking.

Unlike Google, where visitors are actually using the site with so-called purchasing intent, Facebook – and other free-to-use, non-purchase-orientated tech companies – cannot rely on advertising as a driver of long-term value. However, the model has been successful for some, and still can be for Facebook, says Coker at MMC Ventures.

“There are some very big companies that have shown that, if you get your advertising model right, you can become a very valuable company. Someone like Facebook has the potential to get to that point if it can get monetisation right through advertising,” he explains.

However, many companies continue to believe advertising is the route when, in fact, it isn’t. As an investor observing the market, Coker says it comes down to making sure that a company is measuring the right metrics.

“Companies that aren’t generating revenue from a big base could be using what I call vanitisation metrics: users signing up and not visiting again. You have to make sure you are not getting lost on poor valuations and get real,” he continues.

TripAdvisor is a good example of how traffic can be successfully converted into revenue. According to Bradley, about 15% of the company’s revenue comes from traditional display advertising, but the bulk of its revenue is derived from qualified lead generation.

“Close to 80% of our revenue comes from an engaged traveller that says, ‘Yes, I want to see if this hotel is available’, and actually proactively checks those rates – and then we pass those leads onto online travel agents, or large chains. So it’s where our customer base is looking for profitable leads, and with high conversions, and that’s exactly what we’re passing to them. So as long as the quality of our traffic remains high and we have an engaged user community that’s looking for a place to stay, we will see revenue continue to grow,” she explains.

Making money

Finding ways to successfully monetise a popular product is something with which tech companies have been wrangling for some time. In the cases of many products, the consumer has been accustomed to getting something for nothing.

According to Sarai, this is a problem for which a solution has yet to be found. “It is like having a great car but not being willing to put petrol in it,” she says.

“It is generally recognised that you can’t rely on advertising for revenue share – compared to years ago. You have to look at other ways to monetise it. The problem with some of these tech companies that are emerging is that their revenue models are not very clear. How you make money needs to be very clear.”

Sarai says investors need to be given confidence that the business will generate cash, and early-stage tech companies should not “just hope and believe” they have a good product.

Interestingly, Knowles at Mind Candy says building a stable business with a great product should come first.

“If you build a great product with a gap in the market, then revenue will come. Build a great product for people and all the rest should follow through,” she says, adding that the key to generating revenue and building stability is diversification of revenue streams.

“Make sure your business idea is diversified in terms of revenue streams. Moshi is a subscription model. We sell time cards, consumer products and we have mobile, so we have many different mobile streams coming in.”

Meanwhile, Pandya at Skrill makes a very similar argument.

“We get zero revenue from advertising revenue. Our focus is on transaction revenue. We are looking at product diversification and geographic diversification. We are looking at wider market spreads across entertainment, digital and retail,” he says.

It seems that it is only a matter of time before Pandya and Knowles realise their listing ambitions. But for Knowles, going public should be a consequence of success, not the driving force behind it.

“It’s good to have an exit in mind but you shouldn’t build your business with that as the only goal. You need to have a solid business strategy at an early stage in the business’ life cycle,” she says. ?