"In Silicon Valley, it seems that business plans – a narrative of how one intends to make money – are... far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses" bewailed legendary investor Seth Klarman in 2014, pointing to the "nosebleed stock market valuations of fashionable companies" and saying in a letter to investors in his Baupost Group fund that "the Fed’s continuing stimulus and suppression of volatility" was to blame for triggering a "resurgence of speculative froth."
If things were at nosebleed-levels in 2014, one can only imagine how Klarman felt in 2021 as price-to-earnings ratios reached fantasy money levels and companies like Rivian, an electric vehicle firm, reached $100 billion in valuation with effectively no revenue whatsoever. As the abrupt tumble in equities in recent weeks has shown, the Federal Reserve's move to tackle inflation by aggressively tightening monetary policy -- 14 years after the 2008 financial crisis precipitated a global experiment in what happens if you pump trillions into financial markets -- means things are changing dramatically. Technology investors are about to take a harder line on fundamentals.
“The Federal Reserve is going to be draining liquidity,” as David Lefkowitz, the head of US equities in UBS’s chief investment office recently put it: “It is those more speculative parts of the market that benefit the most when the Fed is adding liquidity and they [may] face some . . . headwinds when the Fed is going the other way."
Scores of technology companies are already worth a fraction of what they were valued at during their 2021 highs. A arbitrary snapshot by The Stack of five technology companies that have seen their shares fall.
- Cloudflare -- $211, down to $65
- Coupa -- $368, down to $77
- Peloton -- $154, down to $15
- SentinelOne -- $76, down to $26
- Snowflake -- $392, down to $155
(These precipitous falls don't necessarily reflect their fundamentals any more than their highs did. Cloudflare, for example, just reported Q4 revenue of $193.6 million, up a healthy 54% on-year; fiscal year 2021 revenue totaled $656.4 million, up 52% on-year, although net losses more than doubled to $260.3 million for the year...)
Uber CEO: "The goalposts have changed..."
Is much of the technology landscape "speculative"? There's certainly no shortage of companies that have long been operating at crazy valuations, without particularly impressive revenues and whose founders have never known anything other than a bull market and generous investors sitting on massive stockpiles of "dry powder".
Yet an abrupt change of mood is coming to the market and even the once-dirty "P" word (profit) is beginning to be bandied about by some. This week Uber's CEO Dara Khosrowshahi emailed employees about this changing landscape. As the letter, leaked to CNBC's Deidre Bosa noted: "We are serving multi-trillion dollar markets, but market size is irrelevant if it doesn't translate into profit... in times of uncertainly investors look for safety.
The Uber CEO added: "Channeling Jerry Maguire, we need to "show them the money". We have made a ton of progress in terms of profitability, setting a target for $5 billion in Adjusted EBITDA in 2024, but the goalposts have changed. Now it's about free cash flow. We can (and should) get there fast. There will be companies that put their heads in the sand and are slow to pivot. The tough truth is that many of them will not survive."
Fourteen years of quantitative easing and generally buoyant markets mean that there is still no shortage of capital sitting unallocated. Indeed in 2021, the dry powder of private equity companies reached $3.4 trillion, for example. Yet: "Given the high prices paid in 2021, there will inevitably be an increase in pressure on deal sponsors to deliver results this year,” said Hugh MacArthur, who leads Bain & Co's Private Equity practice.
“The chances of success are highest for firms with a long track record in a sector," he noted: "To drive returns during this high-wired time, it is critical that dealmakers fully understand the microeconomics of the sector, the value creation levers available to pull and the risks they’re under writing" he added in March 2022.
Technology companies that have known minimal pressure to-date from their owners can expect the goalposts to be rapidly readjusted this year. One CEO of a B2B technology that recently made a six-digit millions raise told The Stack this month that they were glad they had got in when they did: "We now have a five-year runway to get through this period and our investors believe we can thrive even as markets tighten. But if I were a founder who'd had the opportunity to raise at scale and chose not to, I'd be kicking myself right now."
"Welcome to 'The Truman Show' market" wrote Seth Klarman back in 2014. "In the 1998 film by that name, actor Jim Carrey is ignorant of the fact that his life is a hugely popular reality show. His every action, unbeknownst to him, is manipulated while being broadcast to millions of TV viewers worldwide. He seemingly lives in an idyllic seaside community where the manicured lawns are always green and the citizens are always happy. These people are, of course, actors. The world Truman inhabits turns out to be phony: a gigantic sound stage created for a manufactured “reality.” As Truman starts to unravel the truth, his anger erupts and chaos ensues... Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored, and markets go asymptotic. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding. What is fake cannot be made real."
It took eight years, but Klarman looks more prescient than ever as unconventional monetary policy starts, just starts, to unwind. What that means for the technology companies thriving on froth and buzzwords remains to be seen. But Jeremy Grantham, co-founder of huge asset management firm GMO also called out this "superbubble" in late 2021, warning that "we face the largest potential markdown of perceived wealth in US history"...
Technology vendors meanwhile should be aware that the tighter this market gets and the more the Uber CEO's warning about survival of the profitable starts to get very real, CIOs buying IT platforms and services may find themselves taking a harder look than ever at the likely longevity of their partners.
Fasten your seatbelt, Dorothy.