Opening the Box on Tech Stocks' Next Move
Silicon Valley has been dining out for more than a year on Wall Street's bottomless appetite for growth stories. Like all feasts, though, the bill eventually comes due.
Recently, it has been the cool rich youngsters picking up the tab. The bruising stock selloff over the last month has targeted newer tech firms with hip terms like "cloud," "big data" and "social" in their business plans. Tech's old-timers, which have lagged behind the market over the last year despite actual profits and positive cash flow, have found themselves in favor once again.
How long "value" will be in vogue is the big question. Clues to the answer may be found in the IPO market.
The tech sector has seen many selloffs in the past, but most have been blips. The Nasdaq Composite is down about 5% over the last month, but has seen short-term drops of about 10% on at least four occasions over the last five years. In those instances, the losses were erased in a matter of weeks in a bull market that pushed the index to a 14-year high by early March.
Still, there are eerie parallels with the tech bubble. Structural shifts are upending older business models. Richly priced initial public offerings and buyout deals for companies with limited operating history and zero profit abound. Paper wealth has sparked price wars for real estate and other trappings in San Francisco and other cities.
But the sector hasn't moved in lock step, with a marked split between the young upstarts and the fogies. The Nasdaq Internet Index—down more than 12% over the last month—is still up 46% over the past year. Similarly, companies such as Splunk and ServiceNow, down 28% and 20% respectively over the past month, are still up 57% and 48% in the past year.
Conversely, mature tech companies such as Cisco, IBM and Oracle that have found favor over the past month are still lagging behind the Nasdaq Composite's 12-month gain of 28%. Even Apple has been left out in the cold, with a Nasdaq-trailing 23% gain over the last year.
Any sympathy for the growth stocks taking a beating should be tempered by a look at valuations, though. Workday, which provides cloud-based software for human-resource management, has an enterprise value of 17.6 times forward sales. Its two largest competitors, Oracle and SAP, sport multiples of less than four times. And this is after Workday's shares dropped nearly 20% in the past month.
Tableau Software, which provides cloud-based data-analysis tools, still trades at 13 times forward sales despite its stock having shed nearly 30% since peaking in late February. The stock also trades at more than 200 times forward cash flow, according to FactSet, against about 17 times for Google.
The willingness of the public market to continue bestowing high valuations on young companies that often lack profits will offer the biggest clue as to whether the recent selloff is a blip or something bigger.
So investors should watch the IPO market closely. This has been frothy: The first three months of 2014 saw 64 companies raise $10.6 billion in the U.S., making it the busiest first quarter since 2000, according to Renaissance Capital.
The tech sector saw 15 deals, raising $2.4 billion, according to Dealogic, making it the best first quarter for the sector since 2004. Barely into the second quarter, another $2 billion has been raised already. And the pipeline is packed: 103 companies submitted their initial IPO filings during the first quarter.
One IPO to watch in particular is that of Box, which provides cloud-based data storage services to businesses. Its initial filing on March 24 showed breakneck revenue growth of 111% for the fiscal year ended Jan. 31. But it also disclosed growing net losses, with sales and marketing costs alone outpacing revenue for every period in its reported history. Box may set its pricing terms as early as this week and could complete the deal before the end of the month.
If Box's debut hiccups, it would suggest the IPO market's capacity to digest highly valued, unproven tech stocks is waning—which could have a cascading effect through Silicon Valley.
Venture-capital investors use IPOs as a key source of cashing out on their tech investments. Nearly two-thirds of the listings in the first quarter were by venture-backed companies.
Venture-capital firms invested $29.4 billion in 2013, up 7% from the prior year, according to the MoneyTree Report from PricewaterhouseCoopers and the National Venture Capital Association. More than 60% of those funds went to Internet and software ventures that are landing fat premiums in their own right. At least 20 firms funded over the last 12 months now have valuations exceeding $1 billion, according to research by The Wall Street Journal.
A blockage in the IPO channel could force venture funds to take a breather of their own, in turn reinforcing a sense that valuations have gotten out of hand. At that point, many investors might decide to really push back from the table.