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Beware Of Those Selling “Technology”

“3. And they said to one another, ‘Come, let us make bricks, and burn them thoroughly.’ And they had brick for stone, and bitumen for mortar. 4. Then they said, ‘Come, let us build ourselves a city, and a tower with its top in the heavens, and let us make a name for ourselves; otherwise we shall be scattered abroad upon the face of the whole earth.’” Genesis 11:3-4 (NRSV)

Technology

Technology can be thought of as the development of new tools. New tools enhance productivity and profits, and productivity improvements afford a rising standard of living for the people of a nation. Put to proper uses, technological advancement is a good thing; indeed, it is a necessary thing. Like the invention of bricks and mortar as documented in the book of Genesis, the term technology has historically been applied to advancements in tangible instruments and machinery like those used in manufacturing. Additional examples include the printing press, the cotton gin, and the internal combustion engine. These were truly remarkable technological achievements that changed the world.

Although the identity of a technology company began to emerge in the late 1930s as IBM developed tabulation equipment capable of processing large amounts of data, the modern-day distinction did not take shape until 1956 when IBM developed the first example of artificial intelligence and machine learning. At that time, a computer was programmed to play checkers and learn from its experience. About one year later, IBM developed the FORTRAN computer programming language. Until the early 1980s, IBM was the dominant tech company in the world and largely stood as the singular representative of the burgeoning technology investment sector.

The springboard for the modern tech era came in 1980 when the U.S. Congress expanded the definition list of copyright law to include the term “computer program.” With that change, software developers and companies like IBM involved in programming computers (mostly mainframes at that time) had a legal means of preventing unauthorized copying of their software. This development led to the proliferation of software licensing.

As further described by Ben Thompson of stratechery.com –

This highlighted another critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful.

To summarize: venture capitalists fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

Everybody is a Tech Company

Today, every company employs some form of software to run their organization, but that does not make every company a tech company. As such, it is important to differentiate real tech companies from those that wish to pose as one. If a publicly traded company can convince the investing public that they are a legitimate tech company with scalability at zero marginal cost, it could be worth a large increase in their price-to-earnings multiple. Investors should be discerning in evaluating this claim. Getting caught with a pretender almost certainly means you will have bought high and will be forced to sell low.

Pretenders in Detail

Ride share company Uber (Tkr: UBER) went public in May 2019 at a market capitalization of over $75 billion. Their formal name is Uber Technologies, but in reality, they are a cab company with a useful app and a business producing negative income.

Arlo Technologies (Tkr: ARLO) develops high-tech home security cameras and uses a cloud-based platform to “provide software solutions.” ARLO IPO’ed at $16 per share in August 2018. After trading as high as $23 per share within a couple of weeks of the initial offering, they currently trade at less than $4. Although the Arlo app is available to anyone, use of it requires an investment in the Arlo security equipment. Unlike a pure tech company, that is not a zero marginal cost platform.

Peloton (Tkr: PTON) makes exercise bikes with an interactive computer screen affording the rider the ability to tap in to live sessions with professional exercise instructors and exercise groups from around the world. Like Arlo, the Peloton app is available to anyone, but the experience requires an investment of over $2,000 for the stationary bike. PTON went public in September 2019 at the IPO price of $29 per share. It currently trades at roughly $23.

Recent Universe

From 2010 to the end of the third quarter of 2019, there have been 1,192 initial public offerings or IPOs. Of those, 19% or 226 have been labeled technology companies. Over the past two years, many of the companies brought to the IPO market have, for reasons discussed above, desperately tried to label themselves as a tech company. Using analysis from Michael Cembalest, Chief Strategist for JP Morgan Asset Management, we considered 32 “tech” stocks that have gone public over the past two years under that guise. We decided to look at how they have performed.

In an effort to capture the reality that most investors are not able to get in on an IPO before they are priced, the assumption for return calculations is that a normal investor may buy on the day after the IPO. We acknowledge that the one-day change radically alters the total return data, but we stand by it as an accurate reflection of reality for most non-institutional investors.

As shown in the table below, 23 of the 32 IPOs we analyzed, or 72%, have produced a negative total return through October 31, 2019. Additionally, those stocks as a group underperformed the S&P 500 from the day after their IPO date through October 31, 2019 by an average of over 35%.

Data Courtesy Bloomberg

Summary

Over the past several years, we have seen an unprecedented move among companies to characterize themselves as technology companies. The reason is that the “tech” label carries with it a hefty premium in valuation on a presumption of a steeper growth trajectory and the zero marginal cost benefit. A standard consumer lending company may employ technology to convince investors they are actually a new-age lender on a sophisticated and proprietary technology platform. If done convincingly, this serves to garner a large price-to-earnings multiple boost thereby significantly (and artificially) increasing the value of the company.

A new automaker that can convince investors they are more of a technology company than other automobile companies’ trades at many multiples above that of the traditional yet profitable car companies. Still, the core of the business is making cars and trying to sell them to a populace that already has three in the driveway.

Using the technology label falsely is a deceptive scheme. Those who fall for the artificial marketing jargon are doomed to sacrifice hard-earned wealth as has been the case with Lyft and Fiverr among many others. For those who are not discerning, the lessons learned will ultimately be harsh as were those described in the story of the tower of Babel.

It is not in the long-term best interest of the economic system or its stewards to chase high-flying pseudo-technology stocks. Frequently they are old school companies using software like every other company. Enron and Theranos offer stark lessons. Those were total loss outcomes, yet the allure of jumping aboard a speculative circus is as irresistible as ever, especially with interest rates at near-record lows. The investing herd continues to follow the celebrity of popular “momentum” investing, thereby they ignore the analytical rigor aimed at discovering what is reasonable and what allows one to, as Warren Buffett says, “avoid big mistakes.”

Today’s Melt Up Triggers Tomorrow’s Melt Down

Since November of 2016, the NDX has soared by 72% and is poised to break the recent all-time high of 8027. Today, it seems that sentiment is shifting back to selling bonds and buying riskier equities with hyped estimates. FAANG stocks have fueled an ongoing rally, via stock buybacks, non – GAAP financial gimmicky, and promises of eventual profitability for many unicorn startups.

Source: Stockcharts.com – 9/12/19

Sentiment has moved prices up as the market has suspended its disbelief of key fundamentals like future earnings, declining sales, job layoffs, contracting world trade, and negative cash flow.

First, let’s look at downward revised earnings forecasts for the rest of the year indicating a decline almost to a contraction level in the U.S.:

Sources: Bloomberg, IIF – 9/10/19

Analysts expect lower earnings and profitability due to declining sales. The pivotal function of any business is sales. The inventory to sales ratio is now at 2008 levels indicating that sales are declining while production is continuing, which is typical of the later stages in the business cycle:

Sources: The Wall Street Journal, The Daily Shot – 9/12/19

Continuing present production levels with flat to declining sales is unsustainable.  Executives are faced with declining sales overseas in part due to tariffs. As such, the number of production shifts must be reduced, as the highest cost for most businesses is payroll.  A key indicator of executives beginning to reduce staff is indicated by an increase in jobless claims in five key manufacturing states starting about when tariffs were first enacted in November of 2018:

Sources: B of A Merrill, Haver, The Wall Street Journal, The Daily Shot – 8/30/19

Markets are underestimating the devasting impact that broad tariffs are having on U.S. corporate sales.  S & P 100 corporations generally recognize from 50 – 60 % of total sales from overseas, and profits of 15 – 25 % or more from emerging markets like China and India.  When tariffs hit U.S. products, there is a cascading effect on small businesses, and throughout the worldwide supply chain. Even if a product is produced domestically, many of the sourced parts come from several emerging markets which now face tariffs. China’s tariffs on U.S. farm products like soybeans have reduced sales by 90 %.  Soybean farmers are looking for new markets, but are having a difficult time replacing the massive purchases that China makes each year.  Tariffs are culminating sales headwinds and investment uncertainty at the fastest rate since 2008.

Sources: CPB World Monitor, The Wall Street Journal, The Daily Shot – 9/11/19

In the midst of all these economic and business headwinds, executives should be running tight finances, right?  Well, not exactly. Due to a surge in debt issuance, corporations now have the highest debt to GDP ratio in history.  However, they may not have learned about how to keep out of financial trouble.  S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

Source: RIA PRO (www.riapro.net) Chart of the Day -9/10/2019

Unicorn IPO valuations are off the chart, many with unproven business models and large losses. 2019 has seen the highest value of IPOs since 2000, an indicator of high interest in risky investments and soaring investor sentiment. Not surprising, 2019 has the highest number of negative earnings per share IPO companies since 2000 as well.

Sources: Dealogic, The Wall Street Journal, The Daily Shot – 6/18/19

Sources: Jay Ritter, University of Florida, The Wall Street Journal – 3/16/18

The lack of profitability and the number of IPOs ‘to cash out before it’s too late’ evokes memories of the 2000 Dotcom Crash.  Then, investors were looking for ‘high tech growth’ stocks, and as it was assumed that companies would figure out their business model later. 

When?  As an example, Uber just recorded a $5.24 billion loss for the 2nd quarter of 2019.  Lyft lost $644 million in the same quarter.  Despite the popularity of their services, the business models for both ride-sharing companies has yet to be proven. Making profitability even harder for these companies, the State of California legislature just passed a bill recognizing ride-sharing drivers as employees and not contractors. Gov. Gavin Newsom is expected to sign the legislation.  If Uber and Lyft have to pay salaries, benefits and other costs for full-time employees they will incur staggering costs, and may likely never be profitable.  Uber says it is building a ‘transportation platform’ where drivers are delivering food and packages not transporting passengers so they can avoid being labeled a passenger transportation company.  Both firms are planning to put an initiative on the ballot to declare their drivers as contractors to save their business models.  It is still unclear, even with drivers being recognized as contractors, that they have viable business models. Yet investors just didn’t care at IPO time, though both stocks have since dropped in price dramatically since their IPO dates. Ride sharing is just one small industry and one example. There are many other unicorns with questionable businesses that are flourishing in the markets.

The suspended disbelief we see today is similar to the sentiment that sent the NDX up nearly 400% just before the Y2K crash.   We can learn from what happened beginning 20 months before the Y2K crash.  The NDX started in October of 1998 at 1063 and peaked at 4816 in May of 2000:

That astounding move up was followed by a roller coaster ride down to 2897 for a 38 % decline by May of 2000, followed further by a two year decline to 795, or 84 % decline from the 2000 peak.  The NDX would not reach the 4816 level again for another 16 years!  Investors had to wait a long time just to break even.

One similarity to the Y2K related drop in sales we see today is from tariffs. Companies have pulled purchases forward to avoid tariffs. Similar activity occurred in 1999 as IT departments bought new software and hardware to solve a possible year 2000 (Y2K) software bug. Software and hardware purchases were pulled forward into 1999, then as one IT manufacturer CEO put it ‘the lights went out on sales.’  The hard dates for tariff increases a year ago forced corporations to pull up purchases that would otherwise be made later in the year, resulting in an unnatural boost followed by a contraction of business activity.

Consumer products will be hit with 15 % tariffs in October and 25 % in December, so consumer, like businesses, are likely moving up their purchases. We expect consumer spending to show increases in August, and September, and decline after that.  A contraction in consumer business operations is likely to follow pulled up consumer purchases.

Plus, investors need to be cognizant of the huge transformation of the world trade infrastructure into two competing trade blocks triggered by the trade war by the U.S. and China as discussed in my post: Navigating A Two Block Trading World. The forming of two trade blocks will change the character of world trade, and therefore create uncertainty in international sales for all businesses dependent on overseas customers to maintain growth and profitability.

Today, sentiment is set in suspended disbelief that ‘the Fed will cut rates’ and make the economy grow.  Corporations are swimming in low-cost debt, with negative cash flows and flat to falling sales.  If the Fed governors pick up an attaché case with a sales pitch and get sales going again then the Fed might have an impact on corporate profitability. Yes, cheap money may help stave off layoffs or cost reductions, but in the end businesses will have to cut costs to match new lower sales levels.

The market ‘hopes’ that a trade deal will revive the economy as well.  An ‘interim’ trade deal where China gives up very little except a commitment to purchase agriculture and livestock products in return for a suspension of increased tariffs won’t change the broad-based tariff damage to the economy.  Unless broad-based tariffs are ended, as 1,100 economists recommended in a letter to the Trump administration 18 months ago, the hemorrhaging of sales will continue.

So what can we learn from today’s investor sentiment compared to sentiment observed during the Dotcom crash?  When the market finally ends its disbelief and is hit with the reality of business fundamentals, the decline will be fast and deep. The melt up, or whatever is left of it, will trigger a melt down.  The 4:1 return difference in the 2000 melt up versus today’s melt up today is likely due to the 4.7 % GDP rate in 1999 versus the forecasted 1.7 % GDP forecasted for 2nd quarter this year.  In 2000, the economy was simply growing a lot faster than today, and productivity was rapidly growly. This helped sentiment and provided some basis for the melt up.  Further the melt up in 1999 was fueled by the Fed providing excessive liquidity to help ensure that Y2K did not shut down the economy.

The current melt up is occurring at a much lower level of economic activity. Yet, both instances are based on a disconnect between what is happening in the economy and the valuations of stocks. The longer the disconnect with fundamentals, the longer it will take for the reversion to the mean to rebalance the economy. Plus, the further the disconnect the larger reversion to the mean or even an overshoot and it will take longer to get back to ‘even’ – maybe 16 years from the peak as we saw in Dotcom Crash in 2000.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.