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Lazard Insights

Are Silicon Valley Valuations in the Clouds?


Bret Miller, CFA, Vice President, Research Analyst

Summary
Media coverage and investor appetite for growth in
the technology sector has intensified, leading some
individuals to reflect on bubble-like developments.
Some signals of enthusiasm include the steady
increase in the number of merger-and-acquisition
(M&A) transactions within the software and
internet industry since 2009, a recent upturn in
venture capital investment in 2014, and stong IPO
performance.
On the other hand, many indicators are nowhere
near the extreme activity of the prior tech bubble in
the late 1990s/early 2000s, while fundamentals and
valuations of the technology sector remain healthy
in the aggregate.
We are in the middle of a generational platform
shift toward the mobile/cloud era. Many investors
are seeking to capitalize on opportunities related
to this trend, thereby driving some valuations up.
While we continue to evaluate these disruptive
players, we are still finding many compelling
opportunities in other technology companies,
primarily those with strong balance sheets,
profitability, and consistent revenue growth.
Lazard Insights is an ongoing series designed to share valueadded insights from Lazards thought leaders around the
world and is not specific to any Lazard product or service.
This paper is published in conjunction with a presentation
featuring the author. The presentation can be accessed via
www.LazardNet.com.

The Current Landscape in the


Technology SectorEvidence and
Narratives on the Bubble Debate
Recent headlines and quotes from key market participants, including US Federal Reserve Chair Janet Yellen, suggest that many in the
investment community believe we are once again in a technology
bubble. It seems like there is a story every other day about Silicon
Valleys latest startup that is going to change the world. We are constantly reminded about the quintessential twenty-something-year-old
entrepreneur that started his company in his dorm room and became
instantly rich through an IPO or by selling to Facebook or Google.
Do the concerns of a tech bubble have merit?
There are certain market indicators that give some credibility to the
discussion of a tech bubble. The availability and deployment of venture capital investment has increased significantly over the last year.
The number of M&A transactions within the software and internet
industry has steadily increased since the market bottomed in 2009,
as larger technology companies have used their balance sheets and
cash flow to invest and acquire growth and innovation (Exhibit 1).
For the most part, post-IPO performance has been solid as investors
have purchased many of the newer high-growth companies, even if
they have yet to execute on delivering profitability, cash flow, or even
market leadership.

Exhibit 1
Renewed M&A Activity in Internet and Software Industries

Exhibit 3
Startup and IPO Valuations, 2014 Transactions

Deal Count
300

($B)
168
30
IPOs
238

240

Capital Raise

24

Acquisition
18

Internet

194
12

180

2012

2013

2014

Airwatch

Trulia

Oculus

GrubHub

GoPro

Square

Palantir

Dropbox

Airbnb

OpenTable

2011

Nest Labs

2010

Pinterest
Arista
Networks
Cloudera

2009

Snapchat

60
2008

Uber

WhatsApp

120

Alibaba

Software

As of 19 September 2014

As of 31 July 2014

The securities mentioned are not necessarily held by Lazard for all client portfolios,
and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these
securities was, or will prove to be, profitable.

Source: Bloomberg, Lazard

Source: Bloomberg, Deutsche Bank, company filings

Exhibit 2
The Valuation Gap Appears to Be Widening in the Technology
Sector
Valuation and Revenue Growth, Russell 3000 Index Technology Sector
EV/Sales

(%)

20

60

15

40

10
20
5
0

0
2009

2010

2011

2012

2013

2014

Median EV/Sales of Top 15 Most Expensive Tech Stocks [LHS]


Median EV/Sales of All Tech Stocks in the Russell 3000 Index [LHS]
Median Revenue Growth of Top 15 Most Expensive Tech Stocks [RHS]
As of 26 August 2014
Source: Bloomberg

Valuation multiples, for a narrow part of the technology market, may


appear stretched. For example, the median enterprise-value-to-sales
(EV/sales) multiple for the fifteen most expensive tech stocks in the
Russell 3000 Index has expanded significantly over the last few years,
going from just over 5 times EV/sales in the depths of the recession
in 2008 to over 14 times today. Relying on this same multiple, we
observe the gap between the fifteen most expensive stocks and the
median of all technology stocks in the Russell 3000 Index continues
to widen. Clearly investors are paying a significant premium for this
cohort of companies. However, one reason that may explain why
multiples have expanded is that the revenue growth rate for the most

expensive companies has steadily accelerated from the 20% to 30%


range a few years ago, and has now ramped up growth to the 50% to
60% range (Exhibit 2).
This year, many tech startups have gone public or have received
venture capital infusions, while others have been acquired, and many
of these transactions have resulted in multi-billion dollar valuations
(Exhibit 3). Some of the highest profile deals, including Ubers recent
capital raise at an $18 billion valuation and Facebooks acquisition
of WhatsApp for roughly $18 billion, both of which have limited, if
any, profitability, are examples of where valuations may have become
somewhat excessive. In the current macro environment, where GDP
growth remains rather tepid, some investors may be paying up for
exposure to disruptive and high-growth companies because they have
large market opportunities and are driving high levels of revenue and
user growth. In addition, many investors have an appetite for the
option value if these companies can execute on their vision.

Todays Technology Environment


Stands in Stark Contrast to the Prior
Bubble
Despite the aforementioned indicators, we believe todays environment is drastically different than the time before the dot-com bubble
burst in the late 1990s/early 2000s. Current levels of venture capital
and IPO activity are well below those during the last bubble (Exhibit
4). While valuations for private and recently-public high-growth,
innovative companies have picked up, we are nowhere near the excess
exuberance of the past. Companies that are going public today are
more mature. On average, companies in recent IPOs are also much
larger in terms of revenues and profitability. The median sales level for

Exhibit 4
Venture Capital Financing and Global Technology IPO Issuance Are Well Below 19992000 Levels
Number of US Companies receiving VC Financing

6000

5,476
50% Lower

4000
2,746

2000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Number of Global IPOs
400
310

300

87% Lower

200
100

41

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Thomson ONE, Morgan Stanley Equity Capital Markets. Data per Dealogic, Bloomberg, and Capital IQ

Exhibit 5
Comparison of IPO Characteristics, 19992000 versus 2013

Median Company Age (years)


Median Sales ($M)

19992000

2013

12

17

91

28

63

18

77

49

Percentage of Companies Earning Revenuesa


Over $50 million (%)
Over $1 billion (%)
Percentage of Companies with Negative EPS

Exhibit 6
Technology Fundamentals Are Attractive in the Aggregate
S&P 500 Index
Technology Sector
December December
1999
2007

S&P 500
Index

August
2014

August
2014

Valuation

a Revenues adjusted to 2005 purchasing power


Source: US IPO database of Dr. Jay Ritter, Cordell Professor of Finance, University of
Florida

P/E , CY
Gross Margin (%)

When evaluating the fundamentals and valuations of the broader


technology industry in aggregate, the sector remains very healthy and
attractive relative to prior cycles and the rest of the market. Exhibit 6
shows the price-to-earnings (P/E) multiples, profitability, and balance
sheet strength of the technology companies within the S&P 500 Index
today and at prior peaks. Clearly, all of these metrics are much more
attractive currently than in past environments. As one can see, todays
technology sector generates higher levels of profitability, as measured
by margins and return on equity (ROE), and has stronger balance
sheets holding more cash and less debt. In addition, when compared

22.2

16.7

16.7

40

43

52

42

Profitability and Returns


EBITDA Margin (%)

20

20

31

20

ROE (%)

21

18

24

15

Balance Sheet
Cash/Market Cap (%)

recent IPOs has been $91 million, more than 5 times the size of the
median sales of IPOs in 19992000. Other key metrics highlighting
this divergence are shown in Exhibit 5.

64.7

Debt/EBITDA

11

13

0.9

0.9

0.8

1.9

As of 28 August 2014
Source: Lazard, Bloomberg

to the S&P 500 Index as a whole, the valuations of the broader technology sector are currently in line with the benchmark.
While there may be some signs of stretched valuations within the
startup market and recent IPOs, we believe the data show that
any potential froth in the market would be narrow in scope, as the
broader investable technology universe remains solid with attractive
valuations and strong fundamentals.

What Secular Forces Potentially Justify


the Higher Startup Valuations?
A Paradigm Shift Toward Mobile and Cloud
We believe we are in the midst of a generational shift in technology
platforms. To put this change in context, note that the computing and
application architectures have only shifted a few times over the last fifty
to sixty years. Computing began with the mainframe. Then the client
server model gave birth to the personal computer (PC) which expanded
the availability and affordability of computing to hundreds of millions
of people and thousands of packaged software applications. Companies
like Intel and Microsoft built tremendous businesses on this clientserver
model and during the PC era. Now, we are in the middle of a platform
shift to the mobile and cloud era (Exhibit 7). Mobile and the cloud
are expanding the accessibility of computing and connecting billions
of peopledisrupting the information technology (IT) landscape. We
believe the next Microsofts and Intels are being built during this transition.

Why Does Mobile Matter?


The adoption rate of mobile has made it one of the most pervasive
technologies ever invented. There are more than 6 billion mobile
handsets in use across the world, which is a staggering number when
compared to the number of people who live in homes with electricity
(5.9 billion), or have bank accounts (3.5 billion) or PCs (1.5 billion). Today just about 2 billion of those 6 billion handsets in use are
smartphones with internet connectivity.1 Over time, however, the vast
majority of handsets will become smartphones.
The growth of smartphones is expanding internet access and enabling
new types of mobile services and applications. Among the early beneficiaries of this mobile transition has been the smartphone hardware
market. As smartphone suppliers have rode down the cost curves on
components, the price of low-end smartphones has moved well below
$100. This has driven the smartphone market to over 1 billion units
a year, an unmatched scale against any other hardware segment. To
provide a sense of that scale, the 1 billion plus smartphone shipments
per year compares to the PC markets less than 400 million units.2

Apple, Samsung, and Googles Android dominate the profit pools


within the smartphone market, as these are the companies with the
most scale, as well as control over the two leading operating systems
and app stores on which smartphones rely. Along with all the value
they have created over the last five years, the companies have indirectly
destroyed a lot of the value from historical players in the handset industry like Nokia, and threaten much of the value in the PC industry.
The internet is literally in peoples pockets for the first time, and
therefore application developers are shifting their focus and innovation towards mobile, and away from PCs. Mobile is enabling new
types of applications and services that were previously not possible
and this is transforming business models across many industries. For
example, location-based services have created the opportunity for
companies like Uber to disrupt transportation business models, and
the information security industry has been forced to evolve and create
new solutions to deal with the new types of risks and threats with
mobile devices. The emergence of the casual smartphone gamer has
expanded the total addressable market for the video game software
industry by a multiple of more than 5 times. However, mobile has also
introduced many new competitors with much lower barriers to entry
and partially cannibalized the core console-based gaming market.
And in the financials industry, the entire payments ecosystem is now
changing with the mobile wallet.
The digital advertising industry is seeing some of the largest expansion
opportunities driven by mobile. For years, it has been discussed that,
in theory, internet advertising expenditures should grow rapidly to
catch up with how much time consumers were spending with internet
media. This is exactly what has happened as roughly 25% of consumers media time spent now occurs on the PC-based internet closely
matching the 22% of total advertising expenditure. This framework also
applies to mobile, where consumers currently spend 20% of their time,
and yet where only 4% of advertising budgets have shifted (Exhibit 8).
This dynamic has created opportunities for companies like Facebook,
Twitter, Google, and Yelp among many others to capture and grow
those advertising dollars.

Exhibit 7
A Generational Shift in Technology Platforms

Mainframe

Client-Server

Thousands of Users
Hundreds of Apps

Millions of Users
Thousands of Apps

This information is for illustrative purposes only.


Source: VMWare

Mobile-Cloud

Billions of Users
Millions of Apps

private data centers given the sensitivity of data and years of historical
investment in their own infrastructure.

Exhibit 8
The Mobile Advertising Gap
(% of Total)
50

Time Spent
Ad Spend

40
30
20
10
0

Print

Radio

TV

Internet

Mobile

As of 31 December 2013
Data are for the United States only.
Source: KPCB

The Cloud Is Transforming IT Infrastructure


The cloud is a fundamentally different method to host, deliver,
and pay for IT. Using the cloud makes IT akin to buying a service,
instead of enterprises having to build, operate, and manage their own
physical data centers. Traditionally, an enterprise would own and
operate all the pieces of the technology stack within their data center.
Today, with the public cloud, companies have the option of outsourcing their whole technology stack to a cloud vendor. The vendor
will host the companys applications along with other customers
applications in their massive virtualized data center. These applications are delivered and accessed over the internet, in a pay-as-you-go
model. In reality, most companies will likely use a hybrid approach,
putting some applications in the cloud, while keeping others in their

So why are we seeing such strong adoption of cloud-based IT? We


believe the cloud is an improved IT model for most businesses.
With the cloud, applications are faster to implement and easier to
use. Cloud vendors are able to provide continuous innovation and
feature improvements instead of forcing users to go through difficult
upgrades. The economics are more favorable; instead of large upfront
purchases of servers and software, IT becomes a flexible variable cost
based on cloud usage. Importantly, the cloud allows companies to
focus on running their core business, rather than dealing with the distractions of operating IT departments.
The market opportunity for cloud vendors is massive. Over $900
billion a year is spent on hardware, software, and IT implementation and outsourcing services. This pool of expenditures represents
the latent opportunity for cloud vendors to capture and disrupt the
transition from traditional IT to cloud-based solutions. According
to a survey of Chief Information Officers, 10% of their application
workloads run in the cloud today, and are expected to grow to 18%
by the end of 2015.3

Evaluating High-Growth, but Optically


Expensive Companies
As discussed earlier, some of these high-growth, recently public technology companies appear expensive according to traditional valuation
metrics. However, we believe many of these young companies are
investing significantly to drive growth, which obscures the underlying
profitability of their existing installed customer base. Therefore, when
we value these companies, we separate the analysis into two parts.
We first evaluate the existing customer base on their underlying
contribution margin and renewal rates. Then we value future growth
by examining the growth of new business and new customers, the

Exhibit 9

Analyzing the Drivers of Underlying Operating Margin


A Hypothetical Cloud Software Company,
Margin Profile

Analyze the Business in Two Parts:


Existing Customer Base Underlying Margin and Customer Acquisition Costs

Figures as Share of
Total Revenue (%)

Figures as Share of
Total Revenue (%)

Revenue

100

Revenue

100

COGS

25

COGS

20

Gross Margin

75

S&M

40

R&D
G&A
Operating Margin

Gross Margin

80

S&M

15

R&D

10

G&A

10

Underlying Operating
Margin

Figures as Share of
Total Revenue (%)

Revenue, year one

COGS

Gross Margin

-5

S&M

35

15

R&D

10

G&A

50

Customer Acquisition
Costs

0
-40

A portion of COGS is tied to implementation costs of new customers.


The majority of S&M is tied to customer acquisition costs, with limited S&M needed to renew existing customers.

This information is for illustrative purposes only.


Source: Lazard

sales and marketing cost to acquire those customers, and the ultimate
contribution margin of the customers after they have been acquired.
Finally, we use scenario analysis to understand the sensitivity of valuation to key metrics such as renewal rates, underlying contribution
margin, new customer growth, and the cost to acquire those new
customers.
Exhibit 9 illustrates the philosophy behind this valuation framework. A
hypothetical cloud software company might only have 10% operating
margins today, and therefore looks expensive on any valuation multiple
of their earnings. But once we separate that income statement into two
parts, the existing customer base and customer-acquisition costs, we
can then see that the underlying contribution margin of the existing
business is often much higher at 50%. This example shows that the
majority of the sales and marketing (S&M) costs and some of the cost
of goods sold (COGS) are used to drive new customer acquisition, and
actually do not support the existing business. This analysis allows us to
evaluate the entire customer lifetime value, giving us more confidence
in the long-term future profitability of a business.

Conclusion
Technology fundamentals are compelling and appear favorable when
compared to the market as a whole. These valuations are nowhere near
the extremes of the late 1990s. However, we are in the middle of a
powerful platform shift from a PC and clientserver era, to a mobile/
cloud era. To the extent a bubble exists, it would be much narrower
in scope, as some investors are aggressively seeking companies that are
taking advantage of these new secular trends, which will only grow
in size and importance over time. There will be some winners, as well
as many losers who are not able to execute on the opportunity in this
highly innovative but competitive space.
We believe investors recognize this opportunity and are paying a
premium to place option-like bets on potential winners. We continue
to gain a broad and deep understanding of mobile and cloud trends in
order to appreciate industry implications. We plan to continue evaluating the full range of technology investment opportunities using our
investment process, which focuses on future returns, valuation, and
scenario analysis. While we have currently found some opportunities
in pure plays levered to the mobile and cloud trends, we are also seeing
very good risk/reward in many technology companies that feature sustainable recurring revenue growth, high levels of profitability, strong
balance sheets, improving capital allocation, and attractive valuation.

Notes
1 Source: Mobile Future Forward. As of September 2012.
2 Source: Gartner (analysts: Mikako Kitagawa, et al.) Market Share: Devices, All Countries, 1Q14. 23 May 2014
3 Source: Gartner (analysts: Ken Newbury, et al.) Gartner Market Databook, 2Q14 Update. 23 June 2014; Morgan Stanley January 2014 CIO Survey.

Important Information
Originally published on 24 September 2014. Revised and republished on 25 September 2014.
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