In my last article I began to examine the possibility that we are now in a bubble with serious consequences for investors. Referring to John Kenneth Galbraith’s 1955 book, The Great Crash 1929, I concluded we have now reached the point where a fear of ‘missing out’ has replaced fundamentals as the motivation for ownership for many technology stocks. Consequently, the boom has become a bubble and investors should be especially cautious this year.
The boom always starts with a sound reason for expecting growth but where the smart money invests at the beginning, the dumb money does at the end.
And when a corner of the market attracts capital more rapidly than is justifiable by the profitable deployment of that capital, a mis-allocation occurs, and insane and patently unsustainable valuations emerge.
In Australia, the corner of the market that seems to have attracted capital most rapidly is the corner occupied by those companies that have used software or reinvented business models to grow rapidly overseas. The presence or absence of a profit has not distinguished this group known by the acronym WAAAX.
Wisetech, Afterpay, Altium, Appen and Xero represent the very pointy and expensive tail of a market that is already on the expensive side of fair value. We could also add the letter ‘S’ to the acronym to represent the Israeli-based Afterpay-wannabe, Splitit.
Splitit issued a prospectus for its IPO at 20 cents per share earlier this year. By March it was 1000 per cent higher at $2.00, and with a then-market capitalisation of $534 million it was trading at 1069 times revenue.
In 2019, WAAAX companies are expected to collectively generate $1.9 billion in revenue from which they are forecast to earn $162 million in profits.
What would you pay for a portfolio of businesses earning $162 million? 10 times, 20 times, maybe 25 times if they’re growing at above average rates, which history shows eventually slows or mean-reverts?
This collection of companies combined market capitalisation is approaching $27.5 billion, which means they’re trading on a collective profit multiple of almost 170 times FY19 earnings and Afterpay is not expected to generate a profit until next year, while Xero is not expected to turn a profit until 2021.
To be fair, some of the companies in the group are seriously high-quality. For example, Wisetech’s logistics and supply chain execution software is used by three quarters of the world’s top third-party logistics operators and all of the world’s freight forwarders in over 125 countries.
The problem is that its market capitalisation is $8.7 billion or 160 times its earnings. It has the same market capitalisation as Qantas. But the difference is that Qantas generates $16 billion in revenue while Wisetech generates just $355 million and is already very deeply penetrated in its target market.
Appen is to my mind a much lower quality company than Wisetech. Many think of it as a technology or ‘AI’ company but it simply crowd-sources cheap labour to tag millions of photos, which are subsequently collated and fed into the search algorithms of clients including Facebook and Google. In time we believe larger and deeper-pocketed rivals – perhaps even its customers – will develop technology to displace it.
Appen trades on 60 times profits and an Enterprise Value (EV) that is 33 times its earnings before interest tax depreciation and amortization (EBITDA). What is very interesting about its EV/EBITDA multiple is that it’s about 400 per cent higher than the multiple on which its near competitor, Lionbridge, recently traded on.
Lionbridge is the world’s second largest language service provider with more than 6000 employees worldwide, serving more than 800 customers including included Microsoft, Google, Rolls-Royce, The Gap, HTC and John Deere via its technology platforms and more than 100,000 contract translators.
Back in 2016 the Massachusetts-based company was acquired by US-based Private Equity group H.I.G Capital for about eight times EV/EBITDA. And even though neither Lionbridge nor H.I.G. appear to have any business in Australia, they plan to IPO here this year.
It sounds like Lionbridge’s private equity owners are simply looking to take advantage of the most ridiculous multiples investors are willing to pay in Australia.
And it is clear from the pace of funding and acquisitions in the language technology space that Appen is not alone. In the second half of 2018 Lilt, Smartcat, Qordoba and DeepL all raised funds from big venture capital names while TransPerfect acquired Applanga in December, 2018. More recently, in January this year, Tokyo-based language tech and services company Gengo was acquired by Lionbridge.
Altium is another one of the higher-quality companies in the group. Founded in 1985, Altium creates software that helps computer scientists design electronic printed circuit boards. Every computer contains one, and with an internet-connected version for everything on its way there is a long runway for growth. But I wonder whether 57 times earnings is reasonable. Altium trades on the same market capitalisation as JB Hi Fi, Air New Zealand and Metcash. These three companies generate revenues of between $4 billion and $14.5 billion each, while Altium generates revenue of $177 million.
Afterpay is a point-of-sale consumer alternative to credit cards and lay-by. While everyone is excited about the prospect of lending small amounts of money for short periods to millennials who don’t like credit cards, we wonder how this business can remain immune to a credit event. Every generation before the millennials have had to endure a period of rising unemployment or recession and we don’t think this cohort will be immune. Moreover, we believe Afterpay is no more transformative than dressing-up a factoring business with similarly low margins and risks. Inevitably, the company will have to raise capital to fund its consumer finance business; note that the last one coincided with the founders selling $100 million dollars’ worth of shares.
Finally, New Zealand-based accounting software company Xero SME. While the company recently reported it had finally achieved cashflow break-even and profitability, it took 12 years to do so and we wonder how much more scale might be required to deliver the numbers that justify the current 370 times forecast 2021 earnings.
While WAAAX stocks represent only a small fraction of the market’s total capitalisation, they are its litmus test, and their demise could trigger a broader rout by causing a flight of money to safer asset classes. You have been warned.