In December 15 years ago the dotcom crash was a few weeks away. Veterans of that fiasco may notice some familiar warning signs this festive season. Bankers and lawyers are being priced out of office space in downtown San Francisco; all of the space in eight tower blocks being built has been taken by technology firms. In 2013 around a fifth of graduates from America’s leading MBA schools joined tech firms, almost double the share that struck Faustian pacts with investment banks. Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued — and has been largely ignored, just as her predecessor Alan Greenspan was when he urged caution in 1999.
Good corporate governance is, once again, for wimps. Shares in Alibaba, a Chinese internet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.
Yet judged by the financial yardsticks of the dotcom era there is as yet no bubble. The NASDAQ index of mainly technology stocks is valued at 23 times expected earnings versus over 100 times in 2000. That year Barron’s, an investment magazine, published an analysis showing that 51 listed technology firms would run out of cash within a year. On December 6th Barron’s repeated the exercise and found only five listed tech firms with wobbly finances.
Instead, today’s financial excess is hidden partly out of sight in two areas: inside big tech firms such as Amazon and Google, which are spending epic sums on warehouses, offices, people, machinery and buying other firms; and on the booming private markets where venture capital outfits and others trade stakes in young technology firms.
Take the spending boom by the big, listed tech firms first. It is exemplified by Facebook, which said in October that its operating costs would rise in 2015 by 55-75%, far ahead of its expected sales growth. Forget lean outfits run by skinny entrepreneurs: Silicon Valley’s icons are now among the world’s biggest, flabbiest investors. Together, Apple, Amazon, Facebook, Google and Twitter invested $66 billion in the past 12 months. This figure includes capital spending, research and development, fixed assets acquired with leases and cash used for acquisitions (see chart 1).
That is eight times what they invested in 2009. It is double the amount invested by the VC industry. If you exclude Apple, investments ate up most of the cash flow the firms generated. Together these five tech firms now invest more than any single company in the world: more than such energy leviathans as Gazprom, PetroChina and Exxon, which each invest about $40 billion-$50 billion a year. The five firms together own $60 billion of property and equipment, almost as much as General Electric. They employ just over 300,000 people. Google says it is determined to keep “investing ahead of the curve.”
Big firms are also making speculative bets, to add new products and insure themselves against technological change. Amazon is investing in content and recently acquired Twitch, a video-streaming firm. Google is throwing cash at driverless cars, robots and home thermostats. Facebook has acquired Oculus VR, a maker of virtual-reality headsets. Mark Zuckerberg, Facebook’s boss, has said that it will not have an immediate payback: “It’s going to take a bunch of years to get there.”
What are the odds of all this money being spent sensibly? Apple is still tremendously profitable. The other firms have patchier records. Google’s return on capital has halved to about 20%, after accounting for stock-option costs. Amazon has never generated much cash. The longer-term omens are not good. Few firms learn how to create a framework for spending tens of billions of dollars almost overnight.
When previous champions, such as Nokia, Yahoo and Microsoft, made big acquisitions in adjacent areas they often fared badly. There are few obvious sources of restraint at those firms still dominated by powerful leaders who control their companies: Google, Facebook and Amazon. All five of today’s stars have lots of excess cash. Much of this is parked offshore and cannot be brought home without incurring tax, giving an extra incentive to spend it.
The second area of technology froth is in private markets. Their exuberance was demonstrated on December 4 when Uber closed a $1.2 billion private funding round that valued the five-year old firm at $40 billion. Baidu, China’s biggest search engine, is set to buy a stake, too. There are 48 American VC-backed firms worth $1 billion or more, compared with ten at the height of the dotcom bubble, according to VentureSource, a research outfit. In October a software firm called Slack was valued at $1.1 billion, a year after being founded. Two-thousand fourteen looks set to be the biggest year for VC investments since 2000 (see chart 2).
Part of what is happening is a shift away from stock markets. Entrepreneurs are keen to avoid the bureaucracy involved in initial public offerings. They now have alternative ways to raise cash and to award tradable shares to staff. More institutional investors are buying into private technology firms, alongside VC funds. Unlike in 2000 the firms they invest in already have scale. Uber’s gross sales, of which it keeps about 20%, are expected to hit a run rate of $10 billion by late 2015.
But with many investors chasing a few firms, VC gurus are worried about frothy valuations. The best-known of these, Marc Andreessen, has said valuations are getting “a little warm,” and called for discipline. A banker warns that successful funds’ recent run of profitable exits is encouraging them to take “lottery ticket” bets. Among the most recent tech firms to debut on stock markets with huge share-price “pops” are Lending Club, a peer-to-peer lending platform, and New Relic and Hortonworks, two “big data” software firms.
The sins of big, listed tech firms and younger, private ones will be forgiven if their growth continues at a blistering pace for several years: so far there is no clear sign of deceleration. But if these firms do slow down before then, the present investment boom will look like a horrible mistake for the firms and investors that financed it.
For society, though, there is little to fret about. As in 1999-2000, startups and tech giants are creating jobs and investing in new technologies and infrastructure that boost long-term economic growth. But this time round a slump would be unlikely to lead to a broader contagion, since it would be confined to private markets and a few large firms with strong balance-sheets. Silicon Valley still does vanity, bubbles, genius and excess. But when it comes to causing crashes, it has learned to be less evil.
© The Economist Newspaper Limited, London (December 20, 2014)