As shown in the following table, the total return of the technology sector has underperformed the total return of the S&P 500 index in each of the past four years.
Total Return
|
2013
|
2012
|
2011
|
2010
|
Vanguard Information Technology ETF
|
30.95%
|
14.00%
|
0.53%
|
12.67%
|
S&P 500
|
32.39%
|
16.00%
|
2.11%
|
15.06%
|
Given the overall underperformance by the technology sector, we are clearly not in any kind of Technology Bubble. However, within the technology sector high growth, disruptive new publicly traded companies in the areas of cloud software and social networking have shown very strong stock returns. The strong returns have led to valuations that are very high in the post Tech Bubble era. The following table shows a subset of these strong stock performers within the cloud software and social networks sectors.
Company
|
Ticker
|
Trailing One
Year Stock Return
|
Current Valuation
EV/Trailing Sales
|
FireEye
|
FEYE
|
83%**
|
49x
|
Splunk
|
SPLK
|
150%
|
29x
|
Twitter
|
TWTR
|
41%*
|
58x
|
Workday
|
WDAY
|
100%
|
36x
|
* - Twitter's return reflects using the closing price on its IPO on November 7th 2013.
** - FireEye's return reflects using closing price on its IPO on September 20th 2013.
The absolute high levels of EV/Sales multiples for FireEye, Splunk, Twitter and Workday raises the question whether such high valuations can be justified and can these stocks offer a favorable return over the next 3-5 years at such valuations even if these companies grow at "best in class" rates. I believe one relevant historical exercise worth examining in helping answer these questions is how "best in class" disruptive enterprise software and Internet companies were valued during equivalent growth periods and what kind of returns did investors generate if they bought such companies at the same valuations we are seeing today for FireEye, Splunk, Twitter and Workday.
In looking at the post Tech Bubble era, the two "best in class" enterprise software companies one should look at are Salesforce.com and VMware, as these were the two companies in this era that were able to grow annual sales from $200 million to $1 billion in the shortest time, namely 3 years for VMware and about 3.5 years for Salesforce.com. Most other enterprise software companies have typically taken 6 to 11 years to achieve the same growth goal. Industry giant Oracle was also able to grow sales from $200 million to $1 billion in about 3.5 years when it was at that size back in the late 1980s. In the Internet sector in the post Tech Bubble era, Google and Facebook are the two companies to look at in evaluating Twitter's valuation at its current stage of growth. Given Twitter's trailing reported one-year sales are in the order of $500 million, its "best in class" peers were able to grow from about $500 million in trailing sales to $6 billion in trailing sales on the order of 3 to 4 years.
The following table shows the historical respective valuation ranges and peak for both CRM and VMW as the companies were growing towards the $1 billion in annual sales. Note that for VMW, the company went public in the same year it reached $1 billion in annual sales (i.e. 2007), thus, there is a limited amount of data to evaluate. CRM on the other hand, went public at a similar level of revenues as the current class of disruptive, enterprise cloud software companies and provides a more thorough historical analysis.
As the table shows, VMW reached a peak valuation of 41x EV/Trailing Sales as the company was breaking over the $1B in trailing sales level while CRM's much lower peak valuation of 16x EV/Trailing sales was achieved when the company was generating about $300 million in annual sales. If one bought VMW stock at the peak valuation in October 2007 at $117/share, you would still be underwater given the stock is currently trading at around $98. On the other hand, if you bought CRM at its peak valuation in January of 2006 at about $10.40/share as it was still growing towards $1 billion in annual sales, you would still have generated a phenomenal annual return of about 24.5%/year in the stock as it is currently trading at around $60 share. While your return would have been great, you still would have experienced a correction on the order of 45% in the stock price prior to CRM ultimately reaching $1 billion in annual sales. Thus, the longer-term return in CRM was very strong, but there were many corrections along the way, one of which was as high as 45%.
Using this historical analysis, let's look at the current new class of disruptive, high growth, cloud based enterprise software companies that are striving to also grow from $200 million in annual sales to $1 billion at the same rate as the prior generational disruptive software companies Oracle, Salesforce.com and VMware. As the following table shows, FireEye (cloud based advanced malware security), Splunk (big data analytics software) and Workday (cloud based human resources and financial management software) are trading at high valuations more reminiscent of where VMW peaked on an EV/Trailing Sales basis and much higher than the historical peak valuation of CRM. While it is possible that all three of these companies may replicate the $200 million to $1 billion sales trajectory of VMW, ORCL and CRM, the current high valuations and stock corrections we witnessed for VMW and CRM in the past decade suggest there may be better buying opportunities in the future. I for one am waiting for such corrections before adding to my positions.
Company
|
Current EV/Sales
Valuation
|
Current MCAP
|
Trailing 1 Year
Revenues
|
FEYE
|
49x
|
$8.7B
|
$136M
|
SPLK
|
29x
|
$8.5B
|
$268M
|
WDAY
|
36x
|
$16.1B
|
$409M
|
In the Internet/Social Networking sector, the recent IPOs of disruptive and high growth companies Facebook and Twitter also suggest a look back at Google's phenomenal stock history, is worth a look in determining proper entry points from a valuation standpoint. As seen from the following table, if you purchased GOOG at its peak valuation back in late December 2005, you would have generated an annual return of about 13% a year, a decent but not phenomenal annual return. While a decent annual return, Google corrected 27% shortly after reaching this peak valuation in early 2006, demonstrating the risk in buying even great companies at historically high valuations.
Facebook today has very similar metrics to Google at that time in that its trailing revenues, market capitalization and valuation are similar. FB is currently trading at about 19x trailing EV/Sales, which is lower than the peak valuation that Google achieved in late 2005 at 23x trailing EV/Sales. We all remember, however, the massive correction that FB experienced after its IPO on the order of 50%.
TWTR today is trading on the order of 68x trailing EV/Sales, which is a much higher multiple than the peak multiple of either GOOG or FB. The comparison may not be completely comparable, as Twitter has generated only $534M in trailing sales vs. the $6B-$7B that Google and Facebook achieved when they reached their peak valuations. The fact that Twitter went public at a much earlier stage than FB or GOOG, makes the comparison difficult. Even so, one can look at the data and conclude that TWTR could trade at about 20x trailing sales once the company gets to about $6B-$7B in trailing sales if it shows the same growth profile as GOOG and FB. If for example, TWTR can get to $6 billion in sales in the next 4 years, consistent with the growth of GOOG and FB in the past, the company could have a MCAP of about $120 billion at that time reflecting an annual stock return of 20%-25% a year adjusting for expected dilution of stock options over that period. GOOG and FB have demonstrated the ability to monetize advertising revenues from their business models. If TWTR can do the same, then stock is not expensive here. But much like GOOG and FB, corrections on the order of 25% may occur and it may be better to wait for better valuation multiples in the future.
Company
|
Trailing Sales At Peak Valuation
|
Historical Peak Valuation EV/Sales
|
MCAP At Peak Valuation
|
Current Valuation
|
Current MCAP
|
GOOG
|
~$6B
Dec 2005
|
23x
|
$125B
|
5.8x
|
$384B
|
FB
|
~$7B
Jan 2014
|
19x
|
$139B
|
19x
|
$139B
|
TWTR
|
$534M
Dec 2013
|
68x
|
$40B
|
58x
|
$34B
|
Source: Seeking Alpha
