MorningWord 6/21/16: Software Ate the Nasdaq

by Dan June 21, 2016 11:58 am • Commentary

Back in August if 2011, Marc Andreessen, co-founder and general partner of venture capital firm Andreessen-Horowitz penned a prescient essay in the Wall Street Journal explaining; Why Software Is Eating The World. At the time, skeptics wondered if he was merely talking his book (he disclosed that his firm was invested in “Facebook, Groupon, Skype, Twitter, Zynga, and Foursquare and he was personally invested in LinkedIn). But as a former technologist (he invented internet browser Netscape in the 1990s) and prolific investor/VC he had the resume to question how other investors were looking at this new batch of on-the-line companies:

But too much of the debate is still around financial valuation, as opposed to the underlying intrinsic value of the best of Silicon Valley’s new companies. My own theory is that we are in the middle of a dramatic and broad technological and economic shift in which software companies are poised to take over large swathes of the economy.

He went on to detail practical examples of how industries like energy, entertainment and retail (to name just a few) were becoming more and more dependent on software for new found efficiency and how we should be focused on that relationship when determining valuation. He concluded his essay this way:

Instead of constantly questioning their valuations, let’s seek to understand how the new generation of technology companies are doing what they do, what the broader consequences are for businesses and the economy and what we can collectively do to expand the number of innovative new software companies created in the U.S. and around the world.

Nearly five years on, most of the upstarts that emerged in the years after the implosion have also imploded. The divide between the haves and the have-nots has been pronounced. What has survived though is that big money investors, and tech insiders like Satya Nadella (Microsoft CEO) still agree with Andreessen’s statement about valuation.

This is the only way to explain MSFT’s $26 billion take-over bid for LinkedIn (LNKD), a company that is expected to earn $3.46 on an adjusted basis in 2016, but a $1.36 loss on a GAAP basis.

It would be the only way to explain how (AMZN) could have a market cap 35% higher than Walmart (WMT) at $337 billion, despite having just 22% of their sales in 2015 and only booked $5 billion in GAAP net income on a cumulative basis on nearly $500 billion in sales since 2005.

It’s the only way to answer YES to the question recently posed by the New York Time’s Joe Nocera in Times Magazine cover titled Can Netflix Survive in the New World it Created?, as competition rises from every corner, revenue growth decelerates, earnings are allusive, yet the company sports a market cap of $40 billion, 70% of that of Time Warner (TWX) a company with 4x NFLX’s 2015 sales.

Valuation is obviously a moving target, and one’s investment decisions that incorporate valuation often depends on the current economic / market environment and expectations for growth (both macro and micro), oh and I’d be remiss to not mention interests rates and how they play into risk taking.

There are plenty of examples of companies that do prove Andreessen’s point (MSFT for one) and grow into their valuation over time as their business matures. The most recent example being Alphabet (GOOGL), trading 21x expected 2016 eps growth of 12% for a company expected to grow sales 17% yoy from a record $60 billion in 2015 is pretty defensible.  So yes. We should look at valuation of these companies differently while they’re first taking the world by storm. But the same leeway that grants ridiculous valuations based on the ease of software to establish growth so quickly must also account for the risk of market share collapsing even quicker with the barriers to entry so low.

The only way to explain how Facebook (FB) (Andreesen sits on the board), a company with a little less than 30% of GOOGL’s 2015 sales can have a market cap of about 70% of the online ad behemoth, trading at 18x 2015 sales, 12.6x expected 2016 is an underlying assumption that they’ve established a moat around their core business as they continue to expand into new areas just as fast.  Yeah those sales are growing 45% a year, but the company has yet to monetize fast growing properties like Instagram and WhatsApp on a meaningful scale. Facebook is one of those companies that will continue to be one of the handful of winners (but for those who do consider valuation, it’s important to remember that FB’s expected $3.58 in eps in 2016, growing at a whopping 57%. yoy that makes the stock’s P/E at 32 look cheap relative to growth, but on a GAAP basis, that $3.58 is more like $2.54, or a P/E of 54). Considering how many hot apps and cloud companies we see come and go each year it does seem like the club only makes room for a new member every few years.

Since Andreessen’s explanation as to Why Software is Eating the World on August 20, 2011, shares of MSFT have gained 111% (having eaten up Skype for $8.5 billion in 2011 and now LNKD for $26 billion), AMZN is up 300%, NFLX up 210%, GOOGL up 190% and FB up 550% from its all time lows made few months after its May 2012 IPO.  MSFT, AMZN, GOOGL, NFLX & FB have a combined market capitalization of $1.6 trillion, or 31% of the value of the Nasdaq 100, with expected 2016 sales of about $300 billion.  This is truly astonishing.

And there are battles being fought in the commercial and private cloud that I have not even mentioned between old software companies like MSFT, Oracle (ORCL), SAP, IBM and new like (CRM), ServiceNow (NOW) & Workday (WDAY) in an attempt to determine who will run the backbone of the consumer & professional software that are dominating our personal screen time and work related functions.  I’ll save this for another post.

A handful of software stocks have eaten the Nasdaq, and if you have had the stones to disregard caution as it relates to valuation, and follow the lead from the likes of an Andreessen then you have been on a profitable investment path. But riding the coat-tails from those in the know can be a difficult task for mere mortals like us.  How are all those fancy hedge-fund billionaires doing with those hot picks to click like Valeant (VRX) and no-brainers like Apple (AAPL)?  Ride the wave, remembering your risk tolerance is likely far less than that of a billionaire.  If your reading RiskReversal because you think I’m the guy to get you in the next Facebook, then I’ll just tell you now, that’s not our mission. Our purpose is to challenge conventional investment wisdom and let the reader incorporate that into their own investment process.