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Knowing how to value digital tech companies is critical to value investing

Tong Kooi Ong and Asia Analytica
Tong Kooi Ong and Asia Analytica11/11/2021 09:10 AM GMT+08  • 8 min read
Knowing how to value digital tech companies is critical to value investing
Tech companies are synonymous with innovation.
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Not all tech companies are created equal. Some are hugely successful, others less so and yet many more fall by the wayside. The most successful are those that use technology to create new value in business models and customer experience.

Alibaba Group Holding, Facebook and Google are among the world’s most valuable companies today. Their platforms have the key defining characteristics of digital tech — network effect, where each new user adds value for all existing users; and declining marginal costs, which is where the platform costs can be spread out over each additional user. Over time, these characteristics create huge barriers to new entrants, thereby allowing pricing power with near monopolistic outcomes.

On the other hand, Apple started out as a (mostly) hardware company — designing and selling computers, tablets and smartphones. What makes it one of the great tech companies today is the foresight of Steve Jobs, not just in innovative products but also building and maintaining tight control over the entire Apple ecosystem. That now gives the company significant leverage in the digital business, in terms of the new subscription-based services that it can keep adding to its repertoire, which currently includes payments, news-entertainment content, cloud storage, healthcare and fitness apps.

Apple is worth nearly US$2.5 trillion ($3.4 trillion), the world’s second-largest public-listed company by market capitalisation. We agree with the market. We think Apple has some of the strongest and most enduring competitive advantages in the future digital world. The smartphone is a gateway, and Apple is the gatekeeper to more than one billion active iPhones globally. The company demonstrated just how effective it could be in two recent events. It terminated the account of Epic Games — the developer for Fortnite, one of the most popular games in the world — from its App Store, following a dispute on payments for in-app purchases. And a tweak in privacy tracking settings for the iOS resulted in material negative impact on ad-dependent tech companies such as Snap.

Similarly, Microsoft Corp’s Azure and Amazon.com’s Amazon Web Services are very capital-intensive but, without dispute, tech-centred businesses. They require huge upfront investments in both physical assets such as data centres and servers as well as in software, artificial intelligence (AI) and machine learning, the combination of which gives these companies a significant competitive advantage in cloud storage and a wide range of digital services. Scale and security fears will enable both businesses to extend their lead over time against competitors.

Clearly, not all successful digital tech companies have network effect and/or enjoy declining marginal costs. Indeed, the business models for many self-described tech companies rely on traditional economies of scale. As companies accelerate the digitalisation of their operations — including direct-to-customer sales channel, collection and analysis of customer data and so on — the definition of what makes a tech company will be increasingly blurred. For instance, are heavy users of technology and platforms such as Uber Technologies and Airbnb digital tech companies if their true services/industry is transport/taxi and hospitality? Does it matter? They are fulfilling a demand more effectively and efficiently in the marketplace.

Remember WeWork’s failed initial public offering (IPO) in 2019? WeWork was quite successful in marketing the concept of flexible workspaces and, yes, it does fulfil a demand created by tech innovation — for example, the gig economy and remote working — just not at those kinds of premium valuations associated with tech companies. Though, it was not for want of trying. The co-working spaces company used the word “technology” repeatedly — more than 100 times — in its prospectus. It did finally get listed, via a special-purpose acquisition company (SPAC) in October 2021. But its current market cap is around US$7.9 billion, a massive drop from the US$47 billion valuation previously touted by SoftBank Group Corp.

Peloton Interactive, which sells gym bikes and treadmills, describes itself as “a technology company that meshes the physical and digital worlds”. It took great pains to emphasise its connected-fitness subscription business model, even though the bulk of revenue comes from equipment sales.

So, clearly, the answer is yes. Successfully marketing oneself as a tech company can change the market’s perception of even boring and low growth prospect businesses. Tech companies are synonymous with innovation. They are seen as cool and exciting, boast high growth and even higher valuations. Reed Hastings, the founder and CEO of Netflix, has stated that it is not a tech but an entertainment company. Yet, investors continue to perceive the company as tech — Netflix’s valuations remain far higher than those of traditional media-entertainment companies.

Ego and bragging rights for founders aside, market perception has real-world significance — in a company’s ability to attract and keep talent and, crucially, capital. This is especially so for start-ups to attract venture capital monies. Access to cheap funds translates into lower cost of capital. Lower cost of capital, in turn, allows companies to scale rapidly — aggressively pursue top line growth by spending heavily (burning cash) to attract and retain users, and gain market share. Case in point: Most ride-hailing and food delivery platforms are loss-making, and have been for years. Yet, they continue to attract investors by generating high sales growth through heavy subsidies for users-customers, funded by shareholders’ and borrowed money.

Why do investors keep pouring money into tech companies that are consistently making losses, many with yet-to-be-proven business models? For sure, some of these business models could prove more feasible with future tech innovations. For example, we think autonomous vehicles will be a game-changer for the ride-hailing and delivery industries, by eliminating the biggest-cost item: the driver and delivery personnel.

A main reason is that the global financial system is awash with liquidity and money is cheap. In other words, the costs and risks are relatively low while the potential rewards can be exceedingly high. Venture capital firms typically make many diversified bets. They need only find a few hugely successful ones among the majority that are likely to fail.

Every investor wants to find the next unicorn. Investing for the longer term — as opposed to speculating — however, is still very much about intrinsic values and, critically, assessing the feasibility of the underlying business models. The basics of investing do not change whether you are buying a tech stock or otherwise. If anything, Zillow Group has just given us a timely reminder.

The online real-estate marketplace company is winding down its tech-powered home-flipping venture, after racking up hundreds of millions of dollars in losses. Its AI-driven algorithm, as it turns out, is not smarter than the market. The home-flipping business model — buying houses, sprucing them up and reselling at higher prices — is nothing new or revolutionary, even with the heavy tech spin. And while machines can analyse massive amounts of data in a fraction of the time that humans can, its CEO concedes that “fundamentally, we have been unable to predict the future pricing of homes to a level of accuracy that makes this a safe business to be in”. Should investors have expected that it could? Does the ability to crunch lots of data in seconds create any real advantage in the home buying/selling process that is replete with idiosyncratic details and requires months to complete?

Another example is Katerra. The start-up in the construction tech space had a highly ambitious goal of building homes more efficiently and cheaply across the world and attracted the likes of SoftBank to invest. Again, the myth of “tech” was emphasised as the enabler. In truth, however, what was proposed had been tried for decades with no new substantial ideas. Katerra filed for bankruptcy in June 2021, after burning through US$3 billion of investor money with its hyper-growth at any cost strategy.

It is real. Digital transformation is a secular trend. Companies across all sectors of the economy, including traditional brickand-mortar, will increasingly intensify the use of technology in their business operations. There is no question that digitalisation will improve productivity. The real question is whether it creates new business models and/or enduring, competitive advantages that would justify labelling a company as digital tech and, more importantly, the premium valuations. There will be many real winners and they will be big winners — but likely even more losers, and big losers. As we said earlier, the super-sized gains from one could outstrip the losses of a few — and this is why tech will continue to attract funds. This will remain the single-biggest challenge to investing in the medium term — picking the real tech winners.

The Global Portfolio gained 0.7% for the week ended Nov 10. Leading the gainers were Airbnb (+11.2%), Builders FirstSource (+11.1%) and Mastercard (+8.7%). On the other hand, shares for PayPal Holdings fell 11.2% after reporting slightly disappointing earnings results. Other notable losers include Wells Fargo & Co (-3.2%) and ServiceNow (-2.4%). Last week’s gains lifted total returns since inception to 70.2%, an all-time high. This portfolio is outperforming the benchmark MSCI World Net Return Index, which is up 62.8% over the same period.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

Photo: Bloomberg

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