Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Cloud, Mobile, Social, Dead: Will Tech Startups Survive the Next Recession?

By

The industry has defended itself to investors by arguing that losses feed growth. It has also relied on outside capital. Are these strategies sustainable?

PrintPRINT
We're now four years into a bull market. Countless tech companies have come of age during this long summer, and we know them generally by their buzzwords: cloud, mobile, social media, big data. They've grown quickly, as things usually do in favorable weather. One day, though, a recession will come, and these businesses will have to prove that they can survive the winter.

Two issues haunt them, and the first is a low return on investment. Most of the technology firms that went public during this business cycle remain unprofitable. Streaming audio has been a money-loser for Pandora (NYSE:P), and streaming software has been unprofitable for NetSuite (NYSE:N). Big data upstarts like Splunk (NASDAQ:SPLK) and Tableau (NYSE:DATA) are in the red, and social/mobile gaming giant Zynga (NASDAQ:ZNGA) has struggled to find profits. Of the current crop of tech companies, the only ones that seem to enjoy healthy margins are those that own infrastructure, and rent it out, like Facebook (NASDAQ:FB) does with advertisers, or Rackspace (NYSE:RAX) does with cloud developers.

The industry has defended itself to investors, often successfully, by arguing that losses feed growth. This may be true -- charity usually finds a willing market -- but it doesn't tell us whether these products can actually be sold for a profit. It's a bad sign when new technologies require Workday (NYSE:WDAY) to earn operating margins of -30%, while traditional competitors like Oracle (NYSE:ORCL) are pulling in +40%. If cloud software is a great improvement, then growth shouldn't require such a steep discount. Perhaps the problem is scale -- Workday is much smaller than Oracle -- but then losses have risen in step with growth, and there's no reason to expect large efficiencies of scale in a software company.

For investors, the problem is made worse by misleading earnings reports. More than a decade after the dot-com bust, the tech industry still prefers non-GAAP earnings. Cash flow statements don't always show the actual damage; Pandora reported operating cash flow of negative $2.3 million in the last quarter, when in reality, it burned through $14 million. Income statements tend to be overwhelmed by capital coming in and capital going out. By watching net current and cash assets on the balance sheet, and correcting for new stock and debt, capital expenditures and acquisitions, we can arrive at a better idea of how the core business is doing.



The picture isn't always pretty. Of the new kids on the block, most sit in a core cash flow range of -12.6% to 2.5%. By reference, Rackspace earns 25%, and Facebook earns 20%. Older firms like Cisco (NASDAQ:CSCO), Oracle, and VMware (NYSE:VMW) also sit around 20-30%. There's a marked gap between the haves and the have-nots, and it's not always explained by growth; Facebook has expanded as fast as many of the enterprise cloud companies, but still experienced healthy and rising margins. I have no doubt that Marc Benioff, CEO of Salesforce.com (NYSE:CRM), could offer compelling reasons for why his company is different, and since he knows his business much better than I do, I would have to take his word for it.

That makes me uncomfortable -- first of all, because trust is a poor risk-management strategy. Additionally, his reasons may not matter in a recession when margins are pushed down even further – nor do we know how today's Web-based products will fare in the event of a recession. They may be hypercyclical; their flexibility might place them first on the chopping block, with clients believing that they can quickly redeploy once the economy has turned around. On the other hand, Salesforce's expenses are mostly salaries, and these are not so easily or painlessly cut.

The second problem facing younger tech companies is a heavy dependence on outside capital. Long after their IPOs, these firms are still leaning on debt and stock markets. The three largest cloud enterprise firms -- Salesforce, Workday, and NetSuite -- have all issued debt in 2013 to the tune of $2 billion, or an amount equal to revenue in the period. Netflix (NASDAQ:NFLX) and Pandora have also issued new debt, although in smaller proportion. For companies in the enterprise space, stock dilution is an even more serious issue. Many of them routinely issue shares worth 20% of revenue. Stock compensation, employee investment plans, and new issues all represent an infusion of cash into the balance sheet, either directly or by lowering cash salaries.




Investors haven't objected, and since stock valuations are currently so high, the dilution is modest. However, capital markets are cyclical, and a time will probably come when employees don't want to be paid in a declining stock, investors don't want to tolerate further dilution, and bond markets don't want to buttress an already bloated balance sheet. For some of these companies, a freeze would basically eliminate their ability to finance new investments. For others, it could potentially threaten the core business. Many have generous cash positions, but a few ill-timed acquisitions could leave any one of them naked in the cold.

Of course, winter might not come. Margins might spontaneously improve, consumers might reprioritize their lives, the Fed might have killed the business cycle, and everything might work out. Hope is gratifying -- but it's not a strategy. Unfortunately, the pursuit of growth at all costs has left today's tech companies with little choice but to cross their fingers and pray for a mild December.

Also see:
Tech Products News: Apple's Trade-In Program, and a Simple Android Controller That Kickstarter Loved

Four Reasons the New York Times Was Hackable

Fresh iPhone Rumors, New Rules Proposed at Facebook, and Gossip From Google

Decoding Nintendo's 2DS and Cheaper Wii U: Is the Video Game Giant Struggling?
No positions in stocks mentioned.
PrintPRINT

Busy? Subscribe to our free newsletter!

Submit
 

WHAT'S POPULAR IN THE VILLE