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“If you build on infrastructure so much in advance and then burn cash so much in advance or acquire customers who will bleed you for so many years, then the net present value of that to an investor is going to be very poor,” says Rahul Bhasin, Managing Partner, Baring Private Equity.



When the new age tech stocks went public, there was a paradigm shift. Everyone thought that this is the future, these are new companies which will change the way how we do business and how earnings would be and how these businesses will only grow. But now we see a complete reversal. Hard questions are being asked on relevance, cash burn and dilution?
I have learnt now that every time I hear about a new investment paradigm or using new metrics or new jargon to explain how businesses should be valued, it typically does not end well. I think there are various models for investing in technology and the most relevant one at this moment would be the Gartner model which talks about triggers for innovation. Then the peak of inflated expectations happens and I think what we saw was akin to that peak of inflation expectations. Then there is what they call the trough of disillusionment which is what we are seeing now with the market and that is typically followed by the slope of enlightenment.

The technology trigger for innovation is obvious. One reaches a certain critical mass in technologies which actually facilitate a better product or service which is value. People get extremely carried away with what it can do. For example, look at the crypto currencies and that whole area. There are a lot of use cases which are extremely valuable but they have been ascribed values which are in zones of fantasy.

Just to give an analogy, money is very important for playing Monopoly. A lot of tokens are very valuable for playing various kinds of games on the net and on the digital medium but does that mean that Monopoly money is worth real money? Many times, we lose sight of reality. Not to say, the entire architecture in the breakthrough in terms of technology which the entire blockchain infrastructure represents is fundamental.

We will get more and more use cases as with Web 3.0, the valuations subscribed to it is just completely out of whack. That is where we are seeing the trough of disillusionment. Then we will get the slope of enlightenment which means that some of these use cases actually come through and then many of the use cases will start to broaden and we will see slow pick up in those companies which will deliver those use cases.

We will ultimately reach what is called the plateau of productivity, when it will be widely adopted, it will become everyone will have it and then increases in efficiency etc. the incremental innovation which typically takes place in every industry does not add marginal utility to the customer and then we do not stop any economic pay off for it. So one gets investment returns if one invests right at the beginning. Then there is this sort of peak where one should be getting out and now we are getting the trough of disillusionment. But let us accept one thing. Technology has fundamentally changed the way we live and it will continue to do so but we are going through a very needed correction zone in this life cycle.

If I draw a parallel with the TMT boom and the bust, the number of companies which survived when the cycle reversed was less than 5%. Are we going to go through that change? Will it be the survival of the fittest and only the giant companies will survive?
Absolutely. Let me tell you the ones which are in trouble and will stay in trouble and the ones which will not. There are certain common patterns and mistakes that people have made in overexcitement and over exuberance in the tech space in the recent past.

One is companies which have created augmented products, which are

but beyond the means of the investor or the consumer or the customer to pay for them and they have subsidised them for quite a lot of customers. There are only 10 million consumers in India who do more than six transactions on the net in a year but there are so many businesses which are building out of use cases of 50, 100, 200 million customers.

I am 100% certain that we will get there but if you build on infrastructure so much in advance and then burn cash so much in advance or acquire customers who will bleed you for so many years, then the net present value of that to an investor is going to be very poor. We are seeing one of those kinds of things.

The other thing is that companies which are doing more of the same and doing what other traditional companies are offering but have been acquiring customers and showing very high growth because of discounting in many ways and this is across sectors.

There is a lot of this in the fintech space.So, the utility of the customer or the consumer is not improving but by discounting, they are acquiring customers. We have seen this in gold loan companies and in various kinds of new age fintechs. They are not recovering those costs from the customers and burning a big hole but growing fast. This is just one example, I mean, there are plenty of these which are going around.

The third is the inflation point of going from negative cash flow to positive cash flow being very far out. When the cost of capital is zero, that works fine because your cash flow for 20 years now is equal to your cash flow now and people will be willing to take those bets but as the long bond has gone up in the US, I would say the benchmark for risk free rate around the world is above 3%.

Suddenly one has to recalculate that and the issue that happens when your cost of capital starts to go up after effectively 40 years of secular decline is you just reverse and start going the other way. The problem is now no one knows where this would end up in terms of the cost of capital. Cash flows which are very far out suddenly do not look attractive anymore and again there is that revaluation.

Lastly, there is also what I call the sheer execution inefficiencies in these companies. That would hurt too. But if you look at the global markets, I guess the fifth point I would make would be where regulators step in and put a cap on the economics of the businesses. We have seen that in a large way in China with Alibaba, Tencent, Didi etc getting hurt as a consequence.

In India, we have had the payment companies getting disrupted because of NCPI and UPI. We are also seeing the government taking initiatives to create what they call the ONDC architecture to get on to retailing.

One has to look at government actions and government intent very closely in the tech space. But if one looks at the large companies like Alphabet, adopt the technology evaluation metrics like the M-Score. Just take the enterprise value of the company and calculate the five years cumulative R&D expenditure and that gives the M-Score. It is very cheap, Alphabet is really cheap today.

In terms of how to look at companies and separate the men from the boys, as you mentioned, a lot of these metrics may give you false indicators as well. What is the right way because at some point these companies do become valuable?
That is what I am saying. Some of these really strong companies are very attractive buys. A company like Alibaba for example, has 800 million customers, 10 million sellers. There are only 2.5 million registered companies in India. Alibaba has 10 million sellers and they do not charge a transaction fee. They only charge people for showing their goods or displaying their goods earlier. How do you shake a business like that other than maybe regulatory pressure?

I think that fundamentally it is a very strong franchise. Similarly, with Google, it is very tough to shake them and Alphabet, which is a traded company. There are lots of these companies which are extremely powerful with fantastic cash flows and they are down between 30% and 50%. So how do you shake an Amazon? Look at the kind of franchise that they have built and if Amazon were to raise their rates across the board by 2%, I do not think they will lose any business because the bottom line, the operating leverage is just massive. There are these kinds of businesses with extreme valuation and they are giving opportunities to investors to buy and then there are the kinds which I delineated earlier.

Would you liken the ongoing selloff that we are seeing in a lot of the US based tech companies to the dotcom bust in the early 2000s?
We need to apply that very basic methodology of saying how do you get to cash flows? I can understand two-sided exchanges, saying they are going to burn money because we need to build out the population set on both sides and that will lead to an ecosystem where the traditional cost curves do not apply. We have effectively perpetually declining marginal cost of transactions.

I can understand the use case of burning money which is saying that this is unit fixed cost; once I cross this, my contribution becomes positive and I start making money. But there are a lot of those other kinds of situations a lot of Indian tech companies are guilty of, where they are hurting and will continue to hurt till they fix the stuff on the operating side. I do not see the capital markets being very kind to them.

Thanks

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