Saturday, September 6, 2014

Beware of The Tech Bubble

Global stock markets have been rallying significantly over the last 3 years courtesy cheap money policy adopted by most central banks. One segment all over the world that has seen great moves has been the IT sector. We are seeing a lot of 'billion dollar' valuations for a lot of businesses and a huge spurt in dot coms similar to the 1999-2000 mania

There is no doubt that a lot of these technologies are indeed beneficial to people and technology will continue to improve productivity and efficiency as we move forward. What is really disturbing is the mania and asset bubbles that are being created in the name of a technology wave. Particularly in India, IT has been a darling for fund managers and a safe haven, especially given the weak rupee.

There have been a lot of financial models circulated in the blogospheres about perpetual growth rates in excess of 10%-15% and I can safely tell you that all this is BS! Remember that perpetual growth is an exponential function and as the base increases, it becomes increasingly difficult to achieve 10% -15% growth rates when the base itself doubles or triples.

Also, technology space is one area where there is quick obsolete phases and levelling of the playing field for all players. At one point of time, one needed to pay HTML page builders by the hour to write code for a web page. Today, there is automation software that renders such workers obsolete unless they upgrade their skills. Similarly in many computing applications, there is a lot of automation that is coming in and the number of programmers required for that application is decreasing. To summarize, the IT industry within itself will also keep looking for ways to boost productivity and efficiency. So there will no doubt be growth in these areas but profit margins will slowly get eroded and so will the number of employees by a firm.

Another area where the Indian IT segment has been betting on is in providing body-shoppiing [call it BPO, KPO or whatever] where in the cost differential provides an incentive for the developed nations to outsource work to Indians. The last 20 years have seen phenomenal growth for Indian IT firms by this virtue. However, I think we are slowly coming to an end of this party. It is not going to happen overnight but I think this IT wave riding on body shopping is coming to its terminal stage.

Simple Mathematics
On average, an IT worker from the developed economy costs about 6000 dollars per month on a CTC basis

In contrast, the Indian IT worker costs about 3000 dollars per month on a CTC basis.

The core inflation in developed economies is about 1% whilst in India it is about 9%. With this differential in inflation rates, the Indian worker will become as expensive as a developer in western countries within the next 10 years. Add to that challenges of economic recession in Europe and jobs issues. There will also be an added pressure by governments to promote local talent over talent from developing nations.

As suggested by numerical extrapolation, the doom is not going to be overnight. Purely on inflation basis, the doom is at least 10 years away. And even if there are disruptive changes brought by new technology within IT and also disruptive changes brought by governments, the doom is at least 5 years away. And when I say doom, it does not mean that the entire IT industry is going to come down crashing, There will be a Darwinian struggle resulting in survival of the fittest. IT is going to be part and parcel of our lives and the usage will only increase.

However, as investors, we need to bear in mind that stock valuations are reaching excesses and that is something we need to be cautious about. Darlings of the indices like Infosys, TCS, Tech Mahindra etc all have at least 20% more upside over the next 2 years with some healthy corrections in between. However, the IT theme overall has almost played itself out now and wont be delivering those stellar returns moving ahead [in all likelihood I must say as it is a probabilistic view]

Over the next 2 years in India, we will in all likelihood see IPOs coming out for ventures like Flipkart, Ola Cabs, BookMyShow etc and all of these firms funded by Private Equity players have been told that the valuations are in excess of 1000 crores each!

Ola Cabs: It is working in the radio cab theme which is fantastic but it is not the only player. The average profit tends to be about 3 rupees / kilometer for the parent company and is largely driven by volumes. As long as there are such healthy margins in the business, more and more players will come into the picture over a period of time and as classical economics suggests, the industry will saturate into marginal revenue = marginal cost structure and the space will be crowded. This space will eventually settle at about 2 rupees / kilometer. Assuming that the IPO goes well and the company is able to pay a dividend of 1 rupee and a perpetual growth of 5%, the fair price of this stock will come to 20 rupees / share. Do you think that the private equity groups will allow the share to be listed at this price? The stock will get listed at at least 100 rupees / share and then mass hysteria will drive the prices to at least double if not triple the value in the first 18 months post listing. By 60 months post-listing, the price will settle down to the fair value. If one does decide to invest in this venture, remember that you need to be mentally prepared to take a loss within a month of listing and if you are lucky to get gains, start booking profits the moment your absolute return comes to 50%. The fall in stock price will be very sudden and severe just like Opto Circuits and Educomp.

BookMyShow: It charges about 10 rupees per ticket for booking online and this profit margin is pretty steep. More and more cinemas themselves will come into the picture [as is the case already] and many more players will enter the market space. Eventually the profit margins in this segment will have to settle for about 5 rupees per ticket. The good part about this business model is that it is not very dependent on administrative costs and infrastructure. All you need is a good IT server and 10 people to handle operations. The main source of expense is marketing but even with all these brownie points, 1000 crore valuation for this company is absurd!

I would not be surprised to see this venture getting listed at about 200 rupees a share and then climbing upwards of 600 rupees a share within a year of listing. The fair value of this business is about 40 rupees a share which is where it will settle down eventually.

To summarize, the technology bubble is in its terminal stage globally. The boom in this space is assuming maniac proportions just as was the case in the 1999-2000 period. There is still a very good chance of tech stocks delivering another 20%-25% return from current valuations as far as existing stocks are concerned. There are some new tech stories that will hit the markets and go for a rapid fire doubling and tripling of stock prices [as it has happened with Just Dial] Investors can choose to ride this momentum wave but be very very cautious as far as tech stock holdings are concerned. I have given all the fundamental reasons why this bubble will fizzle out. As and when institutional investors pull the plug and choke funding, a lot of this ventures will crash down. As far as core IT companies are concerned, by the end of the mania, a lot of IT jobs will move out from India back to developed countries over the next 5 years to 10 years.

Enjoy the ride till it lasts and don't rush to create shorts. All that I am saying is be cautious and don't herd in to this tech bubble; you may end up being the last person to board the bus before it crashes!

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