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January 21, 2014updated 29 Jan 2016 4:25pm

Will technology stocks deliver on potential, or remain virtually worthless?

By Christopher Silvester


Technology companies are finally being regarded as viable share options — but is this optimism justified? Christopher Silvester

The dazzling recent IPO of Twitter has highlighted the methodology of how to value a technology stock. But this begs the question: what exactly is a technology stock? Is it just a business which happens to involve some technology, or is it a business which is part of a larger narrative about how technology is permitting us to transform our lives?

Facebook and Twitter have allowed new forms of social interaction, while Google has enabled us to search for information, products and services with an ease that we never thought possible. But this holy trinity are still ultimately advertising businesses.

Facebook had a messy IPO, which saw the share price fall back embarrassingly, but it has almost doubled in value in 2013. The company reported a Q3 profit of $425 million, with earnings per share at $0.17 slightly ahead of forecasts.

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Of the 1.19 billion monthly active Facebook users, 507 million access their accounts from a mobile device, and mobile advertising, which represents 49 per cent of overall advertising revenue, is set to keep growing. Yet at the same time there has been a slight demographic blip in that daily-active young teens have decreased in number.

In preparing for its own IPO, Twitter learnt the lessons of Facebook’s 2012 failure. Twitter has 218 million monthly active users, a number that is still growing fast, but it believes the best index of its success is the advertising revenue it receives each time someone views or refreshes their timeline (currently around $0.80).

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Yet unlike Facebook, which was already profitable, Twitter has a cumulative deficit of $418.6 million. Its monthly user growth is slowing, up only 39 per cent in Q3 from the previous year, compared to a 69 per cent rise the year before that.

The stock jumped 73 per cent to $44.90 in its first day of trading, which valued the company at $24.9 billion. But there were plenty of doubters. Jeffrey Sica, president and chief investment officer of Sica Wealth Management LLC, dismissed this valuation as ‘absolute froth… I think this is just way, way above what realistically we should be considering a stable open.’

A pure-play technology stock is a business which actually manufactures the technology or creates the intellectual property for others to do so — such as ARM Holdings plc, a leading UK technology stock (FTSE- and Nasdaq-listed). It was founded back in 1990 and is currently the dominant supplier of microprocessors for the smartphone and tablet market. Instead of manufacturing and selling microprocessors, ARM simply creates and licenses them as intellectual property.

For a short while during the dotcom boom of 1999-2000, ARM was valued at £10 billion. In recent years it has enjoyed a slightly more sober valuation, though at just over £10 (at the time of writing) it is thought to be overvalued by some analysts, who have pronounced it a sell with a target price of £7.50.

Slowing momentum, says analyst Janardan Menon at Liberum Capital, is the result of ‘slower tablet and smartphone demand combined with a mix shift to lower-priced devices’, and rival Intel Corporation is likely to increase market share in the smartphone and tablet markets.

Fruits of fibre

Fibre-optic technology has been out of fashion for a while, but it is about to experience a gargantuan comeback which will drive stock valuations of fibre-optic technology companies skywards. Cisco Systems Inc has pointed out that internet traffic has doubled every year for the past five years.

Broadband providers will need to exploit fibre-optic technology in order to meet the burgeoning demand of YouTube users, Netflix subscribers and broadcasters who will be transmitting to ultra-high-definition TV sets, as well as smartphone and tablet users. Through its Android operating system, Google is adding around 1.5 million hand-held devices to global wireless systems each day.

Cisco believes the so-called ‘Internet of Everything’ will include 50 billion devices by 2020, and the German firm Bosch has predicted that the IoE will be receiving data from 7 trillion sensors.

This rush means that a company like Alliance Fibre Optic Products Inc, whose stock has grown by around 300 per cent in the past year, is poised to climb further. Its current valuation of $320 million is based on a 24 per cent profit margin and a 20.6 per cent return on equity. In other words, it is performing well by conventional measures.

Sometimes a technology business is a commodity play with a clear outlook for its applications, but sometimes it is a commodity play with the prospect of multiple applications as yet undreamt of. Graphene, for example, was discovered in 2004, but we are only beginning to realise its potential. Not a single one of the 30 small European companies manufacturing graphene products is yet available to public shareholders, while the few US companies manufacturing graphene are engaged in other activities as well.

However, a couple of UK investment vehicles, Viscount Resources (which actually operates out of Gibraltar) and Graphene Trade, are offering graphene as a commodity investment, predicting returns of 15 per cent per annum. While supply far outstrips utilisation rates the prospects are for the price of graphene to fall dramatically, with one manufacturer predicting that it will ‘go down from $800 for use on a four-inch wafer to just pennies per square inch’.

Moving markets

Another means of valuing a technology company’s prospects is to consider its potential market. The B2B e-commerce market in the US has been estimated at $559 billion and, according to Intellisys, only 7 per cent of this market is transacted by e-commerce.

Listed on the AIM, @UK was founded in 1999 and is only now beginning to make its mark. Through unique proprietary software it is able to analyse how money is spent within a company and in comparison to its competitors. But it also provides a platform for implementing savings that can be integrated into a company’s financial management systems.

In the early days @UK targeted the UK public sector, which was slow to adopt the technology, but in August it established a three-year exclusive partnership with Visa, which will offer a rebate to purchasers using their cards, a rebate in which @UK will participate. This new business model, called cloudBuy, will be rolled out internationally as well as in the UK and promises repeat transaction revenues rather than revenue from software licences.

Blinkx is another company that is finally taking off. Founded in 2004, it uses proprietary search engine technology to connect online video viewers with millions of hours of content on more than 800 partner websites. Again, it has an advertising revenue model, albeit one that does not require it to sell any ads directly. Although listed on AIM, it does most of its business in the US and a Nasdaq listing beckons, which will increase exposure and liquidity of the stock and will generate wider shareholder interest.

Valuing tech stocks will always be problematic as long as they focus on potential revenue rather than demonstrable revenue and profits — yet it is often the unrealised potential that makes their narratives so compelling. Compared to the IPOs of the dotcom years, the tech companies going public tend to be more mature businesses, with more experienced leaders and more tried and tested business models, and they can all point to growing sales and profits (except Twitter).

Many of the Big Tech companies now have low PE multiples, pay dividends and have substantial cash hoards, making them arguably cheaper than many traditional value stocks, given that in other respects they remain growth stocks. It remains to be seen how the market’s appetite for the newer technology stocks will change when other sectors return to faster growth and interest rates start to climb.

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