THERE is no doubt that the tech sector is out of favour when it comes to investors. As well as growing doubts as to whether pandemic trends would continue into the future - and a growing realisation that, in most cases, they will not - another core reason for the sector's decline has been the expectations of rising interest rates.
Put simply, rising interest rates mean that the future profits of tech companies are discounted back at a much higher rate, resulting in a lower valuation at today's values. Technically, that is the same for all other companies which are valued using a Discounted Cash Flow valuation (which is the standard benchmark for most listed companies) but given that the tech sector has a heavier weighting of companies which generate losses now in the hope of profits later, that has hit the sector particularly hard.
It may seem strange that the valuations of companies, which are supposed to reflect long-term fundamentals, can be so dramatically impacted by what seems like an issue of methodology. I would broadly agree. As I argued in my City A.M. piece in January, the most important thing to consider is the business fundamentals. If they are good, it's likely a business will succeed over the long term despite blips. Conversely, if not, the opposite is likely unless the company gets bought, at which point it becomes somebody else's problem.
CUTBACKS ALL AROUND So far, so normal. What is more worrying is how many tech companies are referring explicitly to the changing interest rate environment as the driver for cutting back both headcount and investment, and sharply swinging from a focus on growth to the preservation of cash.
Last month, Buy Now Pay Later pioneer Klarna shed some 10 per cent of its workforce and was focusing on shortterm cash preservation. Used car reseller Cazoo announced it was cutting 15 per cent of its workforce and will save over £200m in costs over the next 18 months, with CEO Alex Chesterman saying: "In the current climate we are focused on improving our unit economics which involves making some tough but necessary decisions around our priorities." In the United States, challenger insurance companies such as Lemonade and Hippo have also slashed back their spending. Needless to say, shares have collapsed.
Yet the rationale given by companies for the need to retrench seems unusual. A one or two per cent increase in interest rates is not going to change drastically the financial dynamics of many players.
Many of the listed companies have significant levels of cash on their books due to their IPOs raising funds - Cazoo has over £400m of cash on its balance sheet, for example - so, even though cash burn is significant, there should be enough cash available to get through the years of major investment for most examples.
It might be argued an increasing interest rate environment makes it more difficult to raise cash, especially as the issuance of equity is out of the question (for now). Yet, interest rates remain historically low, even if rising, and banks - particularly in the US - have a sizeable war chest of potential lending in the forms of household deposits, which remain highly elevated compared to prepandemic levels.
SEARCHING QUESTIONS So why are these cutbacks happening? The concern is that, in at least some cases, the sharp ascent of such companies was based not so much on the prospects of successful, long-term growth but the availability of cheap cash. More importantly, it might be argued that this led to a less critical analysis of the fundamentals as interested parties benefited from the raising of funds.
This allowed less solid business models to slip through the net and receive funding that, in normal times, may have been denied.
Now that sentiment has turned, the markets are now asking searching questions. One analyst quoted regarding the insurance start-ups said: "There was a lot of goodwill, and the growth of the size of the addressable market had dollar signs in everybody's eyes, but the fundamentals really needed to be explored more deeply."
The obvious riposte is why this did not happen before such names reached stellar valuations.
CYNICS UNITE The more cynical may note that the increased questioning of companies has coincided with a declining deal pipeline and, therefore, a reduction in potential fees.
Where does this leave us now? Well, for a start, a lot of shareholders have lost a lot of money as tech stocks generally have crashed.
Secondly, there is the question whether very significant amounts of stimulus money have effectively been wasted on funding firms that had little chance of long-term success but which earned their founders, and early backers, considerable sums - the term 'moral hazard' is often cited as a reason not to rescue poorer consumers but, for some reason, it is never asked of the financial markets. As I said before, good companies with good long-term fundamentals will survive and thrive in the long term. For those firms, the current situation should be considered a blip. The concern is that, while what happened was a product of a very unusual environment - namely ultra-low interest rates and an unprecedented supply of cheap money - it also reflected a system that asked too few questions. I am not convinced that such a situation would not occur again in similar circumstances and that, perhaps, is the most worrying issue of all.
£ Ian Whittaker is a two-time City A.M. analyst of the year and is now founder and managing partner of Liberty Sky Advisors
Investors are now asking more searching questions of their former market darlings
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