I’m depressed. I have been watching the technology sector for nearly 20 years now and I can think of no time, other than the collective madness of the dotcom days, where the smaller end of the London stockmarket has been more dysfunctional. In my view, the latest crop of technology IPOs on AIM represent, at best, poorly understood and overvalued growth stocks and, at worst, the beginning of the end for the AIM market.
After several years where the IPO market in London was firmly shut I, like many others, was pleased to see the return of the technology IPO as a few companies made it onto AIM from 2011 onwards. However, my optimism has increasingly turned to dismay as I have witnessed a procession of tiny companies, many of which are of suspect quality, come onto the market only to have their share prices dramatically overhyped.
Wandisco, of course, is the poster child of this mini-bubble. Having been admitted to AIM on what I thought was already a pretty punchy multiple, the shares have preceded to skyrocket to the point where the company is valued at nearly £250m, equivalent to 44x current year revenues. Let’s be clear, this is a totally ridiculous valuation. I think everyone accepts that Wandisco can never justify this valuation organically so the City is betting on it being taken-out at a silly price. While some companies in the consumer technology segment may end up getting acquired for daft numbers because of their user numbers (Instagram for example), this just doesn’t happen in the enterprise software space. The likes of Cisco, Oracle and others may be desperate but they aren’t stupid. They have been known to pay 10x revenue or maybe even a bit more for what they perceive as strategic assets, but never anywhere near the 44x. I don’t really know anything about Hadoop, so maybe I’ve got it all wrong, but I suspect that the tiny bit I do know is a great deal more than most of the people who own the shares.
Wandisco on its own I can live with; ludicrously overvalued companies give me something to talk about when I meet my friends in the City for lunch. However, as I feared, where Wandisco has led, others have followed. Despite my criticism of Wandicso’s valuation, I have nothing particularly negative to say about the company; it is growing rapidly and seems to have a credible product in an interesting part of the market.
However, the same cannot be said for some of those that have followed. Blur Group (which apparently is reinventing commerce) looks a lot like nothing more than low quality facsimile of many other, more established players in the market. While it is undoubtedly growing quickly, gross margins are so low that, by my calculation, it will need to at least quadruple revenues from H1 run rate just to break even. And 1Spatial, which also published results this morning, is growing at 3%, making very little profit, consuming cash and yet still enjoys an EV/sales multiple of 2.5x and an EV/EBITDA of over 40x. And the list goes on. Outsourcery came to the market on 12x EV/sales claiming that it does something unique when many, including us, fail to see the uniqueness of the proposition that would justify anywhere near that valuation. Then there’s Malaysian enterprise software vendor Fusionex; revenues of less that £10m and a market cap of £140m. Anyone remember the last Malaysian company that listed on AIM. That’s right, data centre company CSF Group, whose shares are now trading at a fraction of the IPO price. There have also been other Asian software companies that have tried their luck on AIM and, to my knowledge, all have fallen by the wayside. I could go on.
So what is the reason for all of this hype and nonsense? For me, the fundamental issue remains the way in which fund manager performance is measured. Fund managers that invest in public companies are measured on the relative performance of their funds, usually against some kind of relevant index or basket of stocks. What this means is that, if they do not own stocks that are going up, then they will, by definition, underperform and this will directly impact their pay packets and, in extremis, their employment prospects. The obvious conclusion therefore is that fund managers need to own stocks that are going up which, in turn, makes them go up even more.
This scenario is the exact opposite of the micro-cap cul-de-sac conundrum that I have so often referred to in recent years. Fund managers funnel all of their cash into stocks that are perceived as strong performers at any one point in time and ignore those that are perceived to be in the micro-cap cul-de-sac. This leads us to the bizarre situation where very similar companies can have wildly differing valuations and some companies that those of us with a few years’ experience in the sector know to be held together with sticky tape, can be worth tens or even hundreds of millions.
It is easy to see the idiocy of this relative performance measurement if we think what it would be like if applied to the other main owners of smaller technology companies; private equity. Can you imagine how the underlying investors in a private equity fund would react if the investor relations manager for the PE firm came back after five years of a fund looking for fresh capital and said; ‘Our investment strategy was to invested in rubbish companies at high prices because that was what everyone else was doing. We ended up losing 25% of your money but don’t worry, this wasn’t as bad as most of the other firms so please can we have some more money to invest’. It’s clearly a ludicrous concept in a private equity context, so why does it wash with public companies. To be fair, I can see how this might be a good way of doing things for a fund manager investing in large cap stocks but, in the small cap arena, this relative performance measurement leads to lazy investment analysis and excessive volatility which ultimately puts off serious companies.
So, with no fundamental reason why these tiny companies have such huge valuations, sure as night follows day, many, indeed most of them will come crashing down. In fact, the cracks have already started to show. Keyword Studios was listed on AIM in July and has already issued a profit warning while, even worse, games company Zattikka, which floated just 18 months ago with a market cap of £22m, never managed to exceed its IPO price and called in the administrators in August.
But why does any of this really matter? If a few people get rich and greedy institutions lose a few quid, who really cares? Well, I do for one. A healthy stock market is a vital ingredient to a vibrant funding environment for technology companies of all ages and sizes. It has been long known that, if stockmarket flotation is not a viable option for raising capital, then all stages of the funding pyramid are affected.
In my early days as an analyst in the mid-90s, we welcomed companies like Fidessa (then called royalbue), Aveva (then called Cadcentre) and Capita to the market and all of which were below £100m value at IPO. My question is; where is the next Fidessa, Aveva or Capita going to come from? Even if we accept that there will always be a few puff stocks like Blur Group out there, the AIM market will not be perceived as a viable source of capital by ‘proper’ technology companies unless we start seeing some of them appear on the market.
And it’s not like there is a shortage of high quality candidates in the UK. As subscribers to our service will know, we track over 150 privately owned UK headquartered software, IT services and telecoms companies, the majority of which are of a size where a stock market flotation would be viable. There are newer, high growth companies such as Acturis, Thunderhead and Pulsant as well as more mature but still high quality businesses such as Sequel Solutions, Midland Software or Gamma Telecom.
My fear is that, with all of these over-hyped, generally low quality businesses coming to the market, the reputation of AIM as a serious place for companies to raise capital is already shot to bits. As such, rather than signalling the recovery of the AIM market, this latest crop of IPOs may well just be another step in the long slow decline in the small cap market that I have witnessed over the last 20 years.