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Spotting winners of the coming tech shakedown

Internet companies have different business models. Since they are loss-making, their success lies in revenue growth. Investors also require newer evaluation metrics. (Photo: Mint)Premium
Internet companies have different business models. Since they are loss-making, their success lies in revenue growth. Investors also require newer evaluation metrics. (Photo: Mint)

  • Shares of some internet companies are down between 49% and 63% from their 52-week highs
  • Some analysts see the recent correction in tech stocks as an opportunity to buy growth stocks at reasonable valuations. ‘Innovation is on sale,’ US-based fund manager Cathie Wood said

NEW DELHI : Many families in Amalner, a small town in Maharashtra’s Jalgaon district, have made a fortune buying and selling shares in a company that was incorporated here—way back in 1945 as Western India Vegetable Products Ltd. Nevertheless, this company’s stock, which we now know as Wipro Limited, has had a bumpy ride. Imagine the panic of these families during the dot-com crash of 2000-01. Wipro’s stock nosedived by as much as 88%. The company survived, so did Infosys, Tata Elxsi, Sonata Software and Zensar Technologies. All of their shares fell anywhere between 83% and 97% during the same period.

Some of these stocks became multi baggers for those who held on to it over the next decade.

Fast forward to 2022. Tech stocks are falling again. This time, it is the new-age ones.

Shares of FSN E-Commerce Ventures Ltd (Nykaa), One97 Communications Ltd (Paytm), CarTrade Tech Ltd (CarTrade), and PB Fintech Ltd (Policybazaar) are down anywhere between 49% and 63% from their 52-week highs as of 18 February, data from the BSE shows. On a year-to-date basis, while the Sensex has pared losses and is down nearly 1%, Paytm, Nykaa and Zomato are down 38%, 33% and 37%, respectively.

This doesn’t seem to be just about India, much like the 2000-01 bust. Globally, the Nasdaq Composite Index has slumped over 14% year-to-date. Popular Nasdaq stocks have dived—Facebook (39%), Amazon (8%), Tesla 20%), Netflix (36%) and Microsoft (15%).

All this begs the troubling question: is this the beginning of a tech bubble burst, of the sorts we witnessed in 2000-01?

Some market watchers believe it is. The liquidity glut-driven euphoria in internet stocks seems to be fading. Analysts do not rule out further correction. Some tech stocks, they hold, are trading at “insane" valuations even after factoring in the recent fall. However, they caveat their commentary saying a comparison with 2000-01 may not make sense since the penetration and use of the internet is far wider now.

“2022 is not like 1999. The difference is that now, the Internet is a part of everyday life. We cannot live without it. While many tech companies have fallen, the good ones will bounce back once they demonstrate profitability," says Neil Bahal, founder and CEO of Negen Capital PMS, a portfolio management services company.

Other analysts concur with Bahal on the profitability metric.

“Year 2021 witnessed listing of some established new-age companies but the reality check is profitability," says Amit Chandra, assistant vice president at HDFC Securities. “Unless the path to profitability is clear, the market will not value a franchise," he adds.

Innovation on sale?

Survival from the dot-com bust didn’t come easy–even for the profitable companies.

According to calculations by Morningstar, a financial services firm, Wipro took 14 years to cross its dotcom bubble peak compared to Sensex that took just about two years. Infosys and Tata Elxsi surpassed their dotcom peaks in five years while Sonata Software and Zensar Technologies took 13 and 12 years, respectively.

According to data from Negen Capital PMS, in the US, companies such as Microsoft, Amazon, Priceline, Adobe, IBM and eBay took a decade or more to bounce back after their dot-com bubble peak.

Meanwhile, many firms such as Lucent, Nortel and WorldCom, which seemed stronger at the time, have either merged with other companies or no longer exist.

At the same time, experts do see a great opportunity to buy.

“Innovation is on sale," US-based fund manager Cathie Wood, famously called the ‘star stock-picker’, recently said, talking about the recent rout in tech stocks.

Wood is known to pick disruptive companies over the Googles and the Facebooks of the world. Her flagship fund, ARK Innovation ETF, includes stocks such as Roku, Zoom Video Communications and Coinbase among its top five holdings. Tesla stands atop.

She may have a point. In the US, which is a more mature market for internet companies, the top five US companies by market cap included General Electric, AT&T, Exxon Mobile, Coca-Cola and Merck & Co in 1995, data from brokerage Motilal Oswal shows. They have ceded the pole position to tech companies such as Apple, Microsoft, Alphabet, Amazon and Tesla. Cathie is already looking beyond incumbents to bet on newer tech firms.

In the case of India, Bahal of Negen Capital PMS holds that the older stocks will struggle to catch up with high-growth companies. “I don’t know who will be the end winners, but they will dominate the Nifty," he says.

He dubs the recent correction in tech stocks as a generational opportunity to latch on to some of growth stocks at reasonable valuation. “There could be further correction, but that would give you an opportunity to average down your buying price," he adds.

He sees opportunities in sectors such as e-commerce (especially video commerce), music, gaming, e-sports, software as a service (SaaS) and metaverse.

New metrics

Internet companies have different business models. Since they are loss-making, their success lies in revenue growth. Investors also require newer evaluation metrics.

“Hyper growth in revenue is the key to success for such companies. The losses can be erased only when revenues hit a critical mass, driving operating and financial leverage," states Motilal Oswal Financial Services Ltd in a recent report titled ‘Atoms to Bits—wealth creation in the digital era’.

So, how do investors identify the revenue growth creator?

“Investors should look at valuation metrics such as price-to-sales or price-to-revenues," says Dhaval Kapadia, director-portfolio specialist, Morningstar Investment Advisers.

Market cap divided by sales is price-to-sales. The lower the ratio, the better the company is valuation-wise. “If you are paying 15-20 times price-to-sales for a company, then you are entering the stock at expensive levels," says Kapadia.

Price-to-sales ratio, however, does not consider the varying rates of sales growth. For example, if two companies are valued at price-to-sales of four times (4x), and one company is expected to grow sales at 20% and the other at 40%, clearly the latter is preferable. But price-to-sales ratio does not capture this. Experts, therefore, suggest yet another metric—PSG or price/sales to future sales growth rate.

“Thus, in the above example, the first company has a PSG of 0.2 (4÷20), while the second company has a more attractive PSG of 0.1 (4÷40)," explains Motilal Oswal in the same report cited earlier.

Data available from Screener, a stock analysis and screening tool, shows that Nykaa has a price-to-sales ratio of 28.4 compared to 1.56 for Shoppers Stop even as both the companies are growing sales at over 30%. Why compare Nykaa with Shoppers Stop?

Nykaa’s quarterly earnings report shows it has opened 12 new retail outlets, taking the total store count to 96 as of December 2021. Warehouse storage space is also expanding.

“Nykaa has a physical plus digital model but gets valuation of a pure play e-commerce internet company. It could well be compared with Shoppers Stop, which is trading at much cheaper valuations," says Amit Chandra of HDFC Securities.

Among other internet names, Indiamart Intermesh, which listed in 2019, is quoting a price-to-sales ratio of 21 even after a 30% fall from its 52-week high hit on 18 October 2021. The company, however, has delivered robust profit growth of 52.10% CAGR over last five years, data collected from Screener shows. Its return on equity and return on capital employed is also over 30%. Despite the recent rout, the stock is up over 300% from its listing price.

Another profitable internet firm, Info Edge, quotes a whopping 42 times price-to-sales. According to ICICI Securities, the stock is among the top two contenders for entry into NIFTY50 (the other being Apollo Hospitals).

The Nifty index is reviewed twice a year. The upcoming semi-annual changes to the Nifty50 index could be announced this month.

Time-tested metrics

In tech circles, the Amazon story is viewed with a certain awe. Its case study is often touted to justify how a growth stock can reward investors. The company has grown its market cap from $4 billion in 2001 to $1.5 trillion now. But there’s a catch. Its e-commerce business barely records profits while Amazon Web Services (AWS) is the real profit generator. “In the case of Amazon, while highest revenues come from its e-commerce business, most of the profitability comes from AWS," says Chandra.

Apple, too, diversified itself from Apple II (home computer), to Macintosh and then to the all-in-one desktops, iMac. Over the years, it introduced several new products and services including the iPod, iPhone series, iTunes, AirPods, and so on.

Indian new-age companies, too, need to diversify into profit-making ventures—beyond what they currently sell, market watchers hold. “Such scale-up can be vertical i.e. in existing business, and/or horizontal, i.e. in adjacent businesses and/or completely new businesses," states Motilal Oswal.

Analysts also suggest tracking user growth. Companies can easily game user growth figures by influencing people to sign up in return for freebies or cashbacks. “If you give enough economic incentives, it is possible to have a huge number of people sign up to your website or app and perform actions on it, who can then be counted as users to show growth. Such users will not generate any real business. If anything, they would only slow the business down," says Nithin Kamath, founder and CEO, Zerodha, a financial services company that offers retail brokerage services. Separate the wheat from the chaff, he suggests.

The capital conundrum

High liquidity, globally, fuelled the euphoria around new-age tech stocks. That liquidity pipeline is drying with global central banks hinting at raising interest rates. This could result in a detrimental impact on companies in dire need of cash to run their businesses.

In such a scenario, the growth companies got to reach a stage where they don’t need fresh capital to expand their business or generate user growth.

“Old tech companies and the survivors of the tech bust (2000-01) had no leverage. They never needed fresh money, but only growth avenues to run their businesses," points out Shyam Sekhar, founder, iThought, a financial advisory firm.

That is not the case with new-age companies. “I don’t see any self-reliant new-age company at the moment. They will need capital to run for a few years till the growth becomes adequate to make them self-sufficient," he adds.

Capital self-reliance, therefore, is what investors must keep an eye on, experts stress.

Usually, market leaders or those with a sustainable revenue model, corner the capital when less money is chasing growth. “Keep an eye on companies that have raised capital. They becoming self-reliant over the next 12-18 months after raising funds will be a positive cue," says Sekhar.

While the liquidity glut and high valuations of new-age companies do mirror the tech boom of the past, the burst phase may have only begun. It is too early to predict the bottom or survivors of the current tech bubble. However, in the end, companies with a clear path to profitability, could be the last guys standing.

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