Growing Tech Bubble?

Last week we learned that Facebook had purchased the mobile messaging tech company WhatsApp for an astonishing $19 billion in cash, stock and restricted stock. While $19 billion is not the $147 billion that AOL paid for the TimeWarner merger, it is the most paid for a venture-backed company says the Wall Street Journal (WhatsApp was financed by Sequoia Capital). There are several unique aspects to this story that we wanted to touch on this week.

WhatsApp is a relatively small company of 55 employees, but has experienced unprecedented growth. Business Insider reports that based off of users, WhatsApp grew faster than Facebook did in the same amount of time. WhatsApp provides a messaging service to customers so that they can send and receive content while bypassing cellular service providers, utilizing the internet instead. For Apple customers reading this, imagine an iMessage that you can download on any device.

Bloomberg reported that WhatsApp was responsible for mobile providers like Verizon, Vodafone and Sprint losing $33 billion in revenue during 2013. That decrease has major telecom players on the defensive, especially now that WhatsApp has announced that they are planning to add a voice calling feature which will also be internet based (think Skype).

We are less focused on the business model of WhatsApp this week and more focused on Facebook’s acquisition. Marketwatch.com reports that the cash and investment holdings of the top 25 technology companies have increased every quarter except for one from Q4 2011 to Q4 2013. With cash and investments totaling over $800 billion for these 25 companies, speculation has begun as to whether or not 2014 is going to be a historic year for M&A. That $800 billion figure is up almost 25% from October of 2011.

Furthermore, according to the LA Times, we are beginning to see tech companies reach unprecedented valuation levels. According to the article, while Apple has a price to earnings (PE) ratio of about 13 and earnings per share (EPS) of $40.23, Facebook’s PE ratio is a staggering 113 and EPS is $.61 (PE is calculated by dividing market value per share by earnings per share, while earnings per share can be calculated by subtracting preferred stock dividends from net income and dividing that value by the average number of shares outstanding).

What this tells us is that companies like Facebook are wildly overvalued, strictly speaking from a financial standpoint, not from an investment standpoint. This is reaffirmed by the realization that the average PE ratio of companies listed in the NYSE Composite Index is about 19.

We saw a similar situation back in the 2000s when tech startups were being purchased left and right with absurd amounts of cash and overvalued shares. The New Yorker actually published a chart showing the P/E of several internet companies that was rather interesting to compare, with Overstock.com being the lowest at 5 and LinkedIn being the greatest at 941.

It is far too soon to say whether or not this is the precipice of another dotcom boom and bust cycle, but kudos to companies such as Facebook for leveraging their insane valuations in the M&A sector.

With that being said we remain skeptical that this will last forever. At some point, those P/E ratios will come back to a realistic level, the only question is will prices drop significantly, or will earnings skyrocket?

Ben Treece is a partner with Treece Investment Advisory Corp (www.TreeceInvestments.com) and licensed with FINRA (www.Finra.org) through Treece Financial Services Corp. The above information is the opinion of Ben Treece and should not be construed as investment advice or used without outside verification.
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