We’re wrapping up our discussions on technology from a Wall Street perspective. Part 1 covered internet, hardware, telecom and semiconductors… Part 2 is going to cover 5) networking, 6) software, and 7) Other Tech to touch on all the remaining topics.
Networking is valued in a similar fashion to hardware. When you think of networking the biggest player that should jump out for your average person is Cisco Systems – the $130B networking giant.
As you can imagine there are a lot of mature product categories in this space and when you hear the word mature it usually means slower growth, less deals and more maintenance work and tuck-in acquisitions.
Positively, there are still some bright spots in networking and this post would not be doing the space justice without mentioning some of the hotter pieces of networking IE: Palo Alto Networks for example. So lets go ahead and break down, in simple bullets, what networking comprises of starting with CSCO since it has the vast majority of the product lines.
Switching – Essentially fixed, modular and storage expected to be flat to slightly up on a y/y basis in the future. Think closer to IT spend
Routing Products – you’re all familiar with routers both on corporate environments and in your home for internet/TV connections – similar growth expectations at IT spend flat to slightly up
Service Provider Video –cable access, connected devices, essentially as video becomes the medium of choice this space will grow. Expected to be up mid singles annually
Collaboration – unified communications
Data Center – Growth. As expected by the name, anything related to additional sales into the growing data center space – expect 10-20% here (debatable)
Security – Self explanatory, helping keep enemies out of the network, flattish last year in 2013 but should grow at least mid single digits
Wireless –older legacy products call it IT spend growth
What should you move toward? With this backdrop it is clear the space does have some similarities to hardware in that a lot of the areas are mature but… there are some bright spots. The growth rates alone should point you to the bright spots Security, Data Center and Service Provider Video
Security (PANW): “According to IDC, the worldwide enterprise network security market, defined as IDC’s Network Security market and Web Security market, is estimated to be $10.0 billion in 2012 and is projected to grow to $13.4 billion by 2016.” – pulled directly from PANW IPO filing.
Data Center (ANET): “Nearly all consumer applications today are delivered as cloud services. Enterprise applications are rapidly moving to the cloud as well, since cloud services are easier and more cost effective to deploy, scale and operate than traditional applications. Internet leaders like Amazon, eBay, Facebook, Google, Microsoft and Yahoo! pioneered the development of large-scale cloud data centers in order to meet the growing demands of their users, including business customers. These U.S.-based Internet leaders increased their capital spending from $8.9 billion in 2010 to $19.4 billion in 2013, representing a 29.6% compound annual growth rate.” – pulled directly from IPO filing
Video Services (CSCO): Keeping it simple and referring back to CSCO since there is nothing public that we would refer to for a specific sizing number (feel free to chime in if you know of a pure play here). Service provider video: 4%-6% y/y growth in the future.
Valuation: For the networking sector you’re looking at the same metrics we outlined for hardware, this is a copy paste job below but good for reference if you’re interviewing for a networking slot and want to print this out. You should be more familiar with 1) P/E metrics both on a GAAP and non-GAAP basis, 2) DCF for Large Cap hardware, 3) Sum of the Parts and 4) EV/Sales for growth hardware.
P/E: This is self explanatory, however the point is earnings growth is eyed a bit more in the space as companies are expected to grow EPS faster than sales (assuming we’re talking about larger companies)
DCF: Again focused on large cap tech, as your EPS becomes larger, companies look for quality earnings. As a rule of thumb GAAP net income growth should begin to mirror FCF growth, so a DCF becomes more viable at this point.
Sum of the Parts: As you can see, many of these networking companies will inevitably have multiple business lines. Ideally you will value each sub-segment separately to come up with a fair valuation. Growth rates and margin profile will determine the appropriate multiple.
EV/Sales: When you have no profits and you’re operating at a loss… You better grow like a weed. This is where EV/sales becomes crucial. The idea is that if your company is growing at 50 or even 100%+ that you have a major technology lead, a major company could then become fearful of you and buy your entire company.
This is going to take the bulk of part two, because similar to internet, it is the “hot space” in the Tech industry. Before jumping in it’s probably a good idea to explain in layman’s terms why the space is coveted. The best example we can use is a subscription based model.
Basic Software Business Model: Everyone knows Netflix and Hulu (internet not software). These business models are attractive because individual *consumers* purchase a subscription or access to content that has a fixed/flat cost base. What this means is there are limited costs of good sold so you have higher gross margins and this flow through the financial model. The more users you get, the better since the content you’re selling doesn’t change in price and you simply need to scale.
How does this relate to Software? Well to put it simplistically a successful software company has this on an **Enterprise** level. Meaning your recurring revenue is coming from companies not consumers.
Using a simple example, you buy software from Microsoft for your company… Now this software has recurring annual license / subscription revenue and your software company now makes a huge margin as they sign up more and more enterprise companies on your software. Again the gross margins here are high because the software is a code and this flows through and your main overhead is essentially R&D (ie: the guys you hire to make the new codes)
Now we can go ahead and take this a step further and explain that enterprise users for major software companies also pay for services (be it maintenance or essentially trouble shooting) but the crux of the matter is that extremely valuable software can be scaled quickly, deliver value to an enterprise immediately and give the software company a “long tail” of future revenue assuming they sign an enterprise up for a 2-3+ year agreement.
What Type of Companies Fall into this Space?
You can find hundreds of ways to splice the space “Platform as a Service” (PaaS), “Software as a Service” (SaaS), “Big Data Analytics” (BDA), “Virtualization” (Desktops/Servers), “Cloud Based Companies” (don’t get us started on anything that falls under the cloud).
Instead of going through and trying to bucket exactly where all these companies and segments fall we’ll look at the big level trends and name a few players who touch on each space.
Virtualization (VMW/CTXS/MSFT): This was a bit hotter back in the 2009-2010 time frame when server virtualization was ramping up to speed. For those that are unaware of what virtualization means, in layman’s terms, it essentially allows a server to perform multiple tasks. Previously a single server would be dedicated to just *one* application or task, but now with **Server Virtualization** you can install software and divide the physical server into multiple *virtual* environments.
Moving forward, the next phase is the move to desktop virtualization. Again to put this in layman’s terms what this means is your desktop will now be more secure as it is linked up to a bunch of storage/servers inside a data center. The best form of explanation is as follows:
1) Joe has his laptop stolen
2) Joe reports the laptop stolen to his IT administrator
3) Joe has to explain all items on his desktop/accessible in order to make sure no confidential information is breached
4) Thief tries to steal information in the mean time
1) Joe has his laptop stolen
2) Joe reports the laptop stolen to his IT administrator
3) Due to desktop virtualization and working off servers + storage all the IT guy does is cut off 100% of all access and shut down the computer for life
4) Thief gets nothing because zero information is on the drive, he simply picks up the cheap hardware product that no longer has information on it
There is much more to this, but with the two examples of server and desktop virtualization it should give good reason to see the value.
Business Model: Now in this space you’re looking at around 10-12% long-term revenue growth, gross margins of 85%+ and operating margins in the 30% range. To avoid getting into the weeds too much, the big debates in this space are as follows: 1) what happens when all servers are virtualized and we have finally converted all physical servers to virtual servers?, 2) how much will it really cost to convert all desktops/notebooks to a virtualized environment? 3) Which company will have the best overall solution for the enterprise.
Big Data Analytics (SPLK, DATA and Pivotal a division of EMC)
This space is currently *hot* ie: many are talking about it and the valuations here are getting quite rich as people are looking for the best of breed in Big Data Analytics.
What is big Data Analytics? In short, it is essentially the ability to take a slew of information about a topic and make a decision as to what the information means in real time… And to do this in seconds not minutes hours or days. From a college student perspective think about it like this, big data analytics is trying to come up with a thesis paper… full and complete in less than 3-4 seconds! Okay that was a bit extreme… But that really is the idea.
As a real time example, lets say you *Joe Target School* walk into a local clothing store. With all the information you have given out in the past 1) your previous purchases, 2) your facebook posts, 3) your emails – which Google is free to read and 4) your history with the store…. They will immediately try to sell you the product you’re looking for. Now… Take this a step further… They are looking to do this on a geographic basis as well. If you own the same clothing store in Austin Texas versus Spokane Washington, the clothing store will reorganize the entire store to match the buying preferences of the community as a whole.
Business Model: In this space you’re looking at hyper growth of up to 50%+!!! In addition you’re looking at gross margins of 85%+. Notably, operating margins are generally negative, IE: these companies are *losing money* because they are reinvesting in R&D to make sure they have the best analytics software and in addition are searching for ways to obtain more sales (marketing and sales expenses). Most of our tech savvy readers already know this is how high growth new software companies work, negative operating margins as you build a book of recurring revenue then you should scale appropriately and see the profits flow in at a later date.
Cloud Based Companies (CRM, WDAY)
Now we’re getting into the cross over and broad topics in software. Cloud based companies can be literally any software company that primarily functions on applications for the Cloud or “Platform Three”. A company that uses internet based computing to give a service/product is going to be considered cloud. As you can see this opens up a large large large can of worms in terms of what can be considered a cloud based company. Certainly a software company that has all of its revenue derived from the cloud would count… but deciding if you include a security company as cloud is difficult (looking at you FireEye).
If you wanted to look at one company and say this is a large “cloud” based play, then a good place to start would certainly be salesforce.com (CRM). Even on a $1.2B+ quarterly revenue run rate, the company is growing at 30%+. This is a tall task for any company. The Company operates in 4 segments sales cloud, service cloud, marketing cloud, salesforce1 platform.
Again putting this into simple terms, think of CRM’s business model as access to proprietary software/applications through the internet. Simple as that. Using CRM as the leading example a *service cloud* would be creating and tracking calls and the ability to prioritize importance (through internet medium), *sales cloud* would allow collaboration in tracking and helping close a client/business lead and again escalating to different members as they near purchasing, *marketing cloud* allows customers to bring in outside data and integrate into their customer profile to help analyze and later sell more products in the future.
Business Model: Would like to reiterate that many companies can be considered cloud, but if we’re speaking towards large scale growth (like a CRM) you’re looking at ~30%+ growth this year and 20%+ over the medium term (call it 3-5 years). The Gross margin profile in this space is slightly lower than a pure software company but you’re looking at 75%+. In addition, sales and marketing expenses are higher given the larger support and services piece of the business model, but you’re looking at 10%+ op margins.
Software as a Service… For those that work in technology investment banking… you’ll know why this was listed last… It is simply because you can technically call CRM/MKTO/Netsuite/Workday and other companies mentioned within this write up as… “Software as a Service” companies.
Since we don’t want to go over every single company that is considered SaaS which would take a post in itself, we would recommend this short article that simply talks about high level valuation of SaaS Companies:
Valuation: Here’s the basics for Software Companies, if you’re talking about larger firms such as a CRM a Free Cash Flow multiple may work along with a DCF. When you’re talking about high growth companies (see losing money) then you’re forced up the income statement and you’re looking at Sales multiples. If you’re not using any of those four metrics then you’re likely moving to a P/E metric and lastly a EBITDA metric…. Software is a huge space, we missed out on a lot here and didn’t even scratch the surface (examples RHT/LOGM/LPSN etc etc.) and the fact that there are so many large companies lets you know that there will be a lot of IPOs/consolidation in the future. That’s always music to a banker’s ear.
***Want to reiterate here, unlike Internet which can be more or less understood when looking at the business model at a glance, Software has a lot of overlaps and can be difficult to “position” particularly for a pitch or comp sheet. When push comes to shove you’re going to have to understand how your banker thinks about splicing up the space and how to spin your company into the right “buzz word” areas such as cloud and big data analytics. As a quick note, a smart way to justify your comps/valuations is to stack up like for like growth rates and margin profiles regardless of it being a XYZ software play instead of a ZYX software play. Long story short software can have a full 10+ pager in seconds***
Here we are going to attempt to tie in all the loose ends that could be considered technology. As an example you can use 1) manufacturing, 2) distributors and what we’ll deem 3) electromagnetic devices as “Technology”
For those that work in industrials you see how we begin to blur the lines between “technology” and “industrials”. As an example if a company creates the components within the technology device (think the nuts and bolts connecting everything inside a server or a laptop) is this considered “technology” or is this considered “Industrials”. Without debating how to splice the group we can name a few types of industries that could be considered tech but could also fall into the lap of a few different industries person.
Main Industries that can qualify as *Tech*
Media/Gaming (CBS, GA, SINA, FOXA): Okay… fair we should have another section on this, since it is calledTechnology Media and Telecom… However the issue is the space is generally fragmented (gaming) or quite consolidated (media).
Looking at gaming, upstart gaming companies are quickly scooped up by one of the larger companies such as GA. In this case, when interviewing for a media/gaming based position you should expect to work on a LOT of 1) small sell-side M&A transactions or 2) advising a large gaming company on a lot of small M&A transactions.
Now if your focus is more on media you’re going to be referring to CBS and we would refer back to telecom based valuations for simplicity: focus in on 1) entertainment vs cable revenue growth, 2) subscriber growth 3) Contract renewals with operators such as DirectTV, Cable Vision etc., 4) capital allocation policy – dividend changes and 5) Free Cash Flow. In short, refer back to valuations for “mature technology” since the big names are unlikely to trade on sales multiples gives the growth rates.
Distributors/Value Added Resellers (VARs) – [TECD, AVT]: These companies essentially buy products, warehouse them and resell them. Lets say you’re a small company and can’t afford a massive sales team like the big technology companies. You reach out to distributors/VARs to help sell your product. They generally provide some technical support as well.
[Note: *technically* distributors and VARs should be slightly separate as a VAR is supposed to provide additional features or services at all times before reselling, but we’re just making this easier to clump together]
Manufacturing [Hon Hai, FLEX, Catcher]: All these severs, computers and phones being made someone has to put this stuff together right? Simply put, the job of technology manufacturing is to find ways to efficiently pump out those billions and billions of SmartPhones, laptops, printers, Servers etc. You see this in the news quite a bit with China wage laws and all the other associated manufacturing issues brought up by main stream media.
Electromagnetic Devices [GLW, TEL, BDC]: Lumping a LOT of categories in here, but think about it like this… all of the “stuff” inside. The antennas, the batteries, the sensor for your fingerprint scanner, the control that notices you have turned your iPad up and then back to the side to view a movie etc. All of this “stuff” is going to be technology in some cases. You could also call it “industrials” simply put the guts of the technology product.
Valuation: For this space we’re really looking for P/E and FCF. For the extremely large companies that create the guts of the products you can have a sum of the parts for the different businesses (since they command different margins) but we’re going to avoid extreme detail and stick with P/Es and FCF.
The bigger idea when thinking about valuation for these types of companies is this… They are heavily influenced by the macroeconomic climate. This makes sense. They are trying to sell anything and everything to everyone, or trying to create anything and everything. So if the macro economy suddenly improves their revenue numbers jump and if the macro were to suddenly decline, they would quickly fire all of their employees making all of these products.
Financial Statement Dynamics: Since these companies are creating large volumes it would be clear that inventories need to be monitored. Here is where you can look at working capital swings as proper management of capital is going to impact your FCF.
Finally, this group of “other” tech companies are generally prone to charge offs or one time restructuring as they resize their businesses on a relatively frequent basis to adjust for the macro climate. This should be taken into account when one looks at their performance over a specific time period, IE: a full bull and bear market should give a much more reasonable idea for how the company operates (positive or negative). Can they manage a down turn? Can they take advantage of an upswing? Etc.
Concluding Remarks: At this point we’re burned out with the typing. We have ~20 pages written now on Tech and ~10 pages written on FIG. The big issue? We hardly scratched the surface! Media should be talked about more, same with software, internet and a few other segments mentioned on here. That said the combined pieces should provide more than enough of an overview for someone interested in either sector…. Good luck and as always 1) do your own research, 2) remember to network and learn about each group so you know what *type* of companies you’ll be working with since growth technology and mature technology companies are certainly valued differently and 3) finally… never, never, never tell a banker he is in a mature industry, always be up beat and pretend you think there is a lot of *opportunity* in the space even if you know the segment is mature.