All bubbles burst eventually. Google has become a bigger political donor that Goldman Sachs. The tech sector is no longer the naïve capitalist entity that was startled by the Microsoft antitrust lawsuit in 1998. Venture capital money has flowed profusely into it for half a decade and valuations have reached to the sky. Some of its manifestations seem to have reached their natural limits, while others are running up against increasing legal and ethical concerns. In summary, even more than in 1999, for savvy investors the sector is now a short.
In 1999, the case for shorting the tech sector was simple: valuations had gone mad. With Amazon valued at $50 billion before it had any earnings at all, while infrastructure companies like Cisco and JDS Uniphase were worth more than the giants of industry, it was clear that valuations were assuming future growth rates never likely to be achieved.
In the event, not all the optimistic prognostications were nonsense. The Internet has indeed expanded to around 700 exabytes of traffic in 2014, compared to a mere 300 petabytes in 1999 (for those not hip to these terms, an exabyte is 1,000 petabytes, 1000,000 terabytes or 1,000,000,000 gigabytes in what passes today for real money. Like Reichsmarks in 1923, individual bytes of information have become so small as to be invisible.) That’s a growth rate of 68% per annum, sustained over a 15-year period.
The gigantic surplus of fiber-optic cable capacity, which sent Global Crossing and others bankrupt after the bubble burst, has turned out to be moderately useful in the long run, as cellphone usage and bandwidth consumption has continually increased. Remarkably, even Pets.com, the ultimate bubble company mocked by all, which went bust, complete with its sock puppet, on Election Day 2000, has been succeeded by iPets.com, 1800PetSupplies.com and several other websites specializing in the pet supply genre. Apparently shipping cat food around the country by express mail really can be profitable. Who knew!
The 2000-01 market crash in retrospect did little long-term damage, even though it bankrupted some very substantial companies, notably Enron. That company, although named by Fortune “America’s Most Innovative Company” for six consecutive years, existed largely at the whim of regulators; its energy trading business depended crucially on prices being de-controlled at different speeds in different places. Internationally, it was even more obviously crony capitalist, entering into deals with Nigerian barges and Indian power generation operations that appeared more corrupt the more you looked at them. It was an early lesson that when capitalism turns into crony capitalism, built upon a mountain of operating and financial leverage, and disguised by aggressive use of modern “mark to market” accounting principles, economic failure must surely follow.
The remainder of Silicon Valley, however, was in 1999 pretty purely capitalist. Microsoft’s near-monopoly of operating systems did not rest on regulatory loopholes, nor by and large did Cisco’s growth in networking equipment, nor E-Bay and Amazon’s expansion into entirely new businesses in the retail sector. Nor were any of these companies particularly leveraged, though they did make use of aggressive accounting in not recognizing stock option costs properly. Thus when the dust cleared from the crash, the companies were still there, as were their businesses. They have gone on to prosper in the new environment, even if most of their stock prices still lack their 1999 majesty.
Like Enron, Silicon Valley is moving rapidly towards crony capitalism. For a purely capitalist enterprise, a political contributions expenditure larger than Goldman Sachs would be unthinkable. (Goldman Sachs is of course not a purely capitalist enterprise; in today’s over-regulated and billion-dollar-fine-happy financial system it cannot afford to be, even if it wanted to.) Google faces no regulatory threat remotely comparable to that facing Goldman Sachs and the other behemoth banks; hence its political influencing efforts are devoted to gaining an edge on its actual and potential competition, not to fighting off predatory regulation and lawsuits. For those of us who believe in free enterprise capitalism, the company whose founding motto was “Don’t be Evil” has thus become Evil – an outcome that I forecast at the time of its IPO in 2004.
Google is not alone. Facebook CEO Mark Zuckerberg’s campaign to subvert U.S. immigration controls, an effort enthusiastically joined by many Silicon Valley honchos, is another attempt to secure by legislative means special advantages that, when combined with the remainder of the proposed immigration legislation, are thoroughly damaging to the U.S. economy as a whole, and even more so to the living standards of the U.S. people.
With conventional business, one could only scratch one’s head in bemusement at CEOs who professed left-wing political principles, since the principles were at odds with the capitalist means by which they had succeeded. In Silicon Valley, there is now no such contradiction: the principles of political rent-seeking which they espouse in their giving are the same principles on which many of the companies increasingly rely to get ahead.
It goes without saying that valuations – and indeed executive salaries – are now sky-high. The Facebook acquisition of What’sApp for what eventually proved to be $22 billion — $440 million per employee for a company with hardly any revenues, let alone profit – indicates just how exuberant the market has become, while Facebook itself boats a market capitalization of over $200 billion. But exuberant valuations on their own would presage only a stock market implosion, as in 2000-01, doing little damage to the overall economy or even to the more free-market parts of Silicon Valley itself. The more damaging crash will be structural, not financial, caused by a senescence of the business that was not a factor in 1999.
The move of the giants of Silicon Valley towards crony capitalism is important in itself, but it signifies an industry that is already moving into the slowing reactions and creaking joints of late middle age. The B2C consumer-oriented Web has already become commoditized, as developers have produced far more “apps” than anyone could possibly use. Facebook is losing customers in the United States, but making them up from two sources: by increasing penetration in the Third World (where available revenues per customer are inevitably less) and by more intensive mining of the advertising possibilities.
This highlights one huge problem for the B2C space: the total of available advertising revenue is finite, is growing relatively slowly, and is not particularly large. If you are selling soap powder, the first 5% of your advertising budget you devote to “social media” may bring you wonderful returns, as new customers are brought within reach of your message, but after that the marginal returns of increased spending quickly diminish.
The total U.S. advertising spend is increasing only slowly: by 3.7% in 2013 and by an expected 5.3% in 2014, according to eMarketer. Given the explosion of outlets through which advertisers can spend their money, this is very unimpressive indeed. It means that outlets which do not expand their advertising market share are condemned to low single digit growth at best, with a continual pressure from newer and trendier media. Needless to say, the stratospheric valuations of companies in the B2C space are taking no account of this depressing reality.
At the other end of the tech sector, the value of the “Big Data” business is increasingly looking overhyped. Rather than something that benefits the ordinary consumer, Big Data is increasingly looking like a vehicle for Big Brother. The danger comes from two directions. First, as we have seen in the IRS scandal, governments with mountains of information on people are increasingly tempted to use it, generally tilting the contest between government and the individual dangerously in favor of Leviathan.
Second, the repeated thefts of personal information from U.S. retailers make it clear that Big Databases are huge temptations to the world’s most unpleasant individuals, and that even with Big Data capabilities neither governments nor commercial companies are capable of protecting them. Big Data and its users spend huge amounts of time and money worrying about security, but so far, it mostly seems to be wasted. Thus, while it has limited uses in tracking down terrorists, Big Data increasingly appears a sector on which tight legal limits must be imposed, while individuals must waste ever more resources in protecting their information from misuse.
Finally, two underlying factors, one technical and one sociological, are causing the tech sector to age more rapidly than might be expected. The demise of Moore’s Law, propounded in the 1960s, by which the capability of electronic devices would double every two years, has always appeared to be at least ten years in the future. However recent developments suggest that the physical limits could be closer than that, with even optimistic futurologists suggesting that entirely new paradigms will be needed to extend Moore’s Law beyond 2019. A Silicon Valley without Moore’s Law is a place where all the hardware has been commoditized, all the software has been written; it will not be a place that supports either brilliant engineers or the exuberant current level of valuations.
Second, there is the undeniable fact that no technological company that has aged beyond the first generation of management has remained well managed. The roadside is littered with companies that have died or been taken over at a tiny fraction of their former valuations. The 90s giants, Microsoft, Cisco and Yahoo, are all finding it increasingly difficult to grow, and will find it impossible to maintain their current position in a recession.
The 2000-02 downturn produced few large Silicon Valley casualties, other than the egregious Enron (which wasn’t strictly a Silicon Valley company), a few fiber-optic companies whose business suffered giant overcapacity and a multitude of tiny Pets.com clones that never really got going. However the next downturn looks likely to take with it many of the giants of the industry that have worn out their welcome, especially those whose glory days occurred before 2000. Even Apple, Google and Facebook may be far more vulnerable than they appear.
Old age and decrepitude come to us all in the end, and they are settling inexorably over Silicon Valley. Its denizens will fight them, chasing frontier-tech acquisitions like What’sApp, the corporate equivalent of 22-year-old ladies of exciting curves and loose morals, and seeking through financial engineering the magic drug that will prolong their vitality. It won’t work. Huge money will be lost, and the world will move on to something else.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)