I recently represented Blackstone on a panel discussion at the most recent OnDemand conference in Palo Alto
In reflecting on the question, both during and after the discussion, I believe that it is possible we could be developing early signs of a bubble, but that it is not likely. Rather, I believe we are in the very early innings of a trend that will shape the IT industry for the next 20 years, and that there is little evidence to suggest that a bubble is here, or forming, today. In reaching a conclusion on this topic, in my view there are 3 fundamental questions that need to be addressed first:
─ Has the market hit an inflection point yet?
─ Are assets overvalued?
─ Has the buyer / investor universe “capitulated”?
I believe that the answer to these 3 questions is, decidedly, no.
Has the market hit an inflection point yet?
With respect to whether the market has yet hit an inflection point, I find that hard to believe. Admittedly, it is true that we are currently at the top of Gartner’s famed “hype cycle”, a designation typically only achieved once an IT term has become a buzzword, with market hype in excess of market reality. The term “Cloud Computing” certainly falls into this category. It is also true that nearly every company, in the infrastructure software market, at least, is now a “cloud” company, regardless of whether their business model has the first thing to do with Cloud Computing. These ominous signs might suggest that we are nearing a bubble.
Make no mistake, however, the cloud is real, and will happen. It is simply a question of when. Unlike previous investment “bubbles”, such as RFID, grid computing, and Open Source software, embodied by interesting technologies or business models in search of a problem, the trends driving cloud computing – ease-of-use, lower cost, efficiency, collaboration – have been central tenets of the IT industry since the industry’s first days. In other words, cloud computing is a solution to entrenched, difficult-to-solve problems, not simply clever solutions looking for a market.
Viewed through this prism, cloud computing is just beginning to get its legs. We are in the very early innings of a very important trend. The Internet of 1994, not 2001, if you will; the O/S wars of 1983, not 1995. These cycles take time to develop and play themselves out; even if the hype is ahead of the reality today, the reality will come, and until that inflection point is reached, it is a bit early to call a market top.
Are assets overvalued?
To answer this question, we need to look at observable prices paid in the market for Cloud Computing assets, both in terms of publicly-traded multiples and prices paid in precedent transactions. With respect to the former, public multiples, I don’t believe assets in this sector are grossly over- or under-valued in the market today. It is true that many of the “cloud” companies, whether you consider a Salesforce.com or a VMware, sell at premiums to the market averages, this is predominantly a function of, and justified by, one thing: growth. Publicly-traded software companies trade on their future growth prospects, with a correlation of over 80%. In the case of the aforementioned companies, the reason they trade at such high multiples is due to their long-term growth prospects, which are well above 25% on an annual basis. Investors are willing to pay higher multiples of cash flow because their cash flow is growing so rapidly; and as such the present value of those cash flows is higher.
Considering multiples paid in precedent transactions, it also does not appear that we are in a bubble. First off, there simply have not been many pureplay “cloud computing” transactions we can observe. One could argue recent deals such as VMware / SpringSource or Salesforce.com / Jigsaw fall within this category. While true these deals fetched healthy multiples (8 and 14x trailing sales, respectively), it is also true that these multiples may well be justified from a corporate finance point of view. In the case of VMware / SpringSource, VMware was willing to pay a strategic multiple to acquire a strategic piece of the cloud computing stack it did not own: a leading development platform. In so doing, VMware will be able to begin controlling and managing cloud-based applications at the point they are created, something, arguably, no one other than Microsoft can do in the market today. In its quest to build a next-generation “Cloud Operating System”, VMware was willing to make a big bet that Infrastructure-as-a-service and Platforms-as-a-service will, in the long-run, be inexorably linked.
Has the buyer / investor universe “capitulated” yet?
In my view, we are far from the “irrational exuberance” that has characterized previous bubbles, with respect not only to the “frenzy” around strategic assets but also the prices paid for those assets. In prior bubbles, investors bid up assets and bid down risk premiums to levels unjustified by underlying fundamentals. From the public equity perspective, investors during these times are willing to own assets and any nearly price, not due to rational analysis based on business fundamentals, but simply because they believe the price of assets will continue to move higher. From the M&A standpoint, these periods frequently witness a frenzy around scarce assets and a perception on the part of buyers that they “need to own” certain businesses at any price, either because they are playing catch up in a market, or to block a competitor from gaining too big a lead. Despite the relatively high valuations of deals mentioned above, I would argue we are far from witnessing the feeding frenzy and associated sky-high valuations that are characteristic of other bubbles.
The moderator of the OnDemand panel began by referencing the Google / Youtube deal from 2006, in which Google paid $1.5 billion for a company with no revenue, citing it as an example of the pending “bubble” in online video, and asking whether we have seen such a deal yet in the Cloud Computing market. Given the three criteria I have outlined, I actually think it is debatable whether Google’s purchase was indeed evidence of a bubble. In the case of that transaction, Google paid a strategic premium to own a leader in the space, and may have gotten a bargain for the potential synergies to be realized from the deal. The acquisition was also de-risked due to the fact that the price paid represented only approximately 1% of Google’s market capitalization at the time. Time will tell whether the purchase was in fact justified from a corporate valuation standpoint, but it is highly possible and perhaps likely, that this buy was, in fact, a “rational” one.
We will not know for a number of years whether we are at the front edge of a Cloud Computing bubble. Perhaps we will look back someday and view VMware / SpringSource as the catalyst that led to future irrational exuberance in this market, followed by a precipitous decline in asset values. But I suspect not. My view, rather, is that we are not there yet, and may not be for many years to come.
