The New Tech Bubble – How Ugly Could It Become?

“WITCH #2: For a charm of powerful trouble,

Like a hell-broth boil and bubble.

ALL: Double, double toil and trouble;

Fire burn, and caldron bubble.”

The Three Witches in “Macbeth”, by William Shakespeare

When David Einhorn, manager of hedge fund Greenlight Capital, warned investors last week that “There is a clear consensus that we are witnessing our second tech bubble in 15 years”, he wasn’t announcing any real news. But he was among the first respected investment managers to speak out. In the past month, a number of hot tech companies including a few that I mentioned in my last post on the current Tornado in SaaS business applications such as Salesforce, Workday, and Netsuite, have seen their valuations recede significantly. Investors do seem now to be getting concerned about valuations in what’s been a frothy market for some time, and they are growing wary of companies who once again seem to want to defy gravity and defer the evil day when making a profit becomes sine qua non for any sustainable business.

After a prolonged period of sometimes wild investor enthusiasm, the apparent refusal of many visible and highly valued B2C and B2B companies to prove their profitability, or provide a credible roadmap to profitability, is now beginning to actually bother institutional and retail investors. I see this concern as a healthy sign that we might avoid the carnage of the infamous 2000-2001 dotcom bust that followed the Time of the Great Happiness that started in 1995 after the birth of the commercially available internet. Many of us recall the warning issued in 1996 by former Fed Chairman Alan Greenspan, of “irrational exuberance” in the tech market, followed four years later by a massive meltdown of as much as 98% of the paper value of public and private company stocks.

In my last two blogs I discussed the “land grab economics” behind the astounding price paid by Facebook for WhatsApp’s 450 million sets of user eyeballs, and then I questioned the aggressive growth-without-profits strategies employed by leading SaaS business applications vendors as they navigate their way through the Tornado. Little did I know that a reckoning would come so soon afterwards, in a relatively mild pullback (to date) when compared with the bursting of the internet bubble 14 years ago.

Let’s look briefly at the causes of the latest effervescence during the past decade or so. In contrast with the naïve enthusiasm for new untested internet business models in the late 90s, I see eight drivers today which didn’t exist back then. These drivers are providing hitherto unavailable opportunities for consumers as well as enterprise and government customers to invest in disruptive offerings that improve our lives and/or make our businesses more productive:

1. The explosive surge in consumer tech – In particular, Apple’s amazing record of building three successive tornado franchises in mobile devices and services in the space of seven years galvanized this explosion of demand, making mobility the major new technology wave of the past decade. Perhaps more than any other single innovation, when the smartphone became a bona-fide computer to take with you everywhere, keeping you always connected, applications exploded exponentially. Google also provided considerable inspiration to customers, first with search advertising and then by sponsoring Android, which is now ubiquitous and dominates the market for smartphone operating systems. SaaS and app vendors followed suit, providing users with apps to fit every conceivable use case from monitoring sleep patterns to paying for air tickets or cab rides.

2. The consumerization of enterprise IT – Business users have become a force not to be ignored, having more influence over IT investment decisions than their professional IT stewards. In our private lives we have all become accustomed to highly productive and satisfying experiences and now we are demanding the same capabilities in our place of work. The powerful movement to Bring Your Own Device (BYOD) has been joined by a second movement, Bring Your Own Service (BYOS), and for vendors what I’ll term Develop Your Enterprise Service (DYES). BYOD – Macs, iPads, and iPhones and Android phones are exploding in companies everywhere; BYOS – Business users are bringing Dropbox, Evernote, Twitter, Yammer, LinkedIn and even Facebook into the workplace; and DYES – In essence, Box makes an enterprise version of DropBox’s file sharing and synching service, as Dropbox itself is starting to do, Chatter became a prevalent collaboration tool alongside Salesforce.com’s CRM services, Salesforce itself is tailoring its products and services to enterprise requirements, and Amazon, Microsoft, Google, and Rackspace are tailoring their SMB focused private and public cloud computing services to meet enterprise-grade requirements without letting go of the consumer-grade online user experience that has become compulsory.

3. The resulting emergence of five hot new cloud-related product categories – Cloud computing, analytics, big data, mobility, and social media. Think of these as five separate buckets containing increasing amounts of budget dollars. Consumers already use these technologies daily even without realizing it, but enterprises and governments are now starting to invest in them for real. It feels like we are only in the first innings of this game.

4. The emergence four powerful internet-era Gorilla companies – Amazon in e-commerce and cloud computing; Google in ad-powered search and the Android smartphone OS; Apple in MP3, smartphone, and tablet computing; and Facebook in social networking. These powerful new players are threatening to displace the traditional global systems companies, IBM, HP, Oracle, and SAP even in their stronghold of large enterprises. What the presence of these gorilla players promises to most customers, who tend be either pragmatic or conservative in their technology adoption behavior, is an assurance that they will be accountable for providing important cloud-era services for years to come if – as seems increasingly likely – the old reliables falter. Beyond this, these four Horsemen are becoming the acquirers of first and last resort for niche businesses that fit nicely into their broadening portfolios as global systems companies.

5. Business model innovation – The powerful and now surging trend for customers to remove IT spend from Capex and make it an Opex item by “renting” or “consuming” services is challenging every established hardware or software vendor that based their business on the up-front license fee model. Besides this disruption, new age internet businesses are experimenting with freemium models alongside a mix of subscription with/without term licenses, and consumption (or usage) based models. Today, the issue of business models, and particularly the monetization ingredient of these models, is uppermost in investors’ minds – they are asking , in a nutshell, how will these companies make money over the long haul, so we know they’ll be around for a while to serve their users and customers?

6. The continuing rise of open source software – Starting with Linux in the late 90s, followed later by Hadoop and MapReduce in big data, and more recently a number of cloud databases, development languages, and operating systems. Open source represents its own form of business model innovation because if the language, database or other product is open sourced to a community of developers, differentiation must be established through different means such as domain expertise and related professional services or provision of a specific – say, enterprise-grade – version of the open source product certified by an accountable vendor. Red Hat is a successful case in point with its Linux service franchise, Google has accomplished an amazing feat with Android in the smartphone business, and Rackspace drove the OpenStack cloud operating system initiative which has drawn industry-wide participation and is in the process of proving itself to be a valuable alternative to proprietary offerings from AWS, Google, Microsoft and others. Make no mistake, customers love having the alternative of open source tools and systems to protect against proprietary lock-in.

7. The growing tension between Security and Privacy: If nothing else, Edward Snowden’s whistle-blowing about alleged NSA surveillance abuses has made security and privacy more politically and socially charged issues within countries and across international boundaries. As illicit hacking of data centers and laptop systems by individuals and state-sponsored groups has reached epidemic proportions, and today jeopardizes data and productivity everywhere. These issues are influencing increased regulation and innovation in every country, with vast amounts of funding being invested and some countries – especially those with authoritarian regimes such as China and Brazil – even taking steps to develop their own internet.

Today, most customers as well as industry experts believe that there is real substance and durability to most of these trends though, as always, mainstream adoption is likely to take longer than vendors, VCs, analysts, and i-bankers would have you believe. This set of factors makes tech innovation marketplace much more substantial than the flaky, less thoroughly thought-out innovations of The Time of the Great Happiness fourteen years ago.

That said, it’s still important to make a distinction between innovations for consumers and innovations for businesses. It’s too easy to conflate the two into one phenomenon, but they each have their different rules and parameters. The reason for this can be summarized in one word: Risk. When a consumer decides to buy or use smartphone, a tablet, or even an app, the risk they are assuming is generally limited to themselves – wasting their money or their time, or failing to find enjoyment or be more productive in their own personal activities. But when a company makes the equivalent decision to adopt, they are taking risks with their company’s money, the time and productivity of their colleagues or employees, and the revenue or profit objectives of their companies. In fact, most tech innovations sold to consumers are in the form of working products, whereas often enterprises are asked to invest in professional services and/or chip in with their own resources besides money to get a new innovation working for their organization.

Because of the difference in risk profiles, the “buying” criteria and motivations of consumers differs significantly from those of enterprise or government organizations. One clear difference relates to their perception of value, and especially of price and cost to adopt. A consumer typically looks on Free as a good “pricing” offer to take advantage of, whereas a company more often regards Free as suspect and potentially laden with risk elsewhere – will the product actually perform, will it produce results for the business, and so on. Thus freemium pricing – or no pricing at all, just free – has become prevalent with consumer products, whereas enterprise versions of the same services always assume the need to pay a subscription or usage fee. One factor that muddies the water on this score is that small businesses often behave like consumers – i.e., they have low or no budget, and they prefer or expect Free whenever they can get it. But this is because, for the type of investment in question, there is less at stake. At the end of the day, it’s critical for vendors to distinguish between customers (who pay for their service) and users (who consume it, but may never pay). Failure to do this leads many tech management teams to pursue misguided strategies, particularly related to developing a viable economic engine on which to build profitable growth.

Since many tech management teams believe for some mysterious reason that Free will automatically accelerate adoption (it doesn’t, at least not automatically), they transfer this “expectation” to their B2B sales activities and end up training customers to expect freebies and, if they are not careful, significantly eroding the potential value of their business. In summary, Free is for Fun (for consumers), and Paid is for Productivity (for businesses. The reason I raise this point about Free and pricing is that, to my mind, one fundamental driver of the buyer’s remorse that is beginning to influence investor decisions in this latest “bubble” is that so many tech darlings have yet to implement a serious, feasible monetization model. This is as true of established offerings such as Skype, YouTube, and Amazon, as it is about younger players such as Twitter, Dropbox, and Evernote. To be clear, monetization can begin by focusing merely on generating revenue, but sooner or later it needs to turn into profitable revenue.

In other categories, with their infrastructure as a service offerings Amazon Web Services and Google Compute Engine seem locked in a race to the bottom on pricing. Beyond this ongoing battle, Amazon is now seeing its surprisingly long period of grace as a high-growth but unprofitable e-commerce giant finally come to an end, if recent investor decision-making is to be believed. The stock has suffered a correction of 25% in the past month or so, and it appears that investors are wearying of Jeff Bezos’ brazen insistence on growth without profits. In similar vein, Salesforce, Workday and NetSuite have been buffeted by downgrades to their stock prices because of their continuing refusal to explain why they are not yet profitable. Note that I am not saying that they have to be profitable today, just that they need to communicate their strategies more clearly and transparently for developing profitable growth within a specified timeframe.

As Einhorn went on to say in his letter to clients, “Once again (referring to the dotcom bust), certain ‘cool kid’ companies and the cheerleading analysts are pretending that compensation paid in equity isn’t an expense because it is ‘non-cash’. In other words, Einhorn is spoiling the party by demanding a return to normal performance metrics that help ground management teams in financial reality while they continue to build their power with target customers and users.

More than any other single factor, this latest market correction is reminding us that hitherto un-monetized consumer businesses need to get focused on developing an economic engine, and that revenue-generating B2B companies need to get their heads around becoming profitable, without relying on non-GAAP reporting or other ruses to mask the reality of their financial performance. That said, as the news today about analysts’ reactions to Twitter’s’ second earnings report as a publicly traded company reminds us, companies need to leverage their Power levers – engagement and enlistment – as effectively as they leverage their Performance levers – acquisition and monetization. True, Twitter more than doubled quarterly revenues year over year to $250m. But it rightfully drew concerns from analysts because of its unimpressive increases in user numbers and engagement, so investors are questioning whether the company can become a major global platform on a scale comparable to Facebook, WhatsApp, and others.