Jeff Richards, partner with venture capital firm GGV Capital, recently had the opportunity to sit down for lunch with technology M&A and IPO guru Eric McAlpine of The Blackstone Group (BX). Together they discussed valuations of tech companies. Fortunately, Richards was kind enough to transcribe the Q&A exchange, which we have broken down for readers here.
To start, McAlpine has created the idea of "rare air," a concept that refers to a company's uniqueness and which makes it more desirable in the market compared to industry competitors.
For technology IPOs to gain "rare air" status, they should have significant scale and growth. Companies with over 10 years of proven success (in good economic times and bad) can also go a long way in proving to investors their company is a worthwhile investment.
"Beyond growth, important factors are things like sector leadership, long term margins at scale, and operating history." He makes an example of Facebook, Groupon and Zynga, all highly anticipated IPOs with a mix of these characteristics and potential to sell at a premium relative to industry averages.
Secondly, valuation multiples in the technology industry are predominately driven by a combination of earnings multiples and earnings growth. Because tech no longer has "the high earnings growth opportunity equity investors had come to expect," growth in the markets slowed "to around 10% overall, while the median Tech IPO since 2010 is growing at a median of 26% year over year, and an average of 38%."
Therefore investors are increasingly turning to tech IPOs with "rare air" to "gain exposure to growth and alpha" that they crave for their portfolios.
Given that high-growth tech stocks are a rarity, we were looking for ways to sniff out the ones that nevertheless appear to have bullish prospects.
For ideas, we started with a list of undervalued tech stocks, as defined by the price to earnings growth (PEG) ratio. All of the stocks mentioned below have PEG ratios below 1, which usually signals undervalued conditions.
To refine our list, we collected data on institutional buying and short covering, and identified the stocks showing bullish changes in investor sentiment.
All of the undervalued tech stocks mentioned below have seen increased institutional buying and increased short covering (both of them bullish trends). Do you agree that there's more upside to be priced into these names? Furthermore, do you think these names have the qualities to achieve "rare air" status?
List sorted by market cap. (Click here to access free, interactive tools to analyze these ideas.)
List compiled by Eben Esterhuizen, CFA:
2. Fairchild Semiconductor International
5. VanceInfo Technologies
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Eben Esterhuizen and Rebecca Lipman do not own any of the shares mentioned above.