Have We Reached Peak Tech?

In last week’s Take Five I highlighted a Vox story which reported that over the last year the number of companies using terms like ‘tech’ or technology’ in their documents is down 12%. This is an early indicator of a much more fundamental concept – we may have already reached peak in the tech sector, the business sector that has driven the fourth industrial revolution. While some may quibble whether the internet-era transformation was the predecessor to a new industrial revolution built around AI, big data and automation, the underlying factor is that tech – for better or for worse – has shaped the modern world. More in the developed world than the majority world perhaps, but it has shaped it nonetheless. Now, however, with tech so deeply ingrained in our lives and the services and enterprises that facilitate them, has tech become so ubiquitous as to render it meaningless as a way of defining business?

Tech is the modern world

When Tim Berners Lee invented the World Wide Web in 1989 he could have had little inkling of the successive wave of global tech superpowers that it would incubate. As we near the end of the second decade of the 21^stcentury it is hard to imagine daily life without it. The pervasive reach of the web and the Internet more broadly is perfectly illustrated by Amazon’s recent launch of twelve new devices, including a connected oven, a smart ring (yes a ring) with two mics and a connected night light for kids. All of which follows Facebook’s connected screen Portal, which for a company that trades on user data, raises the question: ‘Is this your portal to the world, or Facebook’s portal to your world?’ However, regardless of why the world’s biggest tech companies want us to put their hardware into our homes, this is simply the latest new frontier for consumer tech. Now that we carry powerful personal computers with us everywhere we go, we remain instantly connected to our personal collections of connected apps and services. Tech is the modern world.

The rise of tech-washing

With tech now powering so much of what we do, it raises the question whether tech is any longer that useful a term for actually distinguishing or delineating anything. If everything is tech, then what is tech? It is a question that the world’s biggest investors are starting to ask themselves, too. In fact, we have now reached a stage where a) tech is a meaningless concept – everything is tech, and b) there is the realisation that many companies are ‘tech washing’, using the term ‘tech’ to hide the fact that they are in fact anything but tech companies which happen to use technology platforms to manage their operations. In the era when everything is tech enabled, you would be hard pushed to bring a new business to market that does nothave tech at its core. Companies like Uber, WeWork and just-listedPeleton have managed to raise money against billion-dollar-plus valuations in large part because they have positioned themselves as tech companies. In actual fact when the tech veneer is removed, they are respectively a logistics company, a commercial rental business and an exercise equipment company. If they had come to market simply with those tag lines, they would undoubtedly have secured far smaller valuations and many of their tech-focused investors would not have backed them. Investors are beginning to see through the ‘tech-washing’, as evidenced by the instant fall in Peleton’s stock price, WeWork’s crisis mode sell-off and Uber’s continuing struggles.

Pseudo-tech

Calling yourself a tech company has become a get out of jail free card for new companies, an ability to raise funds at inflated valuations, and a means to persuade investors to focus on ‘the story’ and downplay costs and profit in favour of growth, innovation and of course, that hallowed tech company term: disruption. I have been a media and tech analyst since the latter days of the original dot-com boom, and the mantra of the companies of that era was that ‘old world metrics’ such as profitability didn’t apply to them. Of course, as soon as the investment dried up, the ‘old world metrics’ killed most of them off. Today’s ready access to capital, enabled in part by low interest rates, has enabled a whole new generation of companies to spin the same yarn. But whether it is the onset of a global recession or growing investor scepticism, a similar fate will likely face today’s crop of ‘disruptors’. The dot-com crash separated the wheat from the chaff, wiping out the likes of Pets.com but seeing companies like eBay and Amazon survive to thrive.It also took a bunch of promising companies with it too. The imperative now is to strip away pseudo-tech companies from the tech sector so that investors can better segment the market and know who they should really be backing through what will likely be a tumultuous economic cycle. As SoftBank is finding to its cost, building a portfolio around pseudo-tech becomes high risk when the tech-veneer can no longer hide the structural challenges that the underlying businesses face.

Tech is central to the modern global economy and will only increase in importance – at least until the world starts building a post-climate-crisis economy. It is imperative for genuine tech companies and investors alike to start taking a more critical view of what actually constitutes tech. The alternative is that the tech sector will get dragged down by the failings of logistics companies and gym equipment manufacturers.

Profit Didn’t Disappear, It Just Moved

One of the recurring themes in analysis of tech businesses is the role of profit, and most often, the apparent lack of it – or at the very least, the way in which it plays second fiddle to growth. Amazon, one of the most successful global businesses in today’s global economy, famously sacrificed profit for much of its existence in order to focus on long-term growth and expansion. Similarly, Spotify remains laser-focused on growth and market share, almost apologizing when it generated a net profit for the first time in Q4 2018. The logical way to interpret this worldview is that it points to a lack of sustainability in the underlying business models of such tech companies, and that profit is a scarce commodity in the world of tech business. In actual fact, profit is still being made right across the value chain. It is simply not appearing on the balance sheets of tech companies.

Profit, an ‘old world metric’

Back the early 2000s, at Jupiter Communications in my early days as an internet analyst (back when you could actually have that job title), I used to tire of hearing the same line from dotcom start-ups when asked about profitability: “Profit is an old world metric. We measure ourselves by internet-era metrics.” When the dotcom bubble burst and VCs started pulling their money out of the dotcom space, virtually all of those business quickly learned that profit really did matter when the investment dried up. Most of those companies folded very quickly (Amazon being one of a few strong exceptions to the rule). Fast forward nearly two decades and that ‘new world’ mentality is more in evidence than ever before. So, what gives?

The development of finance is one of the most important 21^st century events

One of the most important developments in capitalism in the 21^st century has been the development of the financial sector, both in terms of the sophistication of products and services and in terms of the sheer scale of value that flows through it. For tech businesses, this has manifested as unprecedented access to finance at all stages of business. Historically, traditional businesses had some access to start-up capital, though it was often debt-based such as taking a bank loan. Fewer new businesses came to market, but those that did had a stronger profit imperative as they needed to service their start-up debt. Tech start-ups now most often have ready access to equity-based finance (i.e. selling a share of their business in return for investment) long before they go to market, and then have the further ability to raise more investment as they build their businesses. This enables companies to focus on growth, product development and brand building at a much faster rate than if they were relying upon organic revenue growth for funding. We wouldn’t have most of the big successful tech companies we do today without this model. The question still remains, however: when and where does profit fit in?

When looking at the financial reports of many tech businesses, net profit is conspicuous by its absence. For example, Uber has warned that it ‘may never be profitable’. This does not mean that profit is not being made, however – it is just found in different places. Take the example of Spotify. It is generating enough gross margin to be able to invest heavily in its business and to pay salaries that are competitive enough to ensure it can build an A-class team. It also generated enough money at its DPO to ensure its founders, investors and record labels all profited from the sale. Meanwhile, Spotify and other streaming services are driving revenue and profit for rightsholders, delivering nearly $10 billion of record label revenue in 2018 alone. Profit is being made by Spotify; it has simply moved across the value chain.

A new commercial ecosystem

The Spotify example illustrates how profit has shifted across the value chain in tech businesses, delivering profit for investors, suppliers and founders. In effect a new ecosystem has evolved in which the new profit centres can support the distribution part of value chain indefinitely. With growth valued over profitability by shareholders, the markets provide further sustenance to the ecosystem.

This model works, until it doesn’t. The big risk factor here is availability of credit. My colleague Tim Mulligan argues that the current availability of credit is the result of an abnormal macro credit cycle rather than a new model of economic sustainability, with interest rates at historical lows. As soon as interest rates go up, VC funding will significantly decrease due to institutional money leaving the VC funds for the equity markets. The corporate debt market will then start to dramatically contract, reducing the working capital available to unprofitable public businesses. On top of this, the cost of holding leveraged positions funded through the short-term money markets will start to become too expensive for many of the existing hedge funds to maintain their positions. An interest-rate driven, financial domino effect could happen very quickly.

Every time we have a bubble we are told that this time it’s different, and it never actually is. The financial component of the value chain can only generate profit as long as its primary cost base – i.e. interest rates – remain low. When they stop making profit, the whole ecosystem crumbles. At which point, tech companies will be well placed to consider the old maxim: revenue is vanity, profit is sanity.