AI Captain! Finding value in the emerging UK tech scene

25 January 2018

If every company has an AI strategy, which one deserves a valuation premium?

Tech valuations are reflecting huge demand from investors across the globe, particularly in  essential technologies such as artificial intelligence as companies compete in races for platform supremacy. Challenging whether a company truly walks the walk in this area is fast becoming a critical part of any deal process, to ensure that the tech premium being paid is justified.  

Our experts from the Technology Industry Hub in Reading and the specialist AI team recently hosted C-suite decision makers from prominent tech companies in the Thames Valley, which we see as a region at the heart of growth within the sector, to discuss the technology deal market in the UK.  

 

Valuations are high, but may be a price worth paying

With the average revenue multiple on the NASDAQ now over 3x and talk of a potential tech bubble, what does this mean for UK valuations? The short answer is, it’s difficult to tell.

The so called ‘big 5’ (Apple, Alphabet, Microsoft, Amazon, Facebook) share a combined market cap of over $3 trillion and dominate the NASDAQ, representing nearly a third of the index based on market cap. Whilst we don't have the goliaths of the US, the UK market has seen recent consolidation and the formation of some major technology players in the form of Micro Focus and Finastra.

In the US market, corporate spend on tech M&A is down significantly on 2016 as they wait for valuations to settle down, but this is not the case in the UK, where there have been a number of significant inbound deals, with buyers taking advantage of the weakening pound since the EU referendum.

Across both markets, a similar trend towards smaller tech tuck-in deals is emerging. Based on Mergermarket data, we’re seeing lower multiples being paid for deals under £100m in the UK, where the scalability potential of these businesses to grow globally and at higher margins may not be as visible. We expect to see increased deal activity in the AI space across all deal sizes, and with this increased attention, our expectation is that significant valuation multiples will be paid for AI businesses which may not all be warranted.

 

AI is going to attract increased attention in the UK

AI is emerging as the defining technology of our age, with the potential to drive an additional $15.7 trillion in global GDP growth by 2030.

Whilst many industries are already utilising AI in some form, a large number of organisations are still at the beginning of the journey. Less than 40% of UK CEOs we surveyed last year had begun, at that time, to explore the impact of AI on their future skills need for example. CEOs are quickly having to marry up the potentially large commercial benefits with the myriad concerns cited such as a lack of understanding of the technology, concerns over governance, the impact on their workforces, and uncertainty over which use cases to start with.

 The lack of some corporates’ awareness of AI, coupled with the increased demand from investors could lead to more and more companies overstating their AI abilities to generate higher valuations.

 

How to tell the good from the bad

Rather than focusing on extrapolating historical performance, we would encourage companies and investors alike to focus on proving the market opportunity and understanding the specific AI capabilities of the target vs. its competitors.

 

What is the scarce asset in this value chain?

  • Many of the software and hardware building blocks in this market are commoditised, with the real value being vested in the way in the which the system is assembled, the skill with which it is adapted for the business case it is addressing, and the ownership of the critical data that fuels it.
  • Level of embedded learning? Systems that truly learn from experience and adopt their approach over time are often more interesting investment opportunities. Accumulated experience can lead to powerful scale advantages in many AI industries - e.g. internet search.
  • How flexible is the system?.
    Is it using one well-honed technique (e.g. deep learning) or can it optimise around different techniques (e.g. tree algorithms, Bayesian techniques), to make it flexible enough to cope with different use cases?
  • Sources of competitive threat?
    As in any tech market, highly use-case-specific solutions need to beware of being rendered unintentionally obsolete by developments in broader markets - the so called ‘tail-of-the-whale’ risk (e.g. smartphones replacing cameras, mp3 players, calculators, torches and compasses, etc.). Being ‘clever’ and being ‘unique’ are very different attributes.

 

 Concluding thoughts

Companies in the AI space are going to attract significant valuations going forwards, but for the best targets that will be a price worth paying. Investors can’t afford to miss out, but they need to make sure they are turning over the right stones on the way.

 For further reading on this subject, please visit our dedicated website.

Simon Harris | TMT Valuations Leader
Profile | Email | +44 (0)7841 490474

Ralph Dodd | Senior Manager, TMT Valuations
Profile | Email | +44 (0)78038 58613

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