“Trust but verify.” – Ronald Reagan

Before launching an initial public offering ("IPO"), a company must submit extensive disclosures to the Securities & Exchange Commission (SEC) on Form S-1; however, the data listed therein does not include a complete history of financial results while the firm was private. In fact, as a result of the JOBS Act emerging growth companies may now elect to include fewer years of financial history than was previously required.

In an attempt to provide a more comprehensive view of recent IPOs, our analysts perform a deep-dive review of the firm’s prospectus and accounting practices, and compare the firm’s financial data to its close peers to gain a better grasp of the quality and sustainability of its reported earnings.

JOBS Act & The Emerging Growth Company:

On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. The act attempted to ease regulation around IPOs by creating a new classification of companies going public called “emerging growth companies” (EGCs). EGCs are defined as issuers with less than $1 billion in annual revenue. One criticism of the JOBS Act legislation is that the less stringent disclosure requirements could lead to diminished transparency, hurting investors in the long-run. 

Three Ways the JOBS Act Reduces Transparency:

Normally, when a registration statement is submitted to the SEC, it becomes available to the public. However, the JOBS Act allows ECGs to submit a registration statement for confidential, nonpublic SEC review. Snapchat (Snap Inc.) is an example of a private company that recently filed for IPO under the new confidentiality regulations.

To make matters cloudier, the JOBS Act requires EGCs to file only two years of audited financial statements instead of the three-to-five-year previous requirement. Releasing fewer years of financial results could make it easier for a firm to “time” its IPO to avoid disclosing negative information.

Lastly, the JOBS Act does not require EGCs to have auditor attestations of internal control over financial reporting, which is required as part of Sarbanes-Oxley for all other publicly-traded companies.

What Gradient Is Doing to Help:

We believe the JOBS Act may have the unintended consequence of creating new opportunities for EGC firms to “manage earnings.” This is why we recently published our inaugural IPO Issue Commentary.

Our goal is to assess the quality and sustainability of each IPO firm’s earnings by examining the quality of its balance sheet and the strength of its operating-cash and free-cash-flow generation. Each firm is given a score from 1-5, with 1 being the worst and 5 being the best with regards to earnings quality.

IPOs Recently Examined:

Our 2016 IPO review focused on six companies: Nutanix Inc. (NTNX), SecureWorks Corp. (SCWX), Twilio Inc (TWLO), Camping World Holdings Inc. (CWH), First Hawaiian Inc (FHB), and Valvoline Inc. (VVV). The remainder of this newsletter will focus on our findings for NTNX and TWLO to exhibit our research and thought-process.

Nutanix Inc. (NTNX): Enterprise cloud platform solutions
Peers: Red Hat Inc. (RHT), Brocade Communications Systems Inc. (BRCD), Commvault Systems Inc. (CVLT), NetApp Inc. (NTAP)
IPO Earnings Quality & Sustainability Score: 2

We generally view elevated receivables as a possible indication of deteriorating revenue quality. To that point, in Q1FY2017, three-month revenue increased 90.1% YOY while accounts receivable increased 207.3% YOY. As a result, AR to three-month revenue increased from 54.8% in the year prior to 88.5% in Q1FY2017. The peer median AR to three-month revenue during Q1FY2017 was 44.7%, nearly half of NTNX.

However, NTNX also has carried a higher level of deferred revenue than its peer group. Deferred revenue is an indication of near-term demand. In Q1FY2017, deferred revenue relative to three-month revenue increased to 99.4%. The peer median was 30.3%. This would lead us to believe that NTNX’s demand is healthy and that top-line growth will likely be strong.

While deferred revenue partially mitigates our receivable concerns, the abnormal growth in AR worries us. NTNX carries a higher level of AR than its peers and cash collected from customers lagged the growth in reported sales as well.

Furthermore, there has been a decline in accrued expenses relative to operating expenses that may pressure operating margin in upcoming periods. If the accrued-expenses account is understated it could serve as a type of “profit reserve” to help smooth or enhance results. Accrued expenses only increased 65% YOY in Q1FY2017 while operating expenses increased by 147%. Accrued expenses to adjusted operating expenses fell to only 11.9%, which may have provided an unsustainable and material benefit to the firm’s operating income. NTNX’s 11.9% accrued expenses to three month operating expenses was 3.8x lower than its peer median of 46.9%.

Twilio Inc. (TWLO): Cloud Communication Platform
Peers: ShorTel Inc. (SHOR), Zendesk Inc. (ZEN), Hubspot Inc (HUBS), Amazon.com Inc. (AMZN)
IPO Earnings Quality & Sustainability Score: 2

Despite improving YOY FCF margin during Q4 2016, FCF margin has remained negative, and growth in net income has far outpaced cashflow. Therefore, cash-flow productivity and earnings quality trends appear negative for the firm.

Our primary earnings quality concern with TWLO is unusual growth in the prepaid expenses and other current assets (OCA). If this account is overstated, it could serve as a type of “profit reserve” to help smooth or enhance results. A large increase may provide an unsustainable and material benefit to the firm’s operating income.

In Q4 2016, OCA increased 2.5x YOY to $21.5 million. This would be fine if adjusted operating expenses increased around the same rate, but they did not. Adjusted operating expenses increased by only 48%. OCA-to-three-month operating expenses increased to 25%, the highest level since TWLO has reported public results.

Had TWLO not seen such an increase in OCA, we estimate that TTM EPS could be $0.06 lower.

While TWLO's OCA-to-three-month operating expenses was 25%, the peer group's median was only 16%. TWLO's metric surpassed the peer median in Q1 2016 and the divergence continued in the next three-quarters.

PP&E is another area of interest. Any earnings “growth” arising from extending the useful lives of fixed assets is not indicative of the company’s core economic earnings power and will prove to be temporary in nature.

TWLO appears to have extended the depreciable life of certain depreciable assets in 2015. TWLO alas has the highest average useful life and average remaining useful life of its peer group. At year-end 2015, TWLO’s average useful life was 16.8 years, 266% higher than the peer median of 4.6 years. Similarly, its average remaining useful life of 11.7 years was 407% higher than the peer median of 2.3 years.

On a positive note, 74% of TWLO’s total assets is in cash. Driven by the cash raised in its IPO, TWLO is in a favorable position to expand, either by organic investments or acquisitions.