As of this writing, we are still in the midst of a bull run that is over five years old. Recent market volatility has some wondering how much steam remains in it, but as of the close on August 8, the S&P 500 index was only 2.8% off its high since the market bottom of March 2009, and the NASDAQ Composite was only 2.6% off its high. Between the market low of March 9, 2009, and August 8, 2014, the S&P 500 index gained 193.8% while the NASDAQ Composite was up 253.6%.
As the market continues its upward march, more and more private firms are capitalizing on investor enthusiasm by setting initial public offerings (IPOs). According to Jay Ritter on Forbes.com, the first six months of 2014 saw 30 technology companies go public in the U.S., including software-as-a-service company Paycom Software (PAYC), cloud-based software company Castlight Health (CSLT) and U.K.-based interactive games company King Digital Entertainment (KING). Ritter goes on to say that if this rate continues, 2014 will have the most tech IPOs since 2007. While robust compared to recent years, this would only be roughly half of the 116 IPOs in an average year between 1980 and 2000.
While the number of tech IPOs has dropped off, they still garner a lot of media attention. Alibaba Group Holding is expected to launch its IPO in September and analysts are predicting it could fetch anywhere between $150 billion and nearly $200 billion, potentially making it the largest IPO ever.
When evaluating a newly minted public company, one area of consideration is its available cash levels and the rate of cash consumption, which is known as the burn rate. Cash is financial power and any analysis of a stock, tech-related or otherwise, is not complete with evaluating a company’s cash flow.
Companies and industries go through a somewhat predictable and often-repeated pattern of development, growth, cash consumption and cash generation that is highly correlated to its stage in the life cycle. Knowing a firm’s position within its life cycle helps identify its risks, need and growth potential.
The Business Life Cycle
Companies, and industries for that matter, typically go through a pattern of formation, accelerated growth, growth, maturity and possibly decline in their life cycle. In the first stage, formation, a firm is started to produce and sell a product or service. The initial capital often comes from the owner or venture capitalists to aid in development and expansion during this formation stage. Companies with compelling products or services that hold promise often go through a few rounds of venture capital infusions during the formation stage as the company begins to implement its business plan. For example, according to Fortune.com, Facebook Inc. (FB) raised $1.3 billion in venture capital, excluding loans, between June/July 2004 and January 2011. Sales growth may be strong during the formation stage, but earnings may be low or non-existent as a company experiences high start-up costs.
It is during the formation stage that most startup companies fail. However, those firms with growth and profit potential move on to the accelerated growth stage. As with the formation stage, the demand for capital is great as the company continues to expand. At this point, with a positive sales track record and the promise of even stronger sales and earnings, an initial public offering (IPO) is an option. Companies that opt to go public use the proceeds to raise capital for the firm and reward venture capital investors for their seed money. IPO proceeds, business cash flow and cash borrowing fuel continued expansion at this aggressive growth stage.
Eventually, a firm’s growth rate begins to slow, but remains strong as it enters the growth stage. At this point, there tends to be a shift from financing expansion via outside sources to financing expansion with internal cash generation or by issuing long-term debt. Usually at this stage, a firm is growing at a supportable rate that is normally greater than, and largely independent of, the growth in the overall economy. Some companies may pay a token dividend, primarily to attract income investors, but the vast majority of cash a company generates is reinvested until the late stages of growth, when cash flows are still strong but the number of profitable capital projects decreases.
If a company does not come up with new products or is unable to expand its market, it enters the mature stage in which it grows at roughly the same rate as the overall economy. Dividend payouts tend to be high during this stage, as there are few profitable capital investment projects to pursue. If the market for the company’s goods or services diminishes and no prospects exist, the company enters a period of decline.
For companies in the development or accelerating growth stage, internal cash flows often are not sufficient to support growth at early stages of the business life cycle. Therefore, firms must seek out additional capital—via equity or debt financing—or they may decide to sell out to a larger company.
Equity financing can take a form of an IPO or private placement. In a private placement, a company sells shares directly to a relatively small number of select investors. Since a private placement is offered to a few select individuals, and if the securities are purchased for investment as opposed to resale, the company does not have to register its private placement with the Securities and Exchange Commission (SEC). The investors are often large banks, mutual funds, insurance companies and pension funds. Private placement is the opposite of a public issue, in which a company makes its stock available for sale on the open market.
However, unlike during the dot-com boom of the late 1990s, Ritter states in his Forbes article that fewer and fewer small tech firms are going IPO. In a paper writer by Ritter, Xiaohui Gao and Zhongyan Zhu entitled “Where Have All the IPOs Gone,” the authors discuss a few possible reasons for the drop in IPOs:
- Additional regulatory compliance costs tied to the Sarbanes-Oxley Act of 2002 discourage companies, especially smaller firms with fewer resources, from going public;
- A lack of underwriters focusing on smaller firms and providing analyst coverage after the company goes public; and
- The possibility of creating greater operating profits by being acquired by a firm in the same or related industry rather operating as an independent firm, e.g., WhatsApp selling out to Facebook (FB) for $19 billion instead of going public (this is the hypothesis Ritter and his colleagues advance in the paper).
According to Ritter, only 43 tech companies went IPO in 2013, whereas venture capitalists sold 376 of their portfolio companies in trade sales to such tech sector giants as Cisco Systems (CSCO), Google (GOOG), Microsoft Corp. (MSFT) and Oracle Corp. (ORCL).
Today, those tech firms that decide to take the IPO route also tend to be larger than those during the dot-com era. Ritter found that the median annual sales of tech company IPOs in 2013 was $106 million, as compared with an inflation-adjusted $25 million in 1996. In their paper, the authors argue that getting big fast is more important than it used to be, especially in the tech sector. For a small technology company with a promising new idea, growing organically takes too long. Instead, companies are increasingly finding that the value-maximizing strategy is to sell out to a large tech company that can immediately integrate the new technology into its existing products. The big companies already have the programmers or engineers as well as a marketing department that can immediately go to work developing and marketing the promising product or service instead of having to wait to hire new employees and develop brand name recognition.
Borrowing options, debt financing, are often limited for companies in the development and accelerating growth stages because of unpredictable long-term cash flows. More established growth firms might be able to issue convertible bonds or convertible stock, which pays interest similar to a bond, but also allows the holder to convert the debt into common stock at a pre-determined conversion rate.
The Importance of Cash Flow
Cash flow gives a company power, flexibility and time. As such, no proper analysis of a company is complete without evaluating its cash flow.
Income statements and earnings do not paint a true cash flow picture. They include a number of non-cash expenses such as depreciation and amortization that reduce earnings, while ignoring the immediate cash impact of capital expenditures.
The income statement and balance sheet are constructed using principles of accrual accounting. Accrual accounting attempts to match expenses and revenues when the revenues are expected to be recognized. For example, cash used to build up inventory is not reflected as an expense on the income statement until the inventory is actually sold. Furthermore, the income statement spreads the cost of buying a machine across its useful life via depreciation, instead of accounting for it at the time the company used the cash to acquire the machine.
Accrual accounting requires many interpretations and estimates by management. Decisions regarding the capitalization of expenses, the recognition of revenue and the creation of reserves against losses are a few of the factors that may vary from firm to firm. Many of these issues are factors that relate to the “quality” of a firm’s earnings.
As a result, a company can show positive earnings but still be expending more cash than it is actually pulling in. If such a condition exists for an extended period, the company faces serious problems without external sources of capital.
The AAII Journal area of AAII.com has a collection of financial statement articles for you to learn more on this.
Statement of Cash Flow
Because public companies tend to use accrual accounting, the income statements they release may not necessarily reflect changes in their cash positions. While a company may be earning accounting profits, it may still be depleting its cash. This is why the cash flow statement is important: It helps investors see if a company is having trouble with cash.
Companies are required to provide a statement of cash flow that discloses the direct uses and sources of cash during a specified accounting period. The statement divides company sources and uses of cash into three primary segments: operating, investing and financing cash flows.
The operating cash flow segment is designed to measure a company’s ability to generate and consume cash from day-to-day operations as it provides goods and services to its customers. Operating cash flows include total sales of goods and services collected during the period; payments made to suppliers of goods and services used in production settled during the period; and payments to employees, taxes and interest payments. Positive cash flow from operations implies a company was able to generate enough cash from continuing operations without the need for additional funds. A negative operating cash flow indicates that additional cash inflows were required for day-to-day operations.
The investing segment of the cash flow statement attempts to capture the company’s investment in long-term capital. An item on the cash flow statement belongs in the investing activities section if it results from any gains (or losses) from investments in financial markets and operating subsidiaries. An investing activity refers to cash spent on investments in capital assets such as plant and equipment, which is collectively referred to as capital expenditures, or capex.
Lastly, the financing segment of the cash flow statement examines how a firm raises capital and pays it back to investors through dividend payments. Financing activities include paying cash dividends, adding or changing loans or issuing new shares of stock. This section of the statement of cash flows measures the flow of cash between a firm and its owners and creditors. A positive number is going to indicate that cash has come into the company, which boosts its asset levels. A negative figure indicates when the company has paid out capital, such as paying off long-term debt or making a dividend payment to shareholders.
Free Cash Flow
Ideally, a company does not just cover the costs of producing its goods and services. Instead, after laying out the money required to maintain or expand its asset base, it produces excess cash flow that it can use for reinvestment or for its shareholders.
AAII’s Stock Investor Pro fundamental stock screening and research database program tracked 1,219 companies in the technology sector (based on Thomson Reuters’ proprietary designation) as of July 31, 2014, which is roughly 17% of the 7,070-company database. Of those, 656 had positive cash flow from operations over the trailing 12 months (54% of the sector). In contrast, 83% of the companies in the S&P 500 had positive operating cash flow over the trailing 12 months.
Operating cash flow is a good place to start when analyzing how well a company manages its cash. But beyond current production, a growing company must reinvest its cash to maintain its operations as well as expend them. While a company may skimp on capital expenditures in the short term, over the long term there are fundamental negative growth implications to such neglect.
Free cash flow refines operating cash flow by considering capital expenditures and dividend payment to shareholders. Some measures of free cash flow exclude cash dividend payments. However, once a company starts paying a dividend, shareholders expect the payments to continue. Companies that cut or drop their cash dividend often see their share price severely punished. This is why the free cash flow data in Stock Investor Pro is based on cash flow from operations, less capital expenditures and cash dividends paid.
Of the 1,219 tech firms in Stock Investor Pro as of the end of July, only 18% (222) pay a dividend, while 86% of S&P 500 stocks pay a dividend.
Five hundred sixty-eight (568) or 47% of the technology sector firms have positive free cash flow. Eighty percent (80%) of S&P 500 stocks have positive free cash flow over the trailing 12 months.
Screening on the Burn Rate
Firms with a cash flow deficit must use the cash they have on hand or obtain additional capital through outside financing. The ability to raise cash and refinance existing debt is dependent upon the risk and return prospects of the company as well as the overall market environment.
A study of a company’s current cash levels and its cash flows can help reveal the financial independence of a firm and may indicate the need for additional financing.
No. of Months
|Energous Corp. (WATT)||2||4||0.26||-1.70||-0.88||-12.07||na||na||na||na||2.2||Computer Services|
|Imprivata Inc. (IMPR)||14||8||0.26||-0.22||-0.39||-0.70||36.9||-24.2||25.0||4.34||3.1||Software & Programming|
|Resonant Inc. (RESN)||9||8||0.32||-0.43||-0.50||-1.97||na||na||na||na||1.9||Semiconductors|
|TubeMogul Inc. (TUBE)||10||9||0.53||-0.62||-0.71||-0.22||na||na||na||3.72||3.1||Software & Programming|
|IMS Health Holdings Inc. (IMS)||positive||13||1.94||1.18||-1.75||0.12||5.6||34.1||12.1||2.84||2.2||Computer Services|
|Castlight Health Inc. (CSLT)||30||18||1.79||-0.71||-1.18||-1.57||na||na||na||43.34||3.1||Software & Programming|
|Five9 Inc. (FIVN)||17||19||0.63||-0.44||-0.41||-0.72||48.7||-157.1||9.7||3.75||3.1||Software & Programming|
|Mobileiron Inc. (MOBL)||22||20||0.86||-0.48||-0.52||-0.58||na||na||na||6.22||3.1||Software & Programming|
|Roka Bioscience Inc. (ROKA)||23||22||1.85||-0.96||-0.99||-1.71||na||na||na||65.50||1.8||Scientific & Technical Instruments|
|Paycom Software Inc. (PAYC)||positive||31||0.26||0.29||-0.10||0.00||37.6||na||23.5||5.50||3.1||Software & Programming|
|Zendesk Inc. (ZEN)||positive||50||1.04||0.04||-0.25||-0.47||na||na||na||12.35||3.1||Software & Programming|
|Sunedison Semiconductor Ltd. (SEMI)||positive||66||0.93||2.07||-0.17||-1.53||na||na||100.0||0.76||1.9||Semiconductors|
|Q2 Holdings Inc. (QTWO)||172||88||6.15||-0.43||-0.84||-0.88||na||na||na||3.05||3.1||Software & Programming|
|A10 Networks Inc. (ATEN)||57||131||8.76||-1.84||-0.80||-0.86||36.8||-291.5||24.2||0.95||3.1||Software & Programming|
|Aerohive Networks Inc. (HIVE)||positive||145||4.36||0.20||-0.36||-1.69||90.1||41.2||20.0||0.56||3.1||Software & Programming|
|Opower Inc. (OPWR)||positive||155||1.16||0.21||-0.09||-0.59||103.0||-1.0||25.0||3.58||3.1||Software & Programming|
|Care.com Inc. (CRCM)||928||283||5.42||-0.07||-0.23||-1.48||84.9||-120.7||na||2.35||2.2||Computer Services|
|Rubicon Project Inc., The (RUBI)||positive||1203||2.01||1.58||-0.02||-0.73||na||na||45.0||1.67||3.1||Software & Programming|
*Ranked on free cash flow burn rate.
nmf=no meaningful figure.
Source: AAII's Stock Investor Pro/Thomson Reuters. Data as of July 31, 2014.
Cash levels and cash flows can be studied on a total dollar basis or per share basis. For this analysis, we used a per share basis because it can be directly related to stock price.
Cash and marketable securities generally represent the funds available to meet immediate cash needs. Marketable securities are very liquid, as they tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices. Examples of marketable securities include commercial paper, banker’s acceptances, Treasury bills and other money market instruments.
For our analysis, we started with the 42 companies in the tech sector that began trading since the beginning of the year (2014). We trimmed this list by excluding those firms that trade over the counter as well as those that have positive free cash flow over the trailing 12 months, since they are likely adding to their cash position instead of depleting it. Table 1 lists the remaining 18 companies.
Burn rate calculations can entail cash from operations as well as free cash flow. Strong positive operating cash flow shows that a company is able to generate sufficient cash flow to maintain and grow its operations. Many investors consider cash from operations as the cash version of net income, since it cleans the income statement of non-cash items and non-cash expenditures (depreciation, amortization, non-cash working capital and changes in current assets and liabilities).
With strong free cash flow, a company can retire debt, develop new products, buy growth through acquisitions, buy back company stock, pay or increase dividends or accumulate cash.
Prolonged negative cash flow from operations or free cash flow means that the company must spend cash reserves, sell off investments, improve profitability, reduce capital expenditures or raise capital from outside sources by issuing debt or stock. Table 1 shows cash from operations and free cash flow over the last four quarters (trailing 12 months) in order to capture the cash needs and generation over a course of a complete year. A single quarterly figure may be more timely, but it is less meaningful because of its brevity and because a single quarter is subject to seasonal fluctuation.
All 18 companies listed in Table 1 had negative free cash flow while 11 had negative cash flow from operations.
The burn rate indicates the net amount of cash a firm is consuming in its operations and development. It is the rate of negative cash flow of a company. By relating negative cash flow from operations and negative free cash flow to the level of available cash, we can arrive at a rough estimate of how long a company can operate before requiring additional financing. The two “months until burnout” columns in Table 1 indicate the number of months of operation the company’s current cash level can support the cash from operation and free cash flow deficits.
We calculated the cash from operations burn rate by dividing the current “cash” level (cash plus marketable securities) by cash from operations over the trailing 12 months and multiplying the result by 12 to equate it to a monthly rate. Companies with positive cash from operations do not burn cash; instead, they create it. Therefore, we did not compute a burn rate for those companies, as indicated by “positive” in the cash from operations burnout column.
The free cash flow burn rate was calculated in a similar manner: dividing the current cash level by free cash flow over the trailing 12 months and multiplying the result by 12.
A low number of months to burnout does not necessarily mean that a company will run out of cash. It does indicate that, if operational elements do not improve, the company will need to seek additional financing.
The trailing 12 months’ diluted earnings from continuing operations figure helps us gauge how these firms rate using traditional earnings figures. Generally speaking, earnings per share tracks free cash flow per share. Most firms with negative free cash flow also have negative earnings.
The three-year annual sales growth figure illustrates the strong recent growth of these firms with sufficient operating history. However, the majority of these firms do not have a sales history long enough to calculate the three-year growth rate. Even when the data is available, top-line growth has not translated into bottom-line earnings or earnings growth. Only one of the eight companies with sufficient earnings history to calculate a three-year earnings growth rate, IMS Health Holdings (IMS), has positive earnings growth over the period.
Despite the poor historical earnings growth rates for most of these firms, analysts still have high expectations for them over the next three to five years, as indicated by the EPS growth estimate column. Here, 10 firms have analysts providing an estimated earnings growth figure, with a range of 9.7% for Five9 Inc. (FIVN) to 100% for Sunedison Semiconductor Ltd. (SEMI). Eight of the 10 companies have projected earnings growth rates of 20% or more a year over the next three to five years. Rates this high are not sustainable over the long term and, historically, not many companies can match expectations this high.
With so many companies in this group reporting negative earnings, which means we cannot calculate a meaning price-earnings ratio, we look to the price-to-sales ratio to gauge valuation levels. Acceptable price-to-sales levels normally vary by industry, growth prospects and risk, so we include an industry median price-to-sales figure as well as each company’s industry designation. Somewhat surprising, those companies with high forecasted earnings growth do not have outrageously high valuations. The highest price-to-sales figure among all the companies in the list is Roka Bioscience (ROKA) at 65.5. This puts the company, which develops advanced testing solutions for the detection of foodborne pathogens, in the 98th percentile of all companies in the Stock Investor Pro database.
A Closer Look at One Tech Company
According to Table 1, Energous Corp. (WATT) has the fewest months to burnout with a figure of two months based on cash from operations and four months based on free cash flow as of March 31, 2014 (the end of the last reported fiscal quarter). The company, which was started with $10,000 in late 2012, is developing technology to wirelessly charge or power electronic devices at a distance. So far, Energous has managed to send energy up to 30 feet from its transmitters, which are similar in size and shape to a Wi-Fi router, to receivers meant to mimic mobile devices. However, since inception the company has also run up debts of about $5.5 million without generating any revenue; debtholders will also receive roughly 1.8 million shares in the company in exchange for their notes. The underwriting bank, MDB Capital Group, has the right to purchase an additional 400,000 shares at roughly $7.50 a share if it chooses. In addition, Energous sold slightly more than 210,000 shares to strategic partner Hanbit Electronics of Korea for $1 million in July in a private placement.
At this point, the company does not have a working prototype, but it hopes to have products to demo in time for the January 2015 Consumer Electronics Show (CES) that it can then start marketing to consumers sometime next year. Energous’ technology also requires regulatory approval from the Federal Communications Commission (FCC), since it uses RF energy waves, which are under regulatory control, to power devices.
Perhaps most telling is the report of Energous’ auditors in the company’s S-1 filing. The auditor, Marcum LLP states, “As discussed in Note 2 to the financial statements, at December 31, 2013, the Company is in its development stage, has not yet generated revenues and is dependent upon future sources of equity or debt financing in order to fund its operations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern.”
For companies with high burn rates, such as Energous, there are potential solutions:
- Decrease the burn rate through cost reductions or by generating more cash from operations.
- Sell off assets to raise additional cash.
- Raise cash via external financing (debt or equity issues).
However, for companies in the development and accelerating growth phases of the business life cycle, as is the case with Energous, the first two options seem self-defeating. Such firms are consuming large amounts of cash to build a company and develop a product or service, so cutting back on costs is difficult. Such companies also need assets to develop their product or service and without them, they cannot generate cash from operations to sustain the company. The only real options, then, are acquiring additional capital or selling out to a competing firm.
The analysis of a company’s cash position, cash from operations and free cash flow can be very revealing. Comparing a company’s cash flows to its cash levels helps to illuminate whether a company is self-sustaining. As an investor, you should be wary of firms with high cash burn rates, as it indicates that the company may be vulnerable unless outside financing is arranged. If such financing is not forthcoming your investment could go up in flames, leaving only ashes.
This article was adapted from the May 2000 AAII Journal article “Analyzing Internet Stocks: Cash Flow and the Burn Rate,” by John Bajkowski.