Recently, we learned that Twitter had begun its initial public offering (IPO) process using the streamlined regulatory framework introduced by the 2012 Jumpstart Our Business Startups (JOBS) Act.  And as analysts and investors search for clues on Twitter’s valuation, many again are raising questions about how the JOBS Act impacts financial reporting transparency.  In questioning the Company’s recent JOBS Act filing, Holman Jenkins of the Wall Street Journal asked:

Why does a super-prominent company like Twitter need to avail itself of these arrangements?

 Great question!  As many of you know already, this grumpy old accountant has never been a fan of the JOBS Act (see “Garbage In, Garbage Out - Are Accountants Really to Blame?” and “Is Model N A Transparency Violation?”).  Any legislation that reduces the ability of market participants to make informed investing decisions, gets a “no” vote from me.  But in this case, what WILL Twitter’s financials really tell us?  Nothing that we don’t already know!   Let me explain…

We should not be surprised by Twitter’s JOBS Act filing.  There are already hints that the 2010 and 2011 numbers were not good, so why not postpone public disclosure as long as possible.  As for current numbers, not much is publicly available, but market-research firm eMarketer reported advertising revenues for the Company of $288.3 million in 2012, and expects $582.8 million in 2013 and $950 million in 2014.  All of this makes valuation a bit problematic, forcing reliance on recent private transactions which some believe may justify a $9 to $10 billion value.  From this one might incorrectly conclude that the Twitter IPO could be a “poster child” for what it is wrong with JOBS Act disclosure.  But we don’t really need current financial statements from Twitter!  We already have everything we need to form a pretty good idea what the post-IPO balance sheet, income statement, and statement of cash flows will look like.

All we have to do is apply the basics of market multiples analysis to create a set of financial statements for Twitter.  If we agree that similar companies have similar assets and capital structures, then we should be able to “back in” to Twitter’s post-IPO balance sheet.  But first we must find a set of “comparable” (comp) companies.  This comp group should share commonalities in industry, technology, customers, size, capital structure, and growth prospects, to the greatest extent possible. 

I used the Global X Social Media Index ETF as a starting point in finding my Twitter comps.  This yielded 27 companies which I narrowed down to 19, as 8 were listed on foreign exchanges which precluded easy data access.  Next, I eliminated companies that did not appear to have a business strategy or model similar to that of Twitter.  For example, I retained all companies with Standard Industrial Classification (SIC) codes 7320 (i.e., computer programming, data processing, etc.) but deleted those with SIC codes 7371 and 7372 (i.e., computer programming services and prepackaged software). Companies like Changyou.com, Zynga, and Jive Software fell out as comps.  Finally, I deleted companies whose primary revenue source was NOT advertising.  This eliminated Nutrisystem, Pandora, Groupon, United Online, Youku, Google, Netease Inc., Yandex, Angie’s List, LinkedIn, Demand Media, and Renren.  This yielded a final comp group consisting of Facebook, Sina Corp, Yelp Inc., and Meetme Inc. 

After selecting comps, I used fiscal year-end 2012 balance sheet data from Wharton Research Data Services to create common-sized balance sheets for each company.  Then, I averaged each balance sheet line item for each asset category.  With this data I then forecasted a post-IPO balance sheet for Twitter.  This yielded a balance sheet comprised of the following major asset categories (and percentage amounts): cash and short term investments (41.84 percent), other current assets (11.83 percent), Net PPE (8.36 percent), and goodwill and other intangibles (28.36 percent). Given the relative recency of these comp company IPOs, Twitter’s hypothetical capital structure is dominated by a stockholders’ equity of 81.16 percent, with current and long-term liabilities totaling only 10.93 percent and 7.92 percent, respectively.

Next, I estimated Twitter’s total assets relying on recent annual revenue amounts reported in the popular press ($600 million), and the average revenue to assets percentage (46.84%) of my four company comp group. This generated a total Twitter post-IPO asset base of almost $1.3 billion. Finally, to get amounts for each balance sheet line item, I simply multiplied the $1.3 billion in total assets by the above balance sheet category percentages for my comp group.  And voila, a post-IPO balance sheet for Twitter!

 Now, does the balance sheet make sense?  Sure and here’s why.  The significant cash balances reflect the recapitalization proceeds from the IPO.  The large amounts of goodwill and other intangibles are the result of numerous company acquisitions made during the past two years according to Victor Luckerson: Vine (October 2012), We Are Hunted (Fall 2012), Bluefin Labs (February 2013), Ubalo (May 2013), Marakana and Trendrr (August 2013), and MoPub (September 2013).  There is no surprise here and some of you may recall the grumpies ranting about intangibles and cost capitalization issues last year in “The Beauty of Internet Company Accounting.”  In that same post, we also explored valuation concerns about deferred tax assets.  As noted above, Twitter’s balance sheet undoubtedly will include these intangibles as well, probably a function of the sizeable tax net operating losses that the Company is now compiling.  

And what about the income statement you ask?  Well, since advertising seems to be the major revenue source in this version of the Company’s business model, it is unlikely that we will see any of the unusual sales treatments found in the recent IPO’s for Groupon (i.e., gross vs. net), Linked In (i.e., multiple deliverables), or Zynga (i.e., virtual goods).  

There is generally nothing very complicated or interesting about advertising revenue recognition.  However, three of the four comps (Facebook being the exception) reported operating losses after depreciation and amortization for fiscal year 2012 which is understandable given the start-up nature of these ventures. Twitter no doubt will report operating losses as well, and can be expected to make liberal use of non-GAAP metrics to “explain away” poor performance as not reflective of “reality.”  It will be interesting to see what expenses the Company deems “special” or “non-operating” in nature: depreciation, amortization, stock-based compensation, acquisition costs?  All of the above?

Then, there are the operating cash flows (OCF).  The same three comps (Sina, Yelp, and Meetme) reported either negative or transitory OCFs for 2012, clearly reflective of their stage in their company life cycle.  We should expect more of the same from Twitter.  For those of you that think I am being overly harsh toward social media IPOs, remember that Facebook earned an “A” in financial reporting from the grumpies.

So, see…we really don’t need those financial statements after all, do we?  But in “Please Twitter, Just Stay Weird,” Fahad Manjoo raises a number of strategic concerns which this grumpy Twitter user wants answered, and soon! For example, once a public company, Twitter will be forced to run more ads.  We already see this coming as the Company “Strikes Deal with the NFL” and “Pitches Itself to TV Networks.”  How will monetization ultimately affect the user experience?  And then there is the continuing social media company dilemma…who is the customer?  The media user who pays little or nothing, or the advertiser who is so key in revenue creation?

Taking care of the advertiser might actually chase off users.  As the Wall Street Journal’s Yoree Koh and Keach Hagey indicate:

Getting companies to pay for Twitter publicity is a crucial distinction for the seven-year-old company as it tries to convert its online influence into a business model—especially when rival Facebook Inc. also wants to become a hub for real-time conversations.

 

If Twitter simply “devolves” into another Facebook News Feed, one could argue that the Company may be sacrificing the very identity that made it special in the first place.  

And the concerns/questions don’t stop there.  Why all the sudden pre-IPO buzz on NFL contracts, new ad products, and new acquisitions?  How do all these tie into the Company’s strategy, or do they? Why the sudden pre-IPO need for working capital?  Is there some sense of urgency to look like a real company?  Or could this just be another Grouponesque scenario designed to enrich a select few by bringing to market a neat idea and platform with no real proven way to make money with it.  Few would disagree that Groupon’s initial premise was exciting…using technology to bring merchants and customers together. However, initially the company had no real strategy, model, or sense of market competition, all of which has contributed to its recent operating struggles.  And it doesn’t help that Twitter turned to a former Zynga player to lead it to market, or that it just now is looking for a financial reporting manager. Just some of the concerns running through this Twitter loving grumpy old accountant’s head.

I vehemently disagree with Wharton Professor Lawrence G. Hrebiniak who indicated that:

[Twitter] must release its data at least 21 days before marketing the IPO, which, in today’s highspeed cyber world, is more than sufficient for investors and others to examine and evaluate the company.

Twenty-one days may be enough to push some numbers around in a spreadsheet, but it is clearly inadequate to promote a meaningful dialogue with management to address the unanswered questions about strategy and business model and leadership.  Yet, people are still going to buy into the Twitter IPO, just like they did for Groupon and Zynga.  Hopefully, the outcome will be more positive.  If not, Twitter’s 140 character limit should be sufficient for the eulogy…


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach
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I’m really getting tired of hearing about the changing role of today’s Chief Financial Officer (CFO), particularly all of the consulting hype about the “need to be strategic.” Good CFO's have always been strategic!  This recent barrage about the advent of the strategic CFO is simply 21st century spin that masks a major human resource dilemma at today’s global companies: the wrong individual is in the CFO seat.  And then there’s the compulsive need to anoint the “Best CFO.”  Yes, we live in a rankings crazed society, but those who feel compelled to create such a list simply don’t know anything about business, much less what CFO’s do, or are supposed to do.  All of this has prompted this former CFO to share my “Ten Commandments” so that readers can judge for themselves who the top CFO’s just might be.  But first, some context is in order.

The “Pragmatic Strategist”

A recent blatant sales pitch in the CFO Journal titled “The CFO as Pragmatic Strategist: Lessons from the Lab,” really made this Grumpy Old Accountant’s blood boil.  This superficial piece resurrects an old theme, and repackages it as something new, this time as coming from the “lab.”  But as my colleague Noah Barsky and I pointed out in “What Makes a CFO ‘the Best’?”, there already exists a rich reading list going back a decade, which offers meaningful insights into the skills needed by a CFO.  And not surprisingly, one of these is a strategic mindset.  It also really bothers me that this article attempts to cloak a consulting exercise in the robes of scientific inquiry by suggesting that its rather obvious finding came from a “lab.”  So, exactly what did the “lab” yield? The big takeaway was a seven question CFO guide to value creation that targeted two main areas: does the CFO know the company’s strategy and the related risks to executing it?  Duh…

In an attempt to reign in my cynicism about this article, I did find one potentially worthwhile nugget.  Maybe the “lab” stumbled on to a serious problem in the C-suite.  Presumably the lab assistants evaluated a large sample of CFO’s.  If so, their finding that CFO’s need to “cultivate” a strategic mindset suggests that currently many CFO positions are being filled by unqualified individuals!  That just might explain the rash of disappointing IPO’s, accounting restatements, internal control weaknesses, and frauds that continue to plague global companies. Maybe we should be addressing this issue in the growing laundry list of risks disclosed in today’s security registration statements and annual reports…it might read something like this:

Our chief financial officer lacks a strategic focus (and potentially other critical skills) which may negatively affect the execution of firm strategy, as well as the management of key processes and related risks. As a result, our operating results are likely to vary significantly from period to period and be unpredictable, which may cause our stock price to decline.

Too far-fetched you say?  Just check out Model N’s prospectus risk list…I think it would fit in nicely, particularly given the company’s recent struggles in the C-suite.

The “Best CFO”

Determining who might be the “best” CFO may be an impossible task because there are just too many determinants. As with so many of today’s rankings (e.g., best company, top college, etc.), there is simply no one answer because the metrics used in these CFO “studies” are generally biased, incomplete, or otherwise flawed.  The CFO role is a function of a variety of factors including organization age, growth, scale, industry, market, etc.  Small firms often get along just fine with using their controller to fill the role of financial leader. And other companies often bridge the gap between controller and CFO using temporary help providers like CFO Edge.  But as companies continue to grow, they realize the need for a CFO to specifically oversee the link between strategy and financial success.

When discussing what makes a CFO “the best,” I feel compelled to demystify the notion of the strategic CFO.  First, we have to understand just exactly what a CFO does, vis-a-vis the controller.  A controller’s duties generally center around such traditional financial and managerial reporting tasks as preparing financial statements, budgets, cash flow projections, performance measurement reports; and creating and monitoring accounting policies, procedures, and internal controls.  And recently, in larger (or more diverse) entities that are suffering the burden of GAAP overload, some of the controller’s financial reporting duties have been spun off into the Chief Accounting Officer position.

In contrast, the CFO’s role is to specifically link strategy to financial performance.  Every company engages in three primary activities: financing, investing, and operating.  The CFO plays a major role in orchestrating all three as a company strives to execute its strategy. Of course a CFO needs to be strategic!  Without a detailed understanding of how a company intends to create value for its customers and differentiate itself in the marketplace, there is little chance that a CFO will be effective.  After all, CFO financing activities will be driven by investment decisions that are made to execute corporate strategy.  So, it is not surprising that today’s CFO’s find themselves increasingly on executive management teams, involved in planning and implementing growth strategies, IPO’s, and acquisitions.  All of these activities clearly fall under “investing responsibilities.”  And to make good investments, the CFO has to be an expert analyst skilled in both financial and tax strategy, as well as risk management. 

But the CFO’s responsibilities don’t stop there…they need a strategic focus not only for their investing and financing roles, but also so that they can monitor the efficiency and effectiveness of the company’s business model.  For example, are all of the business model processes adequately financed and sourced?  And what about process evaluation and risk management?  In short, three terms define the role of today’s CFO: strategy, process, measurement. These provide the criteria by which CFO greatness should be evaluated.

Amy Errett, an experienced venture capitalist, seems to agree in a February 2010 Inc. article:

A great CFO must be a great strategic thinker, strong manager, have a strong business sense and have excellent finance skills.

Several McKinsey consultants also seem to support my contention that “one size does not fit all” when it comes to evaluating CFOs. They suggest that because management roles can vary by organization, industry characteristics, and investor demand, there may actually be different types of CFO's.  Their review of CFO's at the top 100 global companies by market capitalization revealed four profiles for today’s CFO: the finance expert, the generalist, the performance leader, and the growth champion. The finance expert is what we normally would have expected to fill the CFO position historically, a former accountant and controller with audit experience and an advanced accounting degree. The generalist CFO is typically an MBA with significant experience in strategy and business operations and strategy, but significantly lighter in accounting expertise.  The performance leader is simply a generalist CFO who specializes in restructuring situations.  Consequently, the performance CFO’s focus are costs, and performance metrics to assess progress on re-engineering efforts central to strategy execution.  Finally, there is the growth champion CFO whose role is to effect growth strategies through dramatic changes in resource allocation (i.e., acquisitions, divestitures, etc.).  Not surprisingly, the growth champion skill set includes those of the finance expert, generalist, and performance leader, as they must be able to address strategy, process, and measurement challenges across the firm. The McKinsey consultants, Agrawal, Goldie, and Huyett, sum it up as follows:

It would be simplistic to suggest definitive rules prescribing a specific CFO profile for general categories of company.

 And Kristina Salen, the new CFO at Etsy seems to also validate my perspective.  She definitely gets it.  At the top of her advice list on making better investments is “Invest in a Strategy,” followed by “Investing in the Entire Management Team.”  Particularly telling, is her admission that quarterly numbers have little to do with strategy, and likely are poor measures of strategic success.

So, it is simply ludicrous to suggest that CFOs can be somehow classified, compared, and ranked with any degree of validity.  How then will you recognize a top CFO?  You will know them when you see them…they follow this Grumpy Old Accountant’s “Ten Commandments.”

“Ten Commandments” for CFOs

  1. Be honest.  Robin Freestone, CFO at Pearson Group and chairman of the Hundred Group of FTSE CFO’s,  sums it up nicely: "Your greatest asset is your personal credibility. That will travel with you, no matter who you’re working for. Lose it, and you render yourself valueless. The only real way to maintain that credibility is to tell it like it is."
  2.  Honor thy creditors and investors.  Hold the interests and needs of these stakeholders above all others, including your own and those of your management team.  Remember that without the financing provided by these parties, your vision and strategy cannot be achieved.
  3. Put a premium on strategy and process.  As Lewis Carroll stated, “if you don’t know where you’re going, any road will get you there.”  A strategic focus implicitly fosters innovation and promotes world class performance.
  4. Run your own company.  Don’t turn the keys over to consultants…they will never understand your strategy and processes as well as you do, no matter their purported business acumen.
  5. Embrace risk and risk management.  Risk is fundamental to business model processes.  Avoid temptations created by financial reengineering...there is never a good “quick fix.”
  6. Be transparent.  Place a premium on clear, concise, relevant information, and communication.  Avoid MBA speak and accounting jargon.
  7. Make “real” performance measurement a priority.  Recognize GAAP reporting for what it is, a flawed, politically-based, judgment-ridden, and historically focused financial assessment.  Link strategy to performance by adopting a balanced scorecard perspective.
  8. Shun the “earnings game” and avoid all who play it.  Abandon all earnings management activities including aggressive accounting and non-GAAP disclosures.  Instead of asking your independent auditors to “bless” outrageous accruals, require them to do real audits which just might benefit the company.
  9. Think long-term when evaluating performance.  Reject all short-term performance metrics and related incentives, including stock based compensation.  Recognize that it takes time to get things done. Take your pay only in salary and bonus, after you have earned it. Man up!
  10. Respect experience.  Recognize the value that work history and a proven record of accomplishment actually bring to a company. Don’t mistake academic pedigrees, certifications, and high energy for real competence.   

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach