You may have heard of Domo because of its former unicorn status. But if you're an investor who likes to make more money from their stocks, this IPO is probably one you'll want to ignore.

In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain what's wrong with Domo's IPO, and why it's so important to always read the prospectus. Find out more about the glaring red flags in Domo's financials; what all this self-dealing hubbub is about, and why it's not a good look for Domo's management; which companies Domo is competing against, and why that's worrisome; and more.

A full transcript follows the video.

This video was recorded on June 22, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 22nd, and we're saying no arigato to Domo. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what'd you think of that intro? I thought that was pretty clever.

Evan Niu: [laughs] Yeah, it's kind of asking for that pun, you know? It's too easy to pass up. I used a similar pun in one of my articles. [laughs] 

Lewis: We leaned on your articles for the outline of today's show, and I will say, I saw that and I was like, "I have to integrate that somehow into the introduction." I was hoping you'd enjoy it, and I hope our listeners do, too. 

We're going to be talking today about an upcoming IPO, and this is Domo. It's a name that folks that follow the private market might be somewhat familiar with. This is a company that has a decent following because it's a unicorn, it's one of the private companies that has a valuation over $1 billion. And it seems like they're looking at the IPO market and saying, "Hey, there have been some good issuances this year, a pretty warm welcome to a couple of the issuances this year. That looks good. Also, we're a company that desperately needs money, so it's time for us to go raise some!"

So, this is going to be, I think, an IPO that has a decent amount of coverage on it. We wanted to talk about it before too many other folks got in on it. Why don't start out just talking about what the company does, and their space in software-as-a-service?

Niu: They're primarily an enterprise software company, really focusing on data analytics. They try to gather and monitor data from all across your company and organize it in a way to allow these executives to make data-driven decisions. They have mobile phone apps, you can see all these different data points within your company. It certainly sounds good on paper.

Lewis: Yeah. And, this is a space that we traditionally really like. I've had Brian Feroldi on in the past, and he's someone that's a big software-as-a-service type investor. He loves these types of businesses. They're generally high-margin. You have recurring subscription revenue. There's a lot to like with what this company does in this space that they operate in. You talked about data-driven decision-making. There are a lot of buzzwords around this business. It certainly gets people excited.

If you want a quick way to understand this, it's basically an operational dash for a business. It gives monitoring, alerts when things seem to be awry. They use some AI and machine learning. Certainly a business that checks a lot of boxes for emerging tech and what people might be interested in. The founder has a track record of establishing pretty interesting businesses. Josh James sold Omniture to Adobe nearly a decade ago. You have a space that's interesting, a founder with some success in the past, seemingly a thing that investors might be interested in. And yet, I think we're pumping the brakes on this one, Evan.

Niu: Right. You have these kind of things that, like you said, they check off these boxes that investors tend to like. But when you actually go beyond just the service and start to dig in a little bit, everything about this company ... there are just so many red flags when I'm going through this S-1 registration statement, and the amended one, too. The numbers are just terrible. They spend more on sales and marketing than they generate in revenue, which is probably one of the most inefficient marketing spends I've ever seen. It's just insane.

Lewis: Yeah. In the most recent fiscal year, they posted revenue of just over $100 million, which was good for 46% year over year growth; but, they posted pretty big losses, and that was because, on sales and marketing alone, they spent $130 million. That's actually the second year in a row that sales and marketing spend has outstripped their revenue spend. So, just on that line item, they are going to be losing money. The reality is, this hemorrhaging of cash has had a pretty big impact on the business.

Niu: Right. They have about 1,600 customers or so. Of that, there are about 380 big customers that have over $1 billion in revenue themselves. Domo sees them as the big fish, that they want to sell to these customers. They rely heavily on that group, which represents nearly half of the top line sales. 

But they burn through so much cash because, it really boils down to execution. They had negative operating cash flow of almost $150 million last year. They're just straight-up running out of cash. They had about $70 million at the end of April. They've maxed out their credit line. They borrowed $100 million. This is a company that raised $700 million in venture funding while it was a private company, and that's what they have to show for it? I mean, it's just dismal.

Lewis: Yeah. Looking at some of the operational decisions they've made and how's that impacted their financials, they point to this number that you see very commonly with subscription businesses called net retention rate. That is the closest thing that subscription businesses have to a comps number that you'd see with a restaurant. It's basically a look at, customers that we had a year ago, how much money are we getting, how much money are we capturing from them vs. what we got a year ago? 

And they posted growth in the past, but in this most recent fiscal year, the company had a 95% net retention rate, which means that, from that cohort of customers, they're actually collecting less money than they were in the year prior. A lot of that has to do with the fact that they had a lot of customers leave that were in the non-enterprise segment, or, they were collecting less money from those smaller players that they were spending a lot of money to try to bring in as customers to begin with.

Niu: Right. It's very clearly obvious that their whole goal is to get these customers and start upselling, and selling more and more offerings to them. It's pretty clear that they're just failing to do that. But they're spending a ton of money trying to do that. 

You also have to wonder, from a product perspective -- I mean, neither one of us has really had a chance to dig into the product -- it suggests that maybe the product, while it sounds good on paper, isn't actually as good as they're selling it as, or as they're hoping it to be. 

Lewis: That's the danger of the land-and-expand strategy. You hear this a lot with software-as-a-service businesses. They get in with a decision-maker and they slowly grow their use case within that company, they add licenses, they get to become a larger and larger portion of the company's operations. To do that, you need customer acquisition, and you need for people to not only decide to use the product, but then ultimately decide to add users to build out functionality and decide to pay more for the plan. Ideally, the company grows and sees the use case there. 

What we're seeing with the net retention rate in particular is that that's not necessarily happening. When you're spending a lot of money to acquire customers -- and, in their case, I think the payoff period for a lot of the customers that they're acquiring is several years -- and then they are not sticking around, or they're not upselling to higher-level products, that's going to cause a major cash problem for them. And that's what we're seeing, looking at their financials.

Niu: Exactly. You talked about their break-even period being several years. They clearly don't even have several years, because in the filing, another one of the big red flags that jumped out to everyone was, they're very upfront in saying, "If we don't get more money by August," which is two months from now, they will have to immediately start cutting operating expenses, which is probably going to come from more layoffs and downsizing the business. It's probably going to become a downward spiral at that point.

Again, they're just at the end of the line. They don't have that much cash. Effectively, the cash they have is all from a credit line. The amount of money they owe on this credit line is greater than what they have on the balance sheet right now. That's why they need this money. If you're an investor ... obviously, we like to be long-term investors, and they're worried about the next two months.

Lewis: We often talk about the fact that a company chooses when they decide to IPO. Very often, they're looking for the numbers to look really great and be presentable. Maybe they're going through a little bit of a pivot, and they can at least say, "This is what our user numbers look like. We're showing really great growth!" 

In this case, they're not really choosing the fact that they're going public. They were probably going to be going public sometime soon, anyways. But, they need the money. They've exhausted their current credit line pretty much immediately after amending it to be able to get an additional $50 million or so. And they've exhausted that credit facility. They're looking at this truly as a capital-raising event.

Niu: Right. It's worth noting that these types of credit lines have a lot of covenants on them that restrict what the company can do. It's not going to be easy for them to go out and secure -- this IPO is probably their best shot at getting a capital infusion. And I mean, it seems like it's going to go through, but how much they raise and all these other variables, there aren't really a lot of options left for them. It's not like they can go out and take more debt on, because these covenants aren't going to let them take more debt. It's just a mess.

Lewis: Because of this desperation, and because of the current state of their financials, this is a company that's going to be going public at a lower valuation than their recent funding round as a private business, which you don't really see all that often, Evan, right? They raised money at, what, $2.3 billion in mid-2017? I think the IPO valuation suggested is somewhere in the $500 million range.

Niu: Right. They've lost 75% of their value in just over a year. [laughs] 

Lewis: Which is something you just don't see all that often! Even the Blue Apron IPO, which decided to revise down what they were going to price their shares at, I think that was a 30% haircut or something like that. This is a 75% haircut in about a year and change. And actually, they're seeking a valuation that's less than the venture funding that they've received. You said that they raised $700 million or something like that over the last couple of years. This is something you don't see very often in a company going public.

Niu: It all boils down to financial mismanagement to add a little bit of self-dealing, which we'll get into here in a bit. [laughs] 

Lewis: Yeah, I think that's really the main reason that we wanted to talk about this business today on the show. We aren't super interested in them as an investment, but I think that this S-1 really highlights the importance of reading prospectuses to begin with, and it gives us the opportunity to talk about the idea of self-dealing, which is something that we really don't discuss all that often.

Niu: Right, because ideally, it doesn't happen that often. [laughs] But, in this case, Domo has some very interesting business arrangements -- or, it used to. The company has spent a lot of money at other businesses that are associated with CEO and founder, Josh James. 

He has a separate aircraft leasing company. Domo was paying his other company, called -- he has a bunch of weird names for these companies -- JJ Spud. They're not in the potato business, they're in aircraft leasing. So, Domo was paying JJ Spud to lease an aircraft. That's money going directly into the founder's pockets. They spent about $1.8 million over the course of two years. They also spend about $300 per year on catering services from a local restaurant that is owned and operated by James and his brother Cubby. They also spent another $200,000 for interior design from James' other brother. He has a stake in that, too. It's all these really entangled business relationships. 

To be clear, this isn't the kind of money that is going to break the company. It's a few million dollars over the course of several years, vs. the other stuff we just talked about. It's a drop in the bucket. But when you're coming from this position of desperation, it looks terrible when you've been doing this. In the amended filing, they did say that they had basically killed all these business relationships, because they were getting a lot of criticism about this. It just doesn't look right. 

So, they have ended those relationships. But then, what they did after that is, they introduced what's called a directed share program, where essentially a portion of the IPO shares that are being offered get set aside for insiders, as well as their friends and family. [laughs] 

Lewis: Which sounds like a deal that you'd be getting at a department store. It does not sound like something you'd expect with a share issuance.

Niu: Right. They're setting aside about 7.5% of the shares. Friends and family are going to be able to purchase these shares, as well as the insiders. Now, if the insiders buy it, they're going to be subject to a lock-up restriction, because they have inside information. But, if any of these other people that are associated with these insiders end up participating in this program and buying, they will not be subject to a lock-up restriction. 

So, theoretically, if this IPO goes well -- which, I mean, it doesn't look like it will, in terms of what happens after it starts trading -- if you get in at the offering price and the stock jumps and you're not subject to a lock-up restriction, you can make quite a bit of money, particularly if you're family members with some of the executive officers. There's this tremendous potential to basically trade on inside information if you have access to it. If your family, if your brother runs this company ... you know what I mean? There's just so much potential. 

The SEC used to crack down on this many years ago. Companies have been trading cautiously with these types of programs, but there was a Harvard Law study done last year that found that, for all U.S. IPOs across all sectors in the U.S., from 2013 to 2016, almost 40% of IPOs had some type of directed share programs. So, these are actually a little bit more common than you might think.

I think companies have been able to better-manage the risks associated with them, which is why you don't have as many scandals. Not to say that the potential is not still there. The median percentage of how many shares are being set aside from that study was about 5%. This one is about 7.5%. That's in line with what you would expect, so it's not actually that uncommon. But, when you put this into context with all the other stuff that this company is doing, it just looks terrible.

Lewis: Yeah, I don't have so much of a problem with it. The idea of getting people that are bought into the business, are bought into the long-term vision for the founder, I'm sure that's friends and family, in many cases. But for them to not have a lock-up period, and for there to be a history of self-dealing, makes me a little cautious when it comes to this. 

This is all to say, looking at the numbers here, looking at some of the softer elements of this business, this is not something that we are particularly interested in at any point in the future. Right, Evan?

Niu: Yeah. I don't think it's going to pop [laughs] after it starts trading. It's gotten quite a bit of criticism and negative publicity. Again, beyond all the self-dealing stuff, the numbers are just horrendous. They look so bad. I would not touch this with even other people's money.

Lewis: Yeah. I think that a lot of SaaS businesses, there are some swishier metrics that you can use to evaluate them, and they fail even on those growth-oriented, profit-later type approaches. I think that this company has so much to figure out with its sales and marketing spend and being more efficient there and their customer retention and growth initiatives. They need to figure all of that out before I'm even putting it close to a watchlist.

Niu: Another side to it that I think is worth mentioning is, when it comes to this kind of broader business intelligence space of analytics, this is something that we've been seeing a lot of these giant tech companies getting increasingly into. Amazon, Microsoft. Because for them, they start off with their cloud infrastructure stuff. And now, what they're finding is that -- coming back to this whole land-and-expand and upsell strategy -- a lot of companies are going to these giant cloud providers, starting off with just basic infrastructure and hosting. And now, what they're finding is, "Hey, we can actually start upselling on some of the more analytical and high-value stuff," versus the more commoditized stuff like cloud storage or something. That's not really an exciting business. As far as the BI stuff and the analytics, Amazon, Microsoft, they're taking it very seriously. Can Domo compete with them in the state that it's in? I'm not going to bet on that.

Lewis: Yeah, remains to be seen. We'll be happy to watch from the sidelines rather than being on the field with a ticket. Anything else before I let you go there, Evan?

Niu: I think we're good.

Lewis: Alright. Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Anne Henry for doing her thing behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Dylan Lewis owns shares of AMZN. Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends ADBE and AMZN. The Motley Fool has a disclosure policy.