Imagine if Groupon’s wacky accounting caught on

By Reuters Staff
June 13, 2011

By Robert Cyran and Rob Cox
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The world would be a far richer place if Groupon’s wacky notions of accounting caught on. The Internet coupon company had an operating loss of $420 million last year. But it thinks investors in its upcoming initial public offering should look at “adjusted consolidated segment operating income” (adjusted CSOI) instead.

It’s easy to see why Groupon wants prospective shareholders to look at its accounts this way. Strip out marketing expenses, acquisition-related costs, stock compensation, interest expense and payments to the tax man and, presto, the Chicago startup led by Andrew Mason earned $60.6 million. If investors accepted this fantastical form of accounting, all sorts of companies would be worth billions more too.

Groupon argues that adding customers through marketing is a one-time process; stock compensation doesn’t result in direct cash outlays; and taxes and interest payments aren’t relevant because Groupon doesn’t have debt and is still technically “losing money.” In the real world customers leave and need to be replaced by new ones, stock options dilute existing shareholders, and taxes are eventually paid. But suspend disbelief and imagine how this thinking might impact the values of other companies.

Take Netflix. The online video company is growing at warp speed and spending heavily on marketing to attract new customers. Use Groupon’s arithmetic and this cost can be ignored. Netflix also pays taxes and rewards executives with stock. Subtract all of these figures from its 2010 accounts, and it would have had around $600 million of adjusted CSOI. Today, Netflix is valued at around 48 times trailing operating profits of $284 million. Substitute CSOI, and Netflix would be worth $28 billion, twice its market cap.

Or consider an old-school enterprise like Johnson & Johnson. Last year J&J had multiple product recalls. Under adjusted CSOI costs associated with these, like legal bills, advertising, and factory fixes may be treated as one-time expenses. And why stop there? Once a drug is invented, the formula isn’t forgotten, so research and development is a non-recurring cost too.

Do the numbers, and J&J’s CSOI would be about $10 billion higher than its 2010 operating profit line. At the same valuation multiple that J&J now fetches, using CSOI would add $100 billion to J&J’s worth. If Groupon is to be believed, the entire investment community has got its accounting all wrong.

Comments

I, for one, have given up on the American economy. We are going to drag the world down with us in true Schumpeter fashion.

I’m really excited for the reset! We have been propping up failed banks and companies, therefore failed products by default, for so long that they will OBVIOUSLY be overtaken by more flexible and modern systems after a collapse.

“Everything changes and nothing remains still.”–Heraclitus. He was the original Charles Schumpeter and/or Thomas Kuhn.

Posted by AdamMVillarreal | Report as abusive
 

Well, if investors are that dumb… let’s just make sure that we, the tax payer, don’t end up bearing the cost like we did for the poor under-writing at banks

Posted by GA_Chris | Report as abusive
 

This is no different than what occurred during the internet bubble of the late ’90′s, when creative people dreamed up infinitely ridiculous measures in order to value any company with a dot-com in its name at a billion dollars, regardless of whether it had revenues or not.

To exclude a cost that is such a vital part of a company’s business model, as marketing is to Groupon, is akin to measuring the U.S. deficit before expenditures for Medicaid, Medicare and Social Security. Actually, I find it almost insulting.

Marketing is particularly vital to Groupon, which employs a colossal “on-the-street” sales force, because, in my opinion, the model has yet to prove itself. If my understanding is correct, most of Groupon’s customers are restaurants. I recently modeled the economics of a Groupon transaction from a restaurant’s point of view, and determined that, in many cases, it simply doesn’t make sense. For this reason, I am somewhat skeptical about Groupon’s retention rate, but more importantly, in order to support a respectable valuation, it has to scale at an extremely rapid rate. I don’t see the costs of marketing going away anytime soon. In fact, Groupon’s sales force is most likely one of the primary reasons Microsoft recently offered to buy the company for $6+ billion.

Although stock options may not affect cash flows, the related expense incurred is an ordinary, necessary and continuing cost of doing business for companies like Groupon – in essence, a recurring component of compensation.

Investors with any savvy should see through this nonsense, and perhaps there really is a growth story worth being a part of. Hopefully, this proposed accounting chicanery will not be relevant to the company’s valuation, initially and going forward.

Otherwise, why not just use my preferred measure of earnings: “EFRBE” – Earnings From Revenues Before Expenses.

Posted by jmoskovitz | Report as abusive
 

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