Wednesday, June 15, 2011

From revenues to earnings: Operating, financing and capital expenses....

A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.
http://blogs.wsj.com/deals/2011/06/02/groupon-ipo-its-here/
I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
Pretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:
http://blogs.forbes.com/ericsavitz/2011/06/02/deja-vu-groupons-bubble-1-0-approach-to-accounting
Is Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:
a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.
b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.
c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.
Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:
Revenues
- Operating Expenses
- Depreciation/Amortization of Capital Expenses
= Operating Income
- Financial (interest) expenses
= Taxable Income
- Taxes
= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):
a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.
b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.
c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:
http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/intangibles.pdf
This is also a chapter in my book, The Dark Side of Valuation (2nd edition, Wiley)
If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try this spreadsheet.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...)  and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.

25 comments:

guru.650 said...

Awesome post. The company does not have enough ground to treat customer acquisition cost as capital spending. Just curious as to how acquisition cost is treated in mobile services companies (In India, GSM sim cards were distributed for free). What is your view on this?

However, I think EBITDAR makes more sense. Software companies keep innovating/testing a lot of products and services; but, only a few succeed. It is very similar to successful efforts method in oil & gas accounting. What do you think about this?

Anil Bains said...

Dear Sir,

Whatever you have written seems to be perfectly fine, but still I have a feeling that its IPO price will rise by leaps and bounds.
What do you think? How will markets rate Groupon IPO?
If you think that its IPO will rise like LinkedIn's, then don't you think somewhere that traditional way of valuations is wrong or at least missing some important factor.
What do you think?
Regards
Anil Bains

emitchp said...

The other way to analyze this fluff Groupon puts out is to look at cash from operations, although if they are capitalizing expenses, then it will be an inflated number.

Krishnan said...

Prof
Thanks again for your insights;

To a person with an accounting background, I'am surprised how the Auditors allow customer acquisition costs as a qualifying asset (to qualify for a capital expense). If Groupon's business model is such that it needs to keep adding on clients, then it may resort to this practice continually. If such be the case then even the likes of Walmart, Sony, AmEx spend a lot on brand building, and acquiring clients, however these are expensed.

Rating Agencies, Audit Firms...who next?

Kindest,
Krishnan

Aswath Damodaran said...

The fact that they have to keep spending money on customer acquisition is not a reason for not allowing Groupon to capitalize. Let's say that you are a growing manufacturing company that has to build a factory every year. Accounting rules would allow this company to capitalize the factory expenses each year, right?
The bottom line is that accounting, as we know it, was designed for the old-time manufacturing company. Its rules for companies that don't make conventional fixed asset investments are internally inconsistent and make no sense.

Craig said...

Loved the post, thank you for walking us through the new Groupon accounting rules by going back to the basics.

to Anil Bain's point: the markets are new to pricing social media and online couponing firms, so we have to give them time and examples to see where prices settle. In the long run, I'd expect prices more in line with what a DCF model would predict that has realistic reinvestment rates, growth, and operating margins.

Tim said...

Nice post. The adjusted CSOI calculation is simply an attempt at putting lipstick on a pig for a business that is not going to fair well using traditional valuation methods. It's a slippery slope; AOL got killed for going down a similar path many years ago. Bottom line is that social media firms present tough valuation challenges for Wall Street- savvy investors will use alternative methods to find the real gems.

The Doors Of Perception said...

I have a basic question: isnt acquisition of new customers perhaps the only way that Groupon can stay relevant to the vendors? Why will vendors come to Groupon to dole out coupons to their regular/older customers? It doesn’t make economic sense. The only way vendor will be able to make up the lost revenue from giving out coupons to old/regular customers is by getting revenue from new customer. We can easily work out the math of how many new customers are needed to subsidize one 'old/regular' customer. Hence, steady stream of 'new' customers may be almost a necessity for Groupon's survival; hence customer acquisition will not be a one-time cost but an ongoing expense.

Pranav Pratap Singh said...

Such changes in valuation methodologies might come undone easily in bad times. During pre-Lehman crisis, Real estate companies in India had migrated to % completion method for recognising revenues from project completion method. It helped them show big revenues and profits on the basis of sale agreements on the projects that had just started.

Now that stock market would be at 80% of pre-crisis levels while real estate sector index is at less than 15% of erstwhile levels.

Nick Lewandowski said...

Do you have any thoughts on Demand Media amortizing its content creation costs over a five-year period?

RW said...

Great post prof, does a great job of reiterating first priciples and igniting debate on these points from neutral grounds.

Specifically in groupon's case would like to point out that of the $420 million of the operating loss - 203 million is acquisition related expenses and must be excluded to guage true business performance as these are non recurring (from the filing ..."Acquisition-related costs are non-recurring non-cash items related to certain of our acquisitions." )

Also, for a company which is growing at 2241% (revenue in 2011 is 23.4 times of revenue in 2010), the marketing expenditure are generally higher than in normal times (assuming there are return customers and in their case it appears that there are). In steady state these expenses would either not be there or at least be lower (as a proportion of revenues)

Now in normal (GAAP) accounting the above are expensed (as usual) but they are justified in showing them as adjustmet (for adjusted CSOI, as they have done). This is done to indicate to analysts, who base their valuation on steady state financials or in hope of getting to profitablity for a company.

That leaves stock related expenses. One could argue that such expenses too reduce as the company matures, therefore the adjustment. In their defense these are clarly marked as Non-GAAP, and open to subjective judgement. Groupon is not the first company to do so.

As a side note, G&A expenses as a proportion are also likely to decline as company gains scale.

joe said...
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joe said...
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AJAYPAL said...

I am a new reader to your blog(no acquisition cost... :P). And i bookmarked your blog when i was just halfway through the blog post.
I just have one doubt regarding the tax point you made at the end. Won't they end up paying same amount of tax in long term using either approach ?

Thanks

Aswath Damodaran said...

Yes, but they will pay more in taxes up front if they capitalize and less later on.. the present value of taxes paid will therefore be higher.

Ryan H said...

You are a truly amazing.

rpantoja0 said...

http://online.wsj.com/article/SB10001424053111903635604576472531846174782.html

Paula said...

Hi professor, I have a couple of acquisition questions for you!

1. I'm about to analyse a company that is making 1-2 acquisitions/year. Instead of paying whole acquisition price at once, they spread it over (for example) the next 5 years. I thought about this and I think I should discount these payments back to time-0. I haven't done this yet, but I think that otherwise some of their numbers, like ROE, might look a little bit too good. Do you agree with me?

2. Should I treat the whole acquisition price they pay for these companies as capex? They allocate some portion of it (raw material, consulting fees etc) to operating expenses.

regards,
Paula

PS. Sorry about any mistakes, English is my second language :o).

Aswath Damodaran said...

Paula,
Do they actually pay the money over 5 years or account for it as if they do? If it is the former, you can spread it out..
And I would treat the entire expense as capital expense.

smith said...

It is a valuable info and it really helpful for my How to join Groupon business. It offer consumers great values by guaranteeing businesses a minimum number of customers.

j0s3pH said...

Hi Sir,

Just to add on to Paula's comment. Do we treat investments in associates (in this case, investments made allow parent firm to have minority interest in another firm) as part of capital expenditure?

Thank you very much!

Aswath Damodaran said...

No. You would not add investments in other businesses in your cap ex, because you are not counting their earnings as part of operating income.

William Martin said...

Wow,nice post.it will be very interesting and informative to us.good thoughts for your work.
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