If you follow global financial news, you must have come across reports of the recent IPO of Groupon. Well, for those who haven’t heard of it, Groupon is an online seller of discount coupons, and acts like a ‘deal of the day’ website.
The company’s shares listed on the US exchanges on 4th November, and jumped 31% by the end of the first day of trading. This brought the company’s valuation to more than US$ 16 billion.
How much is US$ 16 billion? Well, that’s more than the respective market capitalization of 14 of India’s top 30 companies on the Sensex.
Now that’s not amazing. What’s amazing is that US investors have paid a high price for a company, which…
- Does not have a sustainable business model (there are now many companies offering the same services as Groupon),
- Hasn’t made a dollar of profit since it came into existence three years back, and
- Has been guilty of accounting manipulations.
But who cares?
The promoters of Groupon are now billionaires, and it must have been their billionaire dreams that led them to get their company listed.
More importantly, the US investors have chosen to believe the company’s promoters. At least this is what the surge in stock’s price and its current market cap suggest.
Groupon, in just three years of its existence, has caught the attention of the Netizens and the investment world alike.
In these years, the company has grown revenue at rapid rates – from US$ 0.09 million in reported revenue in 2008 to US$ 713 million in 2010.
However the question is – Are these numbers trustworthy?
Groupon has had to revise its financials numerous times in the months preceding its IPO.
The initial report it filed with US stock market regulator SEC in June showed revenue during the first quarter of 2011 at around US$ 645 million.
The problem with this number was that it was reported on a gross basis – including the portion that the company has to pay to merchants. This was a clear violation of accounting regulations.
After being reprimanded for its over-reporting of revenue, the company submitted an amended report last month. This time, the number stood at just US$ 295 million, or less than half the previously reported number!
If that wasn’t all, Groupon started off its reporting by claiming that marketing expenses don’t matter and that investors shouldn’t worry about them.
It invented a new metric called ‘Adjusted Consolidated Segment Operating Income’. If you ignored Groupon’s marketing expenses, it generated a profit of about US$ 82 million in the first quarter of 2011.
That metric was so ridiculed that Groupon removed it in its second reporting to the SEC. When that was converted to a more normal accounting metric, Groupon actually lost US$ 98 million during the quarter.
Isn’t it a pretty tough sell to say that online marketing expenses aren’t relevant when you’re an online marketing company? Well, Groupon’s promoters and accountants didn’t think it was tough!
Anyways, leaving aside the over-reporting of revenue and profits, even some other accounting adjustments that Groupon has made are worrisome. For instance, the company has changed how it defines certain expenses like marketing expenses, cost of revenue, and sales and administrative costs, all for showing a lower loss.
In essence, Groupon is asking investors to look at their profit before any expenses. And it’s not a surprise because the company’s expenses are rising at a much faster pace than its revenue.
Groupon is like the consistently failing student who suddenly gets barely enough questions right on the final exam to get a passing grade, and that too without showing any of his work.
It’s possible that the student worked really hard to earn a passing grade. Or it’s possible that the student resorted to cheating.
At this point, the latter seems like a greater possibility.
The case of overstating revenue and profits before an IPO isn’t exclusive to Groupon or other such US companies.
Many Indian companies coming out with their IPOs in the past have been guilty of doing this.
Moreover, it has not just been the case of misrepresenting financial numbers. There have been numerous cases of companies and their promoters entering into shady share transfer deals to favour themselves, their families and related companies just before their IPOs.
Not to forget the valuations at which most IPOs in India have been priced at in the past. If you remember the much touted IPOs of DLF and Reliance Power, you will know where I’m coming from.
The funny thing with IPO valuations is that it all depends on which side of the bed the promoters and their investment bankers get off from on the day of pricing the IPO.
What mostly happens is that the promoters tell the investment bankers the kind of price they want to get for their shares, and the investment bankers work their magic backwards to create the reasons why such a price is justified.
It’s like the promoter telling the investment bankers, “I think my company must be valued at 1.5 times the valuations of my next best competitor, or at around Rs 500 per share. What do you say?”
The obliging banker says, “Whatever you say sir! Let me create the math that will justify a price of Rs 500 per share.”
And voila, you have the IPO priced at Rs 500, and then comes a round of justifications why this price is a steal!
What is more, in a bull market, investors are willing to believe that this indeed is the right price (and a cheap price) to get the shares of such a ‘great’ company.
A few years after many such ‘great’ companies come out with their ‘cheap’ IPOs, this is what investors get to see…
Data Source: Ace Equity, Safal Niveshak Research
The above chart shows the comparative performance of BSE-Sensex versus the BSE-IPO index over the past 2 years (BSE-IPO index was launched in August 2009).
During this period, while the Sensex has gained around 9%, the IPO index is down 20%. So much for the faith that promoters and investment bankers try to create in the minds of investors while launching their IPOs!
The truth about IPOs
Benjamin Graham, the father of value investing, writes in his ‘The Intelligent Investor’…
“In every case, investors have burned themselves on IPOs, have stayed away for at least two years, but have always returned for another scalding. For as long as stock markets have existed, investors have gone through this manic-depressive cycle.
“In America’s first great IPO boom back in 1825, a man was said to have been squeezed to death in the stampede of speculators trying to buy shares in the new Bank of Southwark. The wealthiest buyers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value.”
Over my eight years of experience in the stock markets, I have not come across any IPO (at least I can’t remember any) that has been launched keeping in mind the interest of investors.
A majority of them have been launched in the form of ‘legalized looting’ by company promoters and their investment bankers.
I have come to believe how Graham defined IPOs in The Intelligent Investor.
He said that intelligent investors should conclude that IPO does not stand only for ‘initial public offering’. More accurately, it is a shorthand for…
- It’s Probably Overpriced, or
- Imaginary Profits Only, or even
- Insiders’ Private Opportunity
What do you say? Have you burnt your hands in any IPO in the past?
Let me know in the comments below, or post on my Facebook page.
This is apart from what Groupon did but is capitalisation of marketing costs bad? (considering that the value realisation from the spend is going to happen only in the future).
Vishal Khandelwal says
Thanks for your comment, Vipin!
Marketing expenses are normal operating expenses that produce short term benefits. Unless the company can produce evidence that a specific advertising will create long term benefits, it is safe to assume that all marketing costs should be expensed instead of capitalized. This is especially true for Groupon, where the company – being an online business – realizes the benefits of its marketing expenses in the short term. So these costs must be expensed and not capitalized.
I hope that answers your query.
I am of the opinion that IPO are probably over priced, that’s why no major IPO/FPO’s (even from Government) comes out in bear market. In bull market IPO’s get through at any crazy price.
It is quite logical that a owner of a company will certainly sell his company at the best possible (highest price point) price and get maximum benefit for the existing owners/investors/sharholders, otherwise he is not doing justice to his job. There is no logical reason for a IPO being priced at lower level to benefit the prospective Investors. Even Government is not ready to do so.
Luckily, I have invested only in a very few IPO/FPOs of top notch companies and have not lost money. I never touched anything less than Bluechip IPO/FPO’s. But, that was a time when I was not aware much of markets (now just little better than that!). I was investing in IPO/FPO thinking it is always going to fetch me good returns and it was also during those bull phase. Now for almost 5 years, I never invested in an IPO/FPO
Vishal Khandelwal says
Thanks for sharing your experience and views on IPOs, Ajay. I share the same. As Graham rightly defined them – IPO = It’s Probably Overpriced, and Imaginary Profits Only. 🙂
Lucio Miranda says
A great expose’ by you of Groupon which makes one wonder that if, the US with its’ regulations such as SoX, GAAP etc & regulators like SEC allows for such IPOs then what must happen in our wonder-ful India.