The SEC Just Handed Groupon a $198 Million Reality Check

Published Wed, Aug 10th, 2011   Justin Fritz, Executive Editor

Recall, last month we raised three red flags concerning Groupon’s impending IPO.

Well, one of those red flags – a misleading figure in the company’s IPO filing– has since drawn quite a bit of attention.

Especially from the SEC.

You see, the way it used adjusted operating income in its S-1 form, Groupon was essentially saying that its marketing expenses are a capital investment.

In other words, the company views its customers as a fixed, one-time cost for the business.

That’s hardly the case, though, considering its marketing expenses reached $170 million this quarter alone.

Sure enough, the SEC took a keen interest in how Groupon was presenting the metric. And today, Groupon caved under the pressure and released an amended S-1 form omitting the controversial number. 

So why exactly did Groupon want to obscure its marketing costs leading up to an IPO?

Let me explain…

It’s Tough to Hide $198.7 Million From Investors

To Groupon’s credit, it did explain adjusted consolidated segment operating income (CSOI) in full detail in the form. And it stressed that it’s “not a valuation metric.”

But the fact that the company still used CSOI as a key performance indicator isn’t fair to potential investors.

In short, CSOI shows the company’s total operating income, minus certain expenses (i.e. – online marketing costs)…

The problem is, its marketing costs add up to $198.7 million!

This brings the company’s actual operating income to a loss of $117.1 million – a far cry from the $81.6 million it claimed as the adjusted amount.

It kind of reminds me of Enron’s “mark-to-market” accounting methodology. And we know what happened there.

In fact, when Forbes caught wind of the figure in Groupon’s filing, it pulled up a quote from 1998, when venture capitalist Bill Gurley spotted a similar trend in public filings during the tech bubble:

“Certain internet CFOs are pushing investors to look at EBITDAM. The ‘M’ represents marketing, and is an attempt to get Wall Street to ignore what has become the single biggest expenditure for internet startups. This only makes sense if you truly believe that marketing costs will one day go away, which should be considered unlikely. Perhaps we should make it easier and skip straight to EBE (earnings before expenses).”

Of course, Groupon’s subscriber base has grown considerably in a very short amount of time, thanks to its aggressive marketing.

But for its CSOI metric to make sense (as in, allow Groupon to never spend another dime on new customers), those subscribers would need to continue buying deals every year going forward.

Unfortunately for Groupon, that’s the exact opposite of what’s really happening.

Groupon’s Subscribers Are Mostly Dead Weight

In 2009, Groupon boasted 152,203 subscribers. That jumped 54,498% to 83.1 million by the end of the first quarter this year. And now, just a few months later, Groupon lays claim to 115 million subscribers.

That’s astonishing growth, for sure. But it comes with a price. 

As Reuters says, Groupon “shelled out $208 million on marketing alone during the first quarter of this year, up from $4 million in the same period a year earlier.”

And Business Insider adds, “It gets worse when you take into account that Groupon featured almost 50% more merchants in this last quarter. Despite having more deals, Groupon subscribers were buying less Groupons.”

You see, during the first quarter of this year, only 18% of subscribers had purchased deals. Compare that to 2009, when 28% were active buyers.

Add it all up, and it’s clear that Groupon’s aggressive marketing strategy – although insanely successful on the surface – is attracting an increasing amount of worthless names.

As I told Marketplace last month, if this pattern continues, we can expect Groupon to dish out more marketing dollars in the coming months – not less.

So with the vast majority of subscribers idle and more marketing costs on the way, it’s no wonder Groupon has changed its tune for the SEC.

As a new note in the amended S-1 says, “While we track this management metric internally to gauge our performance, we encourage you to base your investment decision on whatever metrics make you comfortable.”

Thanks for the advice Groupon, we will.

Good investing,

Justin Fritz