ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
This past week, CFO.com asked for our opinion on Groupon’s Fourth Quarter 2011 operating results. Regular readers of our blog will not be surprised to learn that we took exception to Groupon’s continued emphasis on non-GAAP financial metrics at the expense of complete and transparent operating cash flow (OCF) disclosures. After all, we first raised the red flag on these two issues almost eight months ago in Groupon: Comedy or Drama?.
What is news is that Groupon’s chief financial officer now finds it necessary to defend his reporting practices from the critique of these two Grumpy Old Accountants! Unfortunately, the Groupon CFO only raises more red flags about the Company, the quality of its management, and of course, it’s financial reporting.
In defending his continued use of non-GAAP measures, Groupon’s CFO argues that he has been “transparent” as to why the Company relies on these disclosures, namely “to help investors better evaluate the company,” because “sometimes GAAP metrics don’t tell the entire story.” That may be true, but it doesn’t imply that non-GAAP metrics add anything substantive to the story. Often non-GAAP numbers tell significantly less of the story.
Take consolidated segment operating income (CSOI) for example. It starts with GAAP operating income and adds back very large expense amounts for stock-based compensation and acquisition-related expenses. Or how about pro-forma net income which starts with GAAP net income and again adds back the very same large expenses related to stock based compensation and acquisition-related charges. These metrics pretend that stock-based compensation and acquisition-related costs are unimportant when they are very real costs that the entity has incurred. Instead of being transparent, managers who eliminate these items are merely trying to find a nonnegative number to report.
We just don’t see how such metrics (which only bias reported performance upward) help analysts unless you believe analysts can’t read financial statements or add and subtract. Could the Company be feeding the “sell side” analyst community performance results that will make it easier for them to sell Groupon stock? After all, these are the only analysts we know of that don’t read and can’t add.
And then there is Groupon’s Magic Cash Machine! Groupon’s CFO took exception to our criticism about providing only aggregate cash flow data that failed to explain the 234 percent improvement in 2011 OCF. But even he recognizes that “it is pretty unusual to have a business that loses money from a GAAP income perspective, but actually generates free-cash flow.” Sorry Mr. CFO, “pretty unusual” does not hack it…this situation refutes all logic!
In most growth companies, OCF tend to lag net income, not the other way around. If costs exceed revenues, how is it possible to create and report huge and increasing cash flows? We know of only two ways: either delay payments to vendors or lie about what your cash flows really are! So, instead of dismissing our suggestion as “silly” that Groupon is boosting its reported cash flows by delaying payments and playing the float, prove us wrong by releasing a complete, detailed statement of cash flows. Surely, the CFO has this handy.
Oh, we almost forgot, Groupon is “a high-growth company that is disruptive and that is effectively creating a new industry.” All Groupon’s CFO left out of this statement was that the Company needed “new accounting.” Implicitly, it’s there already with its previous attempt at gross revenue recognition and continued lack of real financial reporting transparency, particularly in the cash flow area. You might recall that we initially raised concerns about Groupon’s “disruptiveness” in Is Groupon “Cooking Its Books?”
If Groupon’s CFO is serious about wanting “people to understand and trust new business models,” he needs to reengineer his mindset and approach to financial reporting transparency. GAAP may not be perfect, but is the best we have and it can be trusted. Non-GAAP numbers are usually worse because they reflect the idiosyncrasies of their creators. Overreliance on non-GAAP only adds to suspicions about the Company’s true performance.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
US-GAAP took a wrong turn in running stock-based compensation through the income statement. What I have witnessed is the high-cost of coming up with what is essentially a fictitious number. The cost of calculating a number is high, the cost of managers’ endless meeting about the assumptions used is high, and the cost of endless meetings with auditors and outside valuation firms is high. Given the limited tools and knowledge of long-term stock option pricing models, it’s no wonder I have heard people say, “just tell me the number you want, we’ll make the assumptions to fit your requirement.” Interestingly, stock-based compensation expense has the effect of smoothing income. When a high-growth company has a horrible quarter, their stock drops, and then they report huge savings in compensation. Nothing has really changed. I have heard one television stock commentator talk up a stock because of it’s lower expenses, which was a reversal of stock-based compensation expense as a result of new inputs into a Black-Scholes Option Model. No wonder most banks use items such as EBITDA or adjusted EBITDA for loan covenants. In the “old” days, when analysts were making EPS projections, they would usually assume something like 80% of the options would vest and adjust EPS accordingly. This type of assumption seemed more sane. It was easier for an investor to understand, refute or adjust if he had a different idea of vesting and exercise rates. I have yet to have a discussion with anyone about the assumption on log-normal probability density curves.
Anthony and Edward,
Thank you so much for your thoughtful analysis of Groupon and other companies. It’s great to see people doing real fundamental analysis and holding company’s feet to the fire.
I agree that there is something fishy with Groupon’s lack of financial disclosure and can no longer properly model the company because they either changed or don’t provide key metrics from the S-1.
I am also the Co-founder & CEO of Investors Mosaic, a research and collaboration platform for investors. Our goal is to provide curated content for in-depth analysis of best-of-breed companies and very popular IPO’s so the average investor can make more-informed and better investment decisions. We think this blog post and the associated links are a great and we’ve added a link to you from our Groupon Research Center. It can be found here: http://bit.ly/xyypPu
Also, we wrote a blog post demanding better financial disclosure and thought you may find it interesting. That can be found here: http://bit.ly/zdIMHk
Thanks again for your hard work!
-Evan
Excellent blog post. As an investor, I am hugely interested in large non-cash expenses calculated by Black-Scholes option pricing model using a variety of assumptions and estimates. Analyzing a company based on its cash inflows and operating income seems silly to me.
It is the popular thing to beat up on Groupon now a days, but the CFO has a solid case to make. Analysts perform their own ratios/ metrics as it is, and 95% of the community does not care what GAAP results are. GAAP results are used as a starting point to provide comfort, from that point analysts back out non cash items and model based upon their own metrics.
For example, if a company loses 10 million in a given year, but intangible amortization from a acquired customer list is 50 million from an acquisition that happened 5 years ago, no analyst is going to sell stock based upon the GAAP loss. All that matters is the pro forma EBITDA, that is the bottom line. GAAP is still important as it sets the groundwork so all companies can be comparable.
In regards to your article, acquisition related expenses are non recurring and stock compensation does not have cash flow implications. If you are assessing cash flow of business and more importantly projecting EBITDA 1 year out, you will not meet an analyst who will not back this out. You guys are out of touch with how wall street looks at companies, I spent my career in public accounting as well but have learned a blended sense of what is useful.
Reminds us of Charlie Monger’s comment, “Every time you see EBITDA earnings, you should substitute ‘[$#%@&] earnings.’” But we guess Mr. Monger is out of touch with reality.
Ed, I spent 9 nine years in public accounting, and am currently at large tech company going public in Chicago. I believe more than anything that GAAP is essential and very important. I have been around these I bankers, and VC’s who have provided us capital and none of them care about GAAP earnings, it was a shock to hear coming out of public accounting at a large firm, but its really a valid point. These guys take our GAAP Net income then pro forma to dice into what they feel the business is really worth. Very similar to what a Due diligence analysis looks like, where you back out non recurring items.
‘…stock compensation does not have cash flow implications.’ Really? If so, please address this belief by answering the following questions:
1) If Groupon had not used stock options to compensate its employees, what other (likely cash-based) compensation would it have used to fairly compensate them?
2) When Groupon employees exercise their stock options (assume that they do so when the options are in-the-money), and pay Groupon cash equal to the exercise price, how much financing cash does Groupon sacrifice by issuing the share to the executive instead of issuing the same share to the market at the existing (larger) stock price?
A clear answer to each question would help me to understand your notion of how options are cash-flow irrelevant.
1. You answered your own question, stock option 123R expense has no cash flow implications to the company. If the expense is 100 Million or 1 Billion cash flow is not impacted, that is what analysts look at. Its all about non cash expense
2. The valuation of a public company already considers that all options are vested in the intrinsic value, its all non cash once again. When we compute our Cap Table, and look at dillution VC’s like Benchmark factor in all equity issued including options. Once again its not a current year operating result.
If we pick up 50 million of 123R expense in 2011, from options issued in 2008, how does this impact my business from a cash flow perspective or how does this predict what we will do in 2012? It doesn’t Paul. Don’t forgot I am a CPA, but you have to learn that GAAP is just GAAP. Tell me one GS, or Morgan Stanley analyst who factors in 123R expense into the valuation of a company.
I didn’t ‘answer my own question.’ What I’m stating, in fact, is that the use of options had cash flow implications: it initially saved the company cash by compensating the employee through granting options rights, and then lost (likely more) cash by issuing stock to exercising employees instead of to the market. Ignoring transactions that do not result in direct short-term cash flows, but that have indirect/long-term cash flow effects or other non-cash value impacts on the firm, results in an incomplete analysis of the firm. If analysts ignore this information, their analyses are hardly praiseworthy.
And by the way, I’m not hung up on GAAP; I’m hung up on the economics of the company transaction. I am of the belief that the accounting for stock options is still incomplete because it doesn’t fully account for the actual opportunity cost of issuing the stock at a discount. Financial reporting doesn’t often (hardly at all) reports opportunity costs, but should if the full impact of firm transactions is to be understood.
The topic of stock based compensation continues to be one which evokes strong viewpoints both pro and con. Your comment about underpaying cash compensation to employees via substitution of options is valid. That said, SBC is the one expense is also very unusual in that it is never paid for by the company in cash but rather by the company’s owners through potential dilution. As a result, I do not believe that SBC belongs on the income statement on that basis. Nearly every items of sales and expense in an income statement is a true cash inflow or outflow (positive or negative) to the company while SBC never will be. SBC is addressed in the financial statements through eps calculations and that is where I believe it should be left.
When I saw their aggregate cash flow data that showed a big positive figure, all I could think was “IPO proceeds.” I was thinking that to try to sneak that in as cash earnings would be beyond absurd, but could that actually explain the big jump up?
Possible. When the 10-K comes out, we shall have a much better idea.
Want to say first off great article, I enjoyed the debate noted above. Groupon collects the money up front, then pays back to the vendors 60 days later. On the cash flow they have a giant liability for 200 million that went to 400 million or so as of 12/31/2011 which represents money owed to vendors for groupons sold. Its really just timing to be honest. When they sell a groupon they collect all cash then repay to the vendor net of their commission.