Problems for the Company and Stock Price Declines Continue

Groupon just released its 3^rd quarter 2012 earnings report, marking its first full-year cycle of earnings reports since its initial public offering (IPO) in November 2011. While the net operating results show improvement year-to-year, the company still shows a net loss for the quarter. Moreover, while its revenue has been increasing in fiscal 2012, its operating profit has declined over sixty percent. This means its operating expenses are growing faster than its revenues, a sign of impending disaster. The company’s stock price on Nasdaq has gone from $26.11 per share on November 5, 2011, the end of the IPO day, to $4.14 a share on November 30, 2012, a decline of more than 80 percent in one year. The company did not meet financial analysts’ expectations for the 3^rd quarter of 2012.

Groupon blamed the disappointing results on its European operations. Some analysts took solace in the fact that Groupon reported it has 39.5 million active customers, an increase of 37 percent from the previous year. But, what good does it do to have a larger customer base if it also leads to larger-than-expected operating costs? This is the question Groupon needs to answer.

I want to go back awhile to the day of the IPO to show how Groupon’s problems first started. On November 5, 2011, Groupon took its company public with a buy-in price set at $20 per share.  Groupon shares rose from their IPO price of $20 by 40% in early trading on Nasdaq, and ended at the 4 p.m. market close at $26.11, up 31%. The closing price valued Groupon at $16.6 billion, making it more valuable than companies such as Adobe Systems and nearly the size of Yahoo.

At a size of up to $805 million, Groupon ranked as the third-largest Internet IPO sold in the U.S.in 2011, after a $1.4 billion issue by Russian search-engine operator Yandex NV in May and a $855 million issue by China social networking platform Renren, according to Dealogic. It was the ninth-largest ever on a list topped by the $1.9 billion sale by Google in 2004.

Less than five months later on March 30, 2012, Groupon announced that it had revised its financial results, an unexpected restatement that deepened losses and raised questions about its accounting practices. As part of the revision, Groupon disclosed a “material weakness” in its internal controls (accounting speak for we blew it, were caught, and now admit it), saying that it had failed to set aside enough money to cover customer refunds. The accounting issue increased the company’s losses in the fourth quarter to $64.9 million from $42.3 million. The news that day sent shares of Groupon tumbling 6% to $17.29. Shares of Groupon had fallen by 30 percent since it went public and the downward trend continues.

In its announcement of the restatement, Groupon explained that it had encountered problems related to certain assumptions and forecasts the company used to calculate its results. In particular, the company said it underestimated customer refunds for higher-priced offers such as laser eye surgery.

Groupon collects more revenue on such deals, but also carry a higher rate of refunds. The company honors customer refunds for the life of its coupons, so these payments can affect its financials at various times. Groupon deducts refunds within 60 days from revenue; after that, the company has to take an additional accounting charge related to the payments.

As Groupon prepared its financial statements for 2011, its independent auditor, Ernst & Young, determined that the company did not accurately account for the possibility of higher refunds. By the firm’s assessment, that constituted a “material weakness.” We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate,” Groupon said in its annual report.

In an interesting twist, in response to the conclusion that the company’s internal controls contained a material weakness, Groupon said it’s been working for several months with an accounting firm, not Ernst & Young, and will report on the effectiveness of those controls by the end of 2012. This could be because the company blames Ernst & Young for not finding the problem earlier. In fact, it was management’s own report on internal controls over financial reporting that first disclosed at the problem.  

In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon accusing the company of misleading investors about its financial prospects in its IPO and concealing weak internal controls. According to the complaint, the company overstated revenue, issued materially false and misleading financial results, and concealed how its business was not growing as fast and was not nearly as resistant to competition as it had suggested.

These claims bring up a gap in the sections of the Sarbanes-Oxley Act that deal with companies’ internal controls. There is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon would have no obligation to disclose the problem until it filed its first quarterly or annual report as a public company – which is what it did.

What should we make of the financial results at Groupon? I see a company that hasn’t reigned in its operating costs while it expands into new markets. This may be a disaster ready to happen if Groupon doesn’t get a handle on these costs and soon. One area to look at is executive compensation. Groupon wouldn’t be the first company to overpay its top executives while it struggles to develop a sustainable market. I can just see LivingSocial and Amazon chomping at the bit as it reads about the continuing problems at Groupon.

Blog posted by Steven Mintz, aka Ethics Sage, on December 3, 2012