A Steal at $30 Billion!

Are Groupon’s creative performance metrics masking problems with its business?

Is Groupon’s valuation too good to be true?

Since the daily deals site Groupon launched in November 2008, its story has been about huge numbers, giant savings, and astronomical growth. According to one accounting, it is the fastest-growing company, ever. According to its own accounting, it has become profitable far sooner than most tech startups. Wall Street seems poised to reward it with an initial public offering valuing the company at as much as $30 billion. But are all these big numbers based on questionable metrics? And can Groupon really keep up the soar-away growth justifying that fantastic valuation?

Those are the questions investors have been pondering since Groupon started the process of going public. In June, the Chicago-based company filed an S1 with the Securities and Exchange Commission, allowing prospective investors to take a look under the young business’s hood and to kick its tires before deciding whether to buy shares. (The company expects to make its initial public offering sometime in the fall.)

The document shows truly fantastic growth. In fewer than three years, Groupon has picked up 7,100 employees, gained more than 83 million subscribers, and reached quarterly sales of more than 28 million coupons. Its turnover hit $713 million in 2010. And the company has grown so quickly and found a local-advertising niche so rich that it has already become profitable, it says. It reported operating income of $61 million in 2010 and $82 million in the first quarter of 2011. For context, the world’s biggest advertising company, Omnicom, made profits of about $200 million that quarter—with a 120-year corporate history and a staff of 68,000.

But in a note at the beginning of the filing, Groupon’s CEO, Andrew Mason, indicated that the company does not “measure [itself] in conventional ways.” The document included metrics that do not conform to GAAP, or generally accepted accounting principles. Most notably, the company touted its “ACSOI” or “adjusted consolidated segment operating income”—a yardstick nobody had ever heard of. The “key” metric tallies operating income “before our new subscriber acquisition costs and certain non-cash charges,” Groupon said, thus showing “profitability before marketing costs incurred for long-term growth.”

ACSOI, mentioned nearly 50 times in the document, showed that Groupon made $82 million in the first quarter of the year. But ACSOI left out the hundreds of millions of dollars associated with marketing the service, acquiring other businesses, and bringing in new subscribers. So it left out very real costs of growth—not one-off investments or unusual charges, but expenditures core to the company’s expanding business.

Investors noticed—and howled. The Wall Street Journal termed the filing “magic.” Tech blogs declared the company a sham. Many commentators hearkened back to the worst days of the late-1990s tech bubble, when out-of-nowhere dot-coms with cloudy revenue streams got billions from IPO-hungry investors. Forbes pointed to one especially salient piece of commentary from 1998. “Certain internet CFOs are pushing investors to look at EBITDAM,” Silicon Valley investor Bill Gurley wrote. “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).”

The SEC agreed and sent Groupon back to its books. The company amended its S1 filing Wednesday, with a bit of egg on its face. The new filing drops this description of ACSOI: “[W]e think of it as our operating profitability before marketing costs incurred for long-term growth.” It adds the line: “While not a valuation metric, [ACSOI] provides us with critical visibility into our business.” And it reminds investors, “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.” Looking at the metrics that tend to make investors comfortable, then, Groupon is not making money at all. Factoring in all costs, and judging by regular old operating income, Groupon lost $420 million in 2010 and $117 million in the first quarter of 2011.

So what does it all mean? Should investors run screaming from Groupon? Is it an overrated, hyped-up scam? Are we in the middle of another tech bubble?Well, Groupon does seem rather prone to hyperbole, perhaps because its business has proved so worthy of it in its mere months of existence. The filing makes clear that Groupon is losing money in the way that almost all new businesses lose money. It is burning through cash to establish itself as a leader in local advertising and to keep up that extraordinary rate of subscriber and revenue growth.

Indeed, Groupon spent $379 million on advertising in the first six months of 2011 alone, enough to diminish any large-cap company’s bottom line. But the company tries to justify that spending in its S1 filing, showing how such investment pays off down the road. In a detailed section titled “Subscriber Economics,” Groupon notes that it spent $18 million to add 3.7 million subscribers in the second quarter of 2010, for example. By the end of June this year, it says, those customers had generated $185 million in revenue and $77 million in profit.

The big question is whether the “marketing costs incurred for long-term growth” will really generate “long-term growth.” It makes sense for Groupon to spend hundreds of millions of dollars now to pick up new subscribers and sign up new businesses offering daily deals. But the business has significant overhead in the form of its thousands of copywriting and ad-sales workers. It also carries hefty advertising costs. As the business matures, it needs to convert expensive first-time users into low-cost habitual users.

Some numbers in the filing hint that businesses and individuals who have used Groupon once do not always come back for more—a much bigger problem than Groupon’s silly profitability metric. The company’s case study of its most-mature market, Chicago, shows its average revenue per subscriber and revenue per Groupon sold declining. The number of Groupons sold per customer also seems to be flattening out. The number of merchants with which Groupon has the “exclusive right to feature deals” shrank in North America, from 20,233 in the first quarter to 20,041 in the second. And as noted by the Wall Street Journal, overall growth has slowed down, too. Revenue rose 63 percent from the fourth quarter of 2010 to the first quarter of 2011, but only 36 percent from the first quarter to the second. The company also faces a soured reputation among some local businesses, the wariness of investors, and increased competition of late.

Of course, Groupon remains fast-growing, market-dominating, and young. Those revenue and expenditure numbers should and will look very different a few years from now. But there are some worrisome signs lurking in Groupon’s S1 report. For one, that weird ACSOI metric is less prominent after the revision. But it is stillthere.