Wednesday, June 15, 2011

From revenues to earnings: Operating, financing and capital expenses....

A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.
I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):
Pretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:
Is Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:
a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.
b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.
c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.
Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:
- Operating Expenses
- Depreciation/Amortization of Capital Expenses
= Operating Income
- Financial (interest) expenses
= Taxable Income
- Taxes
= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):
a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.
b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.
c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:
This is also a chapter in my book, The Dark Side of Valuation (2nd edition, Wiley)
If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try this spreadsheet.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...)  and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.

Thursday, June 9, 2011

There is an app for that....

I have a healthy respect for technology. While I don't see it as the cure for any of our problems in valuation, it has made life a lot easier in terms of mechanics. I still remember trying to value companies in the mid-eighties, where data had to be collected by hand (in libraries) and computers were primitive (I started with Visicalc on a Kaypro and it was just a glorified hand calculator, with limited features). I have tried to stay on top of evolving trends, though I have never been cutting edge on any dimension.

As I watch my kids and colleagues increasingly abandon their computers for their smartphones and iPads, I have wondered whether I could make this transition. Thanks to Anant Sundaram, my good friend, who teaches valuation at Dartmouth College, the first step has been taken. Together, we developed a valuation app for the iPad that allows you to value a stock or a business. A confession is in order. Neither Anant nor I have the technological capability to write apps: it is a lot more complicated than it looks. We owe aa great deal to Xiandong Ren, a graduate of the Computer Science department at Dartmouth College, who schooled us on the basics and wrote the code for the app. Initially, we wanted to give the app the moniker of "iValue" but as is common in this space, some one else beat us to that name by a few weeks. So, we used our fall back name for the app: uValue and it is now available on the Apple iTunes store:

uValue is a valuation app, with surprising versatility (or at least, we think so). There are three basic models - a conventional cost of capital DCF model, an Adjusted Present Value (APV) model and a dividend discount model. For the cost of capital and APV models, we have detailed versions, where you are given full control over all of the input levers, and simple versions, where we set many of the input levers to safe defaults. In the near future, we hope to add a relative valuation (multiples and comparables) module as well as a financial tools module. Embedded in the app is a short book on valuation (called the uValue Companion) that leads you through the basics of which model to use in a specific context and the fundamentals of that model as well as data sets on industry averages on key input variables (margins, returns, betas, cost of capital etc.).

While we cannot be objective about the app's capabilities, here is what we see as its pluses and minuses right now. On the minus side:
a. The app is available only for the iPad right now. The output is too intensive for a Smartphone screen and we just don't have the capacity or energy or time (right now) to write the code to allow it work on Android pads.
b. It is a young app. We have already been alerted to a couple of errors in the app (the simple APV has a glitch in the expected bankruptcy cost component, for instance) that we will fix in the next update (in the next couple of weeks). This website for the app will keep you updated on errors as you find them (and we fix them):
c. It does incorporate our "points of view" on DCF valuation, which may not map on to your points of view on the same. Just to make you feel better, even Anant and I have differences on individual components (like what to use for the equity risk premium) and have been open in laying them out in the app.

On the plus slide, we have tried the app out on all kinds of companies: young, growth companies (like Linkedin), mature companies, money losing companies, commodity companies, financial service companies, and it seems to work for all of them. Best of all, check out the price for the app. You will see why we feel absolutely secure in our "money back" guarantee...   

Wednesday, June 8, 2011

Thoughts on intrinsic value

I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
a. What is intrinsic value?
b. Does every asset have an intrinsic value?

On the first question, here is my definition of intrinsic value. It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.

This definition then answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

So, how do people value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picassos have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let's face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

I don't intend this to come across as snobbish, but I think we need to clarify terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.

In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities. Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning.