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New York Times DealBook,  June 17, 2011 article


June 17, 2011, 9:27 pm  I.P.O./Offerings

Abracadabra! Magic Trumps Math at Web Start-Ups


Minh Uong/ The New York Time

Over a decade ago, Internet companies promoted new ways to measure their business performance, introducing concepts like “eyeballs” and “mindshare” to investors.

Now the latest wave of Internet start-ups are adding their own particular yardsticks to the valuation vocabulary.

Try “Acsoi” — a metric so new that there’s no agreement on how to pronounce it. Depending on whom you ask, it’s either “ack-soy” or “ack-swa.”

Short for “adjusted consolidated segment operating income,” Acsoi is one of three yardsticks that Groupon, the online coupon giant, recommends investors use to determine how it is performing. It is essentially operating profit minus the company’s large online marketing and acquisition expenses — a highly nonstandard approach that had many scratching their heads.

Yet without it, Groupon would appear steeped in red ink.

The use of such metrics has come with a meteoric rise in valuations for companies like Groupon, LinkedIn and Facebook that has invited skepticism from analysts and people in the industry. They are questioning whether some business models — be they a social network aimed at professionals or a maker of online farm games — can endure.

“These hot private companies are revealing their numbers, and I for one am surprised how they’re not making money,” said Lisa R. Thompson, an analyst with the research firm Arcstone Partners. “Everything in my space I’ve looked at doesn’t make money.”

Those who worry that the new Internet boom may repeat the mistakes of the last one are concerned that investors will look only for the positive in these hot new companies — seizing upon metrics of the sort that Lynn E. Turner, a former chief accountant for the Securities and Exchange Commission, once called E.B.B.S., or “earnings before bad stuff.”

The question is whether the new wave of Web companies have sustainable businesses or are simply like Webvan and Kozmo.com, mired in a search for profitability.

Pandora Media, for instance, has garnered acclaim for its online radio station format. But under the company’s current licensing deals, the more songs users listen to, the more Pandora pays in royalty fees, prompting some to question whether it will ever turn a profit.

In a research note on Pandora last week, Richard Greenfield, an analyst at BTIG Research, gave the company a sell rating and a price target of $5.50 a share.

Mr. Greenfield’s concerns about Pandora centered on a rise in competitors like Spotify and skepticism that Pandora’s efforts to increase advertising revenue would eventually lead to profitability.

Some of that pessimism appears to have deflated the buzz that surrounded the company’s initial public offering. Shares of Pandora closed Friday — their third day of New York Stock Exchange trading — at $13.40, down 16 percent from their I.P.O. price.

  Groupon likes to use an innovative metric for its revenue, because standard accounting shows it steeped in red ink.

Scott Olson/Getty Images

Groupon likes to use an innovative metric for its revenue, because standard accounting shows it steeped in red ink.

It’s no surprise then that some new companies are trying to show their businesses in the best possible light.

Groupon’s business model is built on offering a variety of daily deals worldwide, pulling in $713.4 million in revenue last year. But it lost $450 million, as the company spent $444.7 million to lure in new subscribers to its newsletters and to acquire smaller competitors.

That’s where Acsoi comes in. By stripping out those costs, the company argues, investors can see just how the core business is doing, though it warns that the measurement should not be used to value the company. Using Acsoi, Groupon earned $60.6 million last year, more than 20 times what it reported in 2009. And in the first quarter of 2011 alone, it reaped $81.6 million.

And Groupon argues that it is choosing to spend large amounts of money now because it is important to acquire as many subscribers as possible, hoping to gain formidable scale as Amazon and Netflix have done in their own industries.

Groupon also says that the cost of maintaining subscribers, which is factored into Acsoi, is far lower than the expense of gaining them in the first place. That cost amounted to about 3 percent of revenue last year, though it rose to about 4.4 percent in the first quarter.

Groupon does offer two other measurements for valuation purposes, free cash flow and gross profit, both of which have a long basis in standard accounting rules. Groupon reported a tenfold rise in free cash flow last year, to $72 million, while its gross profit swelled to $280 million from $10.9 million the previous year.

Other new Internet companies also promote nonstandard accounting metrics. Demand Media, the publisher of thousands of amateur how-to articles, spreads out the cost of paying its army of contract writers over five years, arguing that the long life of its content means that those expenses are really a capital investment.

That accounting measure helps flip Demand’s financial results for the better. On a basis of generally accepted accounting principles, the company lost $5.6 million in the first quarter of this year. On an adjusted net income basis, it earned $5.1 million.

Demand Media also cites “adjusted Oibda,” short for operating income before depreciation and amortization, and a semi-popular nonstandard measure also cited by the likes of CBS and Time Warner.

Such moves bring to mind the last tech boom, when companies drew upon unusual accounting and business yardsticks to help explain their lack of profitability. Amazon.com, for example, briefly reported profits that stripped out its then-steep marketing costs, not unlike Groupon. And Motorola incurred “special” one-time items so regularly that critics asked whether they were fundamental business costs.

Efforts to demonstrate viable business models did not end with customized accounting. Firms increasingly turned to nebulous new measurements like eyeballs and mindshare to represent the number of visitors a site attracted or how well-known it was among Internet users.

In hindsight, of course, all the eyeballs in the world couldn’t substitute for a viable business model. Pets.com arguably achieved a tremendous amount of mindshare, with its spokespuppet appearing in a Super Bowl ad and in the 1999 Macy’s Thanksgiving Day Parade. Yet despite the media attention, the site, a pet food retailer, closed less than a year after its initial public offering, weighed down by an inability to profit from a single sale.

The latest generation of Web companies differs in many ways from its forebears, with many of its ranks drawing real earnings from advertising and other sources of income. LinkedIn generated $3.4 million in profit last year. Using adjusted earnings, which accounts for items like stock-based compensation, it reported nearly $48 million.

Facebook, the biggest social network, earned about $400 million atop $2 billion in revenue, people briefed on the company’s results have said.

And there is a precedent behind some of this accounting. Amazon contended that its huge marketing costs were necessary to get its name out. That bet ultimately worked for Amazon, which now towers over the online retail space. But the same didn’t hold true for Pets.com.

“That’s a perfectly legitimate way for companies to look at these things economically,” said Dennis R. Beresford, an accounting professor at the Terry College of Business at the University of Georgia. “The real question is, is that going to happen?”

Evelyn M. Rusli contributed reporting.

Copyright 2011 The New York Times Company


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