P as in Pride

June 6, 2011

It was a notable irony late last week to see the market’s continued sell off, highlighted by a nearly 300 point down day on Thursday, accompanied by the long awaited filing of the Groupon IPO.  Despite the fact that UBS is apparently not involved (Morgan Stanley is leading both the Groupon and Pandora deals discussed below), the accounting in the filing is nonetheless a complete farce.    When I last waxed on about the state of the overall tech market (Ups and Downs in Technology Earnings- May 4 2011) it was with a fairly balanced tone, suggesting less basis for a broadly overheated market and more support for stock specific moves both up and down based on the fundamentals.  Ironically post the recent sell off, things appear to be making less sense and look less healthy.  I make this observation based both on some of the more egregious aspects of recent and upcoming IPOs (though LNKD seems almost like a value relative to Groupon) mentioned below, and the general outperformance of high multiple momentum stocks in the recent pullback.  This duality does not seem sustainable, and keeps me focused on the cold, broken IPOs (currently NPTN) versus the bubble crowd and given my concurrent thesis regarding the potential value shift from the internet to the telco sector (more recent news on front from Vodafone this week) and the attendant risks to Internet business models has me looking to start nibbling on the short side on the NFLXs and AMZNs of the world.  It is interesting to note that at a technology panel that I recently moderated that featured five experienced and insightful technology fund managers, not one expressed interested in owning LNKD at $90.

Moving back to Groupon (whose CEO was part of the parade of rumpled “ugly” Americans patronizing their European elders  at the recent E-G8 meeting in Paris, and may now be able to afford an iron), the company is offering secondary in addition to primary shares with the added feature of super voting class B stock owned by management. The company has also invented a new financial metric, CSOI which I am not going to define as it is meaningless, that excludes on line marketing expenses associated with adding subscribers.  Including this $200M of cash expense, Groupon lost over $100M on its Q1 revenue of $644M, which suggests that the proper valuation of Groupon could be closer to zero without continued financing than the recent $9B private transaction valuation or the $15-20B plus currently being bandied about.   From a cash flow standpoint the company reports a free cash flow metric of $7M in Q1, interestingly down from $12M in the same period last year and must include some major working capital changes given the huge loss in Q1 and only $20M or so in stock based comp expense and free cash flow of $72M in 2010 includes a $300M contribution from working capital changes.  

I gather that the story is that at a particular scale, when there are no longer any more subscribers to acquire I suppose, marketing expense will lessen and is thus “non recurring” over a long enough period of time.  They also appear to be borrowing from an apparently accepted by many AMZN narrative that near term investments, despite causing declines in cash flow and profits, will pay off over time through a permanent, immutable competitive advantage.  Though AMZNs advantage looks to be more distribution infrastructure based, leading me to wonder whether UPS isn’t a more appropriate comp for AMZN than Groupon, competitive barriers in Groupon’s space appear lower (eg Facebook entered the business a month ago).   Finally given the massive insider selling at levels well below the likely IPO valuation only a few months ago and the difficulty in coming up with a real valuation given the lack of profits or any real operating metrics I will steer clear of Groupon and continue to fret about what the potential acceptance of these accounting machinations and valuation levels means for overall risks to the market.

Adding to these concerns is the upcoming Pandora IPO, which is headed to the New York Stock Exchange under the single letter ticker “P” to take its rightful place next to the company founded by Alexander Graham Bell that (for now) cheerfully provides network infrastructure for Pandora’s bandwidth hungry service for no charge as well as upstarts like Ford and Kellogg. This for a nice radio service that is able to figure out that if I like the Smiths I probably wouldn’t mind hearing a Depeche Mode song every once in a while either.  The company has not yet achieved breakeven on quarterly revenues of $43M, perhaps due to its curious decision to count marketing expenses as expenses and this with 94M registered users in the US.  That’s not a ton of revenue for a ton of registered users (eg more than a quarter of the population) in an intensely competitive market populated by players such as AAPL (we assume they are contacting Agilent about the availability of the letter A ticker as we speak).  Pandora is also helpfully offering a huge number of secondary shares in the offering; in fact 8.6M of the 13.7M shares being offered are secondary. 

At a $1.5B valuation on the cover the shares look comparatively modest in valuation at a sub 10x revenue multiple, the company is growing at a triple digit rate and no new metrics have been invented, if the company is able to double revenues and drop ten percent to the bottom line then we are looking at a non crazy 35-40 multiple. One could do a similar calculation for Groupon, $500M of net supports at $20B plus valuation, though the company is so far away from achieving even breakeven it’s difficult to credibly forecast net income that is around the company’s current quarterly revenue level despite its meteoric and impressive growth rate.  The question remains how much of that growth is generated by shipping dollar bills.

Finally completing the trifecta of triumphalism was the unveiling today of the new SF corporate campus of another beneficiary of accounting gimmickry, CRM, trading at over 100X Non GAAP earnings (which exclude a huge amount of stock based comp expense) of $0.30 per quarter that are flat year over year.  The company spent $300M to buy the land and with 2M square feet of office space planned will likely spend another $500M plus on construction, and today’s release was filled with the names of internationally renowned architects and compelling modernist sketches. We will have come full circle when they acquire some vineyards in Bordeaux of the sort that Alcatel Alsthom owned when I first began covering the company in 1995, perhaps as a venue for the next Elton John concert.     We shall see whether pride indeed comes before the fall, but all of this certainly serves to make me nervous.