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As Groupon shares soar, it's time to discount the frenzy

Groupon Inc. had one of the rockiest paths to an IPO in recent memory: restated and revised financial statements, widespread criticism of its business model, a leaked memo from its CEO that some say nearly caused the company to violate quiet-period rules.

Well, phooey on all that. Investors – if that's the right term – produced so much demand for the company's shares that Groupon bumped up the price and size of its initial public offering last week. Then, Friday's trading produced, at one point, a 55 per cent pop that valued the company at close to $20-billion (U.S.). The share price edged down Monday to $25.82, reducing the market capitalization to a mere $16.5-billion.

"Congratulations, Groupon," wrote investment blogger Conor Sen on the site Minyanville, after he made a series of negative posts. "You've silenced your critics – for now."

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Oh, no, Mr. Sen – some of us refuse to be quiet about risky stocks that have great performances. While the case can be made that the heavy coverage of Groupon's perceived foibles in recent months mean that investors are buying with eyes wide open, there are plenty of folks who might consider – incorrectly – that the first days of trading are an indication that all is well at Groupon.

Readers of VOX may recall that this is my second bite at the Groupon apple. I suggested in March, as news of a potential IPO emerged, that $25-billion was an absurd valuation for Groupon. My argument was based largely on the business prospects for the company, chiefly that there were few barriers to entry in this business.

Since that time, many small competitors have fallen by the wayside, and other companies, like restaurant reservation company OpenTable, have abandoned their daily discount offerings. Groupon argues that this proves its business is hard to replicate and the company has a pioneer's advantage.

I think it shows, instead, that it's far more expensive to develop this model than previously thought, as the common complaint of the felled startups was that they couldn't spend the money on sales representatives to market their services. Groupon, on the other hand, now has more than 10,000 employees, and a sea of red ink to match them, with a $218-million operating loss on $1.1-billion in revenue in the first nine months of this year.

In March, there were no published financials to fuel my skepticism; Groupon's ragged road to get its numbers up to IPO-ready status exceeded my worst expectations for the company.

The company tried to emphasize something called "adjusted consolidated segment operating income," which left out such crucial expenses as the cost to acquire new subscribers and turned a $117-million first-quarter operating loss into a $82-million profit. The U.S. Securities and Exchange Commission questioned the metric, according to The Wall Street Journal, and the number has since retreated to the background in Groupon's documents.

Similarly, Groupon initially tried to count the entire payment for its vouchers as revenue, claiming it, not the merchant who was supposed to provide the services, had the primary obligation in the transaction. "This accounting method was wrong – it did not follow generally accepted accounting principles," said the professors behind the blog Grumpy Old Accountants. Before Groupon fixed the accounting in September, it was overstating 2010 revenue by 150 per cent.

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Yet even Groupon's corrected financial statements give pause. The Grumpy Old Accountants – Anthony Catanach Jr. of Villanova University and J. Edward Ketz of Pennsylvania State University – note that, until Thursday, Groupon had negative stockholders' equity. Its liabilities, weighed down by about $466-million owed to its merchant partners, exceeded its assets by nearly $18-million.

A widely accepted predictive model for bankruptcies, in which scores below 1.1 suggest trouble and scores above 2.6 predict health, put Groupon at minus 5.1 at Sept. 30, by my calculations. A large reason for that is that significant amounts of money Groupon raised in the private markets in recent months were used to cash out early investors, rather than prop up a weak balance sheet.

The company did not respond to an e-mail and phone call requesting comment. After the IPO, its distress score stands at 1.5. It was only through the kindness of the company's new public investors, and the roughly $750-million that was raised, that the company's corporate distress score got out of the danger range. It seems Groupon got a deal from its investors – not the other way around.

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