Short logic

But what is most interesting about its emphasis on the ACSOI metric is that, deep down, Groupon knows what we all know: good investments are profitable investments. It was simply not enough for the firm to report earnings and explain that it was investing for growth. Rather, Groupon felt the need to include a metric of profitability, no matter how contrived, that was actually positive.

You would have to be nuts to exclude marketing costs, for example, when evaluating a company’s operational performance. The only thing helpful about this metric for investors is that it might help the company’s current owners someday flip their shares to the masses. Adjusted CSOI is a public relations gimmick, not a legitimate financial-reporting tool. If Groupon’s bosses want to keep citing it, they should describe it that way.

Grumpy Old Accountants dissects the Groupon IPO filing. 

I wonder where the border between comical and criminal goes, but JPMorgan, Morgan Stanley, and Bank of America Merill Lynch are sure testing it. They all just pushed “research” to support a fantasy price target of $85-92/share. The stock had been trading around $65 for a while, but LinkedIn’s underwriters have successfully pumped to stock to $85.

So they want you to pay $85-92 per share for a company that posted 9 cents per share in earnings last year (or put another way, value a company with $18 million in profits at $8 billion). Heh. I’m sure this analysis is entirely objective, completely based on fundamentals, and has nothing at all to do with the fact that this gang of shysters were the very same behind the IPO.

How are these cats rationalizing this fantasy price target?

Douglas Anmuth of JPMorgan had similar praise. The analyst, who has an overweight rating on the stock and an $85 price target, said the Internet company was “disrupting both the online and offline job recruitment markets.” Given its leading position as a social network for professionals, he said, LinkedIn should also be able to capture a greater share of the $27 billion global market for staffing.

Ohhh, it’s disruptive. Well, sign me up a bajillion shares, then. Hey, wait, LinkedIn has been around for a fucking decade. If they were going to so massively disrupt recruitment as to be worth $8 billion, we’d probably have seen some of this disruption by now.

Now it’s entirely possible that LinkedIn is going to pull some pink rabbit with fluffy money ears out of their hat and suddenly become massively profitable, as to justify the $8 billion valuation. It’s just that we’ve seen nothing so far to suggest that to be the case. To hear the underwriters of LinkedIn’s IPO trying to trick markets into lifting the stock price (which was already grossly over-priced at $65!) is simply disgusting.

Compare this to some actual analysis of the business that puts a price target of LinkedIn at mid-twenties.

The conflict of interest for these investment banks is staggering. LinkedIn paid them $30 million to take the company public. That’s more money than the company has ever made! But as is plainly clear, these guys are more than willing to ride their good name into the mud. The pump tactic worked and LNKD is up more than 10%.

Wall Street finest hard at work.

Bubble valuations leads to headless gambling on vapid companies, NYT reports the Color.com story.

Taking unprofitable tech companies public is a very profitable game. The NYT writes:

Naturally, Wall Street is enjoying a windfall. Technology I.P.O.’s have generated nearly $330 million this year in fees for the biggest banks and brokerages, nearly 10 times the haul for the same period last year, and the most since 2000.

The investment banker’s made close to $30M in fees on the LinkedIn IPO. More than twice the earnings of the company from the most recent year.

Abracadabra! Magic Trumps Math at Web Start-Ups, New York Times examines the latest IPO gold rush.

Compare this to companies like Apple where one in two hundred or Google where one in seventy-five shares are short.

Pandora is currently trading at $13, half of the $26 opening pop. LinkedIn is trading at $66, also close to half of it’s $122 opening peak. Both stocks are below what traders (I don’t think many investors got involved here) could buy them for on the open market. Both are also still massively overpriced and have much further to fall. Last man out of the pool has to clean up!

Pandora’s IPO yesterday peaked at $26/share, giving them a brief valuation of $4 billion. The stock quickly deflated to a closing price of $17.50, moving that valuation to $2.8 billion. Even that is a fantastical and bubblicious number that will not stand up to scrutiny. Here is a back-of-the-envelope analysis based on the S-1 that investors should have made before throwing their money in the box:

Best possible case of active users growth

• 80M users have tried Pandora
• 30M users converted to active users (listen at least 1x per week)
• That gives us a 37.5% conversion rate (30M/80M)
• Pandora is currently only available in the US (and expanding to foreign markets is very hard)
• The US has 240M people online (310M people * 77% internet penetration)
• Facebook is one of the most popular services in the US
• 146M users have tried Facebook in the US (who knows how many are active)
• If Pandora could become as popular as Facebook, they’ll reach another 66M users (146M - 80M)
• That will give them another 25M active users (66M * 37.5%)
• So the likely maximum Pandora’s userbase can grow in the US is 85%, or 55M active users

Revenue extrapolation for 2010
Pandora has reported $77.8M in advertising revenue for the first 9 months of 2010. For the sake of analyzing per customer numbers on a yearly basis, let’s assume no additional growth for the last 3 months (although they most certainly will grow). So that’s $104M in advertising revenue for 2010 (($77.8M / 9 months) * 12 months).

Best case scenario for net advertising profits

• Pandora made $3.46/user from advertising in 2010 ($104M revs / 30M active users)
• It paid $1.56/user in music royalties for 2010 ($45M / 30M active users)
• Thus, gross profit from advertising (before other costs like servers, bandwidth, staff, and marketing) was $2/user ($3.46 - $1.56)
• Music royalty cost may go down a little with additional scale, but that’s not a given (they paid 45% of revenues in royalties in ‘07, 81% in ‘08, 60% in ‘09, and now 50% in ‘10 — it was very high in ‘08/09 before the Copyright Royalty Board adjusted rates until 2015)
• But let’s be kind and assume reduced royalty costs of 40%, so the number drops to $1.24/user, which would increase gross profit per user to $2.21 ($3.46 - $1.24)
• So the most Pandora can make from advertising in gross advertising profits is $122M (55M active users * $2.21)
• Let’s say they reach fantastic economies of scale and their remaining costs only go up 50% even as their user base soars 85%. That means other costs will total 66M (44M * 1.5)
• So the best case scenario for advertising profits (assuming Facebook-like popularity) would be a net $56M ($122M gross profit - $66M costs)

Best case scenario for net subscription profits

• Using the same assumption for 2010 as above, Pandora made $16M from subscriptions
• A subscription costs $36/yr, so that means they have 444K paying subscribers ($16M / $36)
• So their free-to-paid conversion rate is 1.5% (444K paying users / 30M active users)
• If they can keep up that conversion rate as they grow to Facebook popularity (highly unlikely), they’ll get a total of 821K paying subscribers
• That would net a total of $30M from subscriptions (we’ve already included costs of content and operation in the advertising analysis above, so let’s just assume it’s all profit)

Adjusting the best case scenario for total profits
Based on the quick analysis above, the best case scenario for growth in the US gives Pandora the potential for $86M/year in profits ($56M from advertising and $30M in subscriptions). Given that they’d have to become as popular as Facebook to get there, that’s beyond optimistic. So let’s just say if they become 2/3s as popular, they’d make $56M/yr. Still highly optimistic, but not as far removed from reality.

But what if they go international?
They could, but it would be incredibly tough and expensive. Not only would they face daunting competitors in Europe like Spotify, they’d also have to deal with a labyrinth of licensing issues. Add in the increased cost of marketing, overseas offices, and the hardship of international advertising sales (you don’t think it’s as profitable to sell ads in Portugal as it is in the US, do you?) and you’re left with an international expansion that is unlikely to materially increase Pandora’s worth as a business.

So where does that leave the valuation?

• The best case scenario is to become a $56M/yr-in-profits business
• Let’s say they’ll be worth 12x P/E at that point (a generous number given that Apple is trading at a forward 12x P/E and have tremendous growth upside)
• That means Pandora’s market cap — by the time they hit all their best case scenario marks! — would be $672M ($56M * 12)
• Given the current number of outstanding shares, that means the price per share should be $4 ($672M market cap / 160M outstanding shares)

That means $4/share is where the price should land after an awesome 85% growth in active users AND a decade of losses transformed into a delicious $56M/yr in profits. Now factor in that this best case scenario has big risks: they don’t become as popular, royalty costs go up, they get more competition, the users switch to mobile instead of computer with less profitable ads, and on and on. What exactly do you think is the fair price for the stock today? 

Let me continue my generous streak and say that Pandora might be a reasonable gamble at $2/share, tops. That would still value a company that’s never seen a dollar of profit in its decade-long history at almost $320M (~160M outstanding shares at the moment). An astonishing, princely sum for a promise-of-a-perhaps profitable business in the future.

Q. Are we in an IPO tech bubble now?

A. Having gone through this for 30 years, it seems like what we’re going through now is more a return to normalcy.  That’s healthy. I don’t think I want to see a bubble again.

Sure. Take the words of a man who’s about to make a killing floating his investment on a bubble buoy. I’m sure he only has the public’s interest in mind.

John Gapper finds a stinker:

But, whether or not one thinks Silicon Valley is in the middle of a bubble, Groupon’s IPO is disquieting. The company’s filing is filled with unsettling details about its business model, how much money it is spending to sustain its explosive growth and its accounting methods. Its early investors are seeking another infusion of cash, having allocated most of an earlier $1.1bn in fundraising to themselves.

Even if Groupon is a sound investment, which I doubt on the basis of the filing, despite Goldman Sachs, Morgan Stanley and Credit Suisse having attached their names as underwriters, something smells bad. “This will at times be a bumpy ride,” writes Mr Mason, which is a promise you can take to the bank.

And he sure doesn’t like their fantasy metrics either:

Groupon has attempted to comfort investors with its own measure of profitability known as “adjusted consolidated segment operating income” or “adjusted CSOI”, which ignores acquisition and online marketing – much of the expense of achieving all this growth. But that is transparently nonsensical. Without the marketing to find new prospects, it would grind to a halt.

Such manoeuvres to hide costs are spreading among internet companies – Demand Media amortised content creation costs over five years to flatter its bottom line for its IPO in January – but Groupon’s tactic is the most blatant. Bill Gurley, a partner at Benchmark Capital, points out that internet companies tried to get investors to ignore marketing costs in the 1990s internet bubble.

This IPO game isn’t about finding value, it’s about finding a greater fool who actually believes the valuation is true. Trust me, you will be the fool.

Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, analyzed the fundamentals of LNKD and determined a reasonable value of the stock to be $21/share. Or about a third of it’s current $72/share price.

But LinkedIn, last month’s stock market darling, continues to erase smiles all over Silicon Valley. Shares of LinkedIn hit a new low today of $72.87. Recently, the shares recovered a bit from their early morning swoon, and stand at $73.90. The stock opened its first day of trading last month at $83 a share.

That means, folks, that any LinkedIn shareholder who has bought and held stock is holding paper losses on the investment, save for the privileged few who got to buy into LinkedIn at the $45 IPO price