If you see a cockroach on your kitchen countertop and squash it, are you:
(a) happy that you solved the problem.
(b) unhappy because your kitchen is probably infested with cockroaches.
If your answer is (a), may I suggest that you stop reading now, sell all of your stocks immediately, and put your cash in an insured money-market account? The stock market can be a dangerous place and is only suitable for people with a skeptical mind and an understanding of the importance of diversification and other forms of risk control.
The “cockroach theory” as applied to stocks is that when a company announces an unexpected piece of bad news, it is just the first of many bad pieces of news that will trickle out over the following weeks and months. Those Pollyannaish investors who “buy the dip” after the initial bad news and pat themselves on the back for having purchased a “bargain,” will soon learn to regret their decision once the second and third pieces of bad news cause the stock to dip far beneath their buy price.
Case in point: Internet daily-deal coupon company Groupon (NasdaqGS: GRPN). Back in November I called it the Worst Internet IPO of the year for two main reasons. First, it was an unprofitable company – over the long term, companies need to make money for investors to make money (1999-2000 Internet bubble excepted). After all, owning a stock means owning a piece of a business.
Second, Groupon had a history of accounting irregularities and run-ins with the Securities and Exchange Commission (SEC). Companies are like people because they are run by people. If a person is dishonest with you or cheats you in some way, you won’t trust that person in the future because you expect that same type of behavior to occur again. As fictional TV doctor Gregory House likes to say:
People don’t change. For example, I’m gonna keep repeating “People don’t change.”
On March 30th, Groupon announced that it would need to restate its fourth-quarter financial results because of a “material weakness in its internal controls.” Specifically, its initial reporting of fourth-quarter results back on February 8th overstated revenue by $14.3 million, operating income by $30.0 million, net profit by $22.6 million, and earnings per share by $0.04.
According to pages 22-23 of its 10-K filing:
There is a material weakness in internal control over financial reporting related to deficiencies in the financial statement close process. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected and corrected on a timely basis.
We are working to remediate the material weakness. We have begun taking steps and plan to take additional measures to remediate the underlying causes of the material weakness, primarily through the continued development and implementation of formal policies, improved processes and documented procedures, as well as the continued hiring of additional finance personnel. The actions that we are taking are subject to ongoing senior management review, as well as audit committee oversight.
Although we plan to complete this remediation process as quickly as possible, we cannot at this time estimate how long it will take, and our initiatives may not prove to be successful in remediating this material weakness. If our remedial measures are insufficient to address the material weakness, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results.
In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, we could lose investor confidence in the accuracy and completeness of our financial reports, which could have a material adverse effect on the price of our Class A common stock, and we may be unable to maintain compliance with applicable stock exchange listing requirements.
We are not currently required to comply with Section 404 of the Sarbanes-Oxley Act of 2002, and are therefore not currently required to make an assessment of the effectiveness of our internal controls. However, we will need to evaluate our internal controls over financial reporting in connection with Section 404 of the Sarbanes Oxley Act for the year ending December 31, 2012.
Scary stuff, but no one should be surprised by Groupon’s accounting dishonesty given the company’s pre-IPO accounting problems, which were well publicized. Two things in the 10-K statement do surprise me, however:
- Groupon is under the delusion that while investor confidence “could” be lost, it hasn’t been lost yet (note to Groupon management: it already has been lost).
- The company is not required to comply with the Sarbanes-Oxley requirement on disclosing internal control weaknesses until 2013!
Back in 2006, the SEC exempted new companies going public from having to assess and disclose any internal control weaknesses in their prospectuses. You know, the offering document investors use to get information about a company and decide whether to invest in it? In its infinite wisdom, the SEC decided that only after these new companies have filed their first annual report as public companies are such disclosures required.
This is nuts! Investors have the least information on new companies because of their often-limited operating histories. To add insult to injury by letting company managements in IPOs hide internal control weaknesses turns IPO investing into a minefield of ignorance, groping in the dark, and unpleasant surprises. Why bother?
Anyone who bought the Groupon IPO at its $20 offering price on November 4th are now sitting on a huge five-month loss of more than 29%. And those are the “lucky” ones who got the pre-market offering price. Average investors who had to wait until the stock started trading had to pay at least $25.90 on the first day of trading and are now down a whopping 45.3% Thanks SEC!
Oh, and it’s getting even worse for IPO investors. On April 5th President Obama signed into law the Jump-Start Our Business Start-Ups (JOBS) Act, which exempts newly public companies with less than $1 billion in annual revenues from subjecting its accounting to an outside auditor for up to five years. According to Lynn Turner, the SEC’s former chief accountant, the JOBS Act:
won’t create jobs, but it will simplify fraud. This would be better known as the bucket-shop and penny-stock fraud reauthorization act of 2012.
No disclosure of internal accounting weaknesses and no outside auditor verification. That’s my disclosure to investors about the IPO market.