Are Net Ad Firms Overstating Revenues?
The Financial Accounting Standards Board is considering a change that could force DoubleClick (DCLK) , 24/7 Media (TFSM) and other companies to drastically cut reported revenues. Wall Street isn't going to like it.
Revenues have become the litmus test for valuing Internet stocks. While other stocks are valued based on multiples of earnings, Net stocks are often valued on multiples of revenue. And as demonstrated last week by the MicroStrategy (MSTR) debacle, it's a dark day for investors when a company has to admit that it overstated its revenues.
One group of companies now facing scrutiny over their revenue reporting practices are the online-advertising resellers - firms like 24/7 Media, Avenue A, CMGI's Engage unit, DoubleClick and L90. These companies generate considerable revenue by buying advertising space on the Web and then reselling it. In general, the companies have taken an aggressive approach to reporting those transactions, booking the full value of the advertising sold as revenue. But there is a real possibility that they will soon be forced to use a far more conservative accounting method - one that would considerably reduce their reported revenues.
The Financial Accounting Standards Board, which sets U.S. accounting practices, is considering adopting a rule that would effectively ban the use of gross revenues to book the resale of advertising space. Instead, companies would book the difference between the resale price and the original cost of the ad space.
It is likely that this rule would force Net-ad resellers to restate the revenues they reported, and possibly earnings, too. The changes would largely occur on paper, with little effect on a company's financial health. But in the revenue-obsessed Internet world, it's just the kind of thing that could prove damaging to a firm's stock price.
The accounting change under consideration by FASB isn't specifically aimed at the ad sector, but rather at the distinction between gross revenues and net revenues. To get an idea of the impact this change would have, consider Avenue A. Unlike most of its peers, the company discloses both gross and net revenues in its filings with the Securities and Exchange Commission. In 1999, Avenue A reported gross revenues of $70 million; net revenues were $13 million, 80 percent less than gross.
FASB wants to ensure that companies reporting gross revenue figures are doing more than just delivering the goods. According to a recent bulletin on the issue, the board wants to make clear whether "the risks and rewards assumed by the company in the transaction indicate that the company is in substance acting as a principal or as an agent." It's the difference between selling your house, or acting as a real estate agent to sell someone else's house.
The companies say they take on the risk. "If a client doesn't pay us, we have to pay," says Bob Littauer, CFO of Avenue A. The FASB bulletin asserts that "those companies most affected by this issue are likely to have made little or no enhancement ... to the product or service that is provided by the supplier and delivered to the customer." The question, explains FASB staffer Doug Reynolds, is whether the company is "in the business of selling something" or "simply passing paper up and down stream."
For Internet advertising companies, the question comes down to this: Do they merely act as a broker for the advertising space, or are they truly assuming fiscal risk and adding value to the advertising space being sold? It could be months before FASB makes a final ruling on the issue. However, companies in the ad-brokering business are bracing for a change. If FASB makes the practice unacceptable, it would make it harder for a major accounting firm to sign off on the financial results of a company that doesn't comply with the new rules.
Avenue A, 24/7 Media and Engage all concede that a change in accounting is a good possibility. In anticipation of the change, both Avenue A and L90 have altered their client contracts to state that their work is "service-based" rather than "fee-based." The theory is that in a service model, the ad firm actually owns the ad space; in a fee-based model, the firm simply processes the transaction. Therefore, the companies have begun reporting the higher gross revenue figure, in addition to the lower net revenue data.
Tom Volpe, senior VP of financial operations at Interpublic Group, a large offline advertising firm, says offline media buyers - those that buy print, radio and TV ad space - report the net cost of the space. Only ad space sales fees are recorded as revenues, although the companies may at some point assume liability for the cost of the ads that they buy from print, radio and TV suppliers.
Any change that makes the Internet advertising business look smaller - even on paper - is not likely to make investors happy. For fast-growing companies that depend on their stock as capital in acquisitions or to hire talent, the fallout from the change could have far-reaching consequences.