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Two companies, Groupon (GRPN) and Kit Digital (OTC:KITD), reported "a material deficiency in internal controls" on filings on Friday, March 30, 2012. They are also both fast-growing companies that have been controversial. What does "material deficiency" mean for each of them and is there a way to profit from the potential price swings?

Understanding the Material Deficiency

How significant is this report of "material deficiency in internal controls" and what does it mean? First, a little bit of history. This report has its origin in the Sarbanes-Oxley Act (SOX), a US federal law that set new or enhanced standards for all US public limited companies, boards and public accounting firms. This act, enacted in 2002, came in response to major corporate and accounting scandals of that time. The new regulations on companies' internal controls on financial reporting (IFCR) that came into being are considered the most onerous part of the act, especially for smaller firms.

Accounting Horizons studied a sample of 261 public companies that disclosed at least one material weakness in internal control in SEC filings from Aug 2002 to Nov 2004. The report found that there are certain correlating factors when this is more likely to happen:

Table 1:

Correlating factor

Kit Digital

Groupon

There is a lot of business complexity, such as operating segments and subsidiaries.

Yes, 34 subsidiaries

Yes, operating in 47 countries

The existence of foreign currency translation

Yes

Yes

The company is in the computer industry

Yes

No

Younger firms with less established procedures

Yes, a lot of the parts of the company were acquired recently

Yes, recent IPO

Smaller firms by market cap and book value

Yes

No

Firms that are not yet profitable

Yes

Yes

Both the companies had several of the factors correlating with the likelihood of a finding of material weakness in internal controls. The key is to look at the kind of material deficiency there is. Is it simply a question of growing pains and rectifiable or, instead, does it reveal more fundamental problems with the business and its operations?

Kit Digital: "Insufficient Accounting Personnel"

Kit Digital has been on a buying spree, consolidating its position as a premier provider of end-to-end video management services to content creator and broadcasters. It made 5 acquisitions in 2011, on top of a similar number in 2010, with operations in different countries in Europe and North America. Some of these companies were large relative to its size and most of these acquired companies were private non-US companies with little need to be in compliance with SOX mandated controls.

It has clearly taken some time to bring all the accounting controls in compliance with US regulations across these geographies and currencies. Hence, the ding on Kit Digital in its recently 10-K filing is relatively minor:

The Company does not currently have sufficient accounting personnel with an adequate understanding of US GAAP to timely review and ensure that all transactions were reported in accordance with US GAAP.

Management states it is working to rectify this deficiency by hiring and training additional personnel with the required capability. Their auditors, Grant Thornston, have nevertheless stated their satisfaction with the numbers as reported. This material deficiency does not bring their future revenues or business model into question.

Groupon: Are their future revenues reliable?

Given Groupon's limited history as a public company their auditors were not required to file on the internal controls for this reporting period. However, because Groupon ended up restating its financial results for the year ended Dec 31, 2012, it was forced to disclose its own lack of internal controls. Here are the reasons it offered:

•We did not maintain financial close process and procedures that were adequately designed, documented and executed to support the accurate and timely reporting of our financial results.

•We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate and agreed to detailed support, and that account reconciliations were properly performed, reviewed and approved. While these activities should be performed in the ordinary course of our preparing our financial statements, we instead needed to undertake significant efforts to complete reconciliations and investigate items identified in those reconciliations during the course of our financial statement audit.

•We did not have adequate policies and procedures in place to ensure the timely, effective review of estimates, assumptions and related reconciliations and analyses, including those related to customer refund reserves. As noted previously, our original estimate disclosed on February 8 of the reserve for customer refunds proved to be inadequate after we performed additional analysis. [emphasis added]

While the Groupon Auditors, Ernst & Young, did vouch for their current financial statements, issues like inadequate accounting for reserves are fundamental to the business of Groupon. One of the biggest criticisms of Groupon is that it leads to impulse buying and it may need to carry massive contingency for refunds. Rocky Agrawal argued that Groupon is "Poised for Collapse" because of the unknown amount of refund risk. Thus, Groupon's disclosure may lead investors to fundamentally question the risk in its business model.

The businesses of KIT Digital and Groupon are not really comparable. KIT Digital is an infrastructure play in the paradigm shift in video delivery (from traditional broadcast to Internet based) and Groupon is creating a new category in group buying and social marketing. They are both intriguing for investors looking for new opportunities to bet on the rapid changes in how we shop and entertain ourselves in the internet age.

Kit Digital shares already tanked last week on board and management changes. Groupon is still being valued for success. Both stocks are likely to have big moves when the markets re-open creating buying opportunities. Investors will need to decide which "material deficiency" will leave them materially enriched in the long-term. My money, for now, is on Kit Digital. Just for fun, here is a look at the numbers:

KITD

GRPN

Market Cap (on 3/30/2012)

$333 million

$9,710 million

Revenue (2011)

$214 million

$1,610 million

Price/Sales (trailing)

1.55

5.76

Gross Margins (2011)

74%

84%

Projected Growth (2012/2011)

~50% (estimated)

~70% (estimated)

Source: Interpreting The Material Deficiency Reported In Groupon And Kit Digital Filings

Additional disclosure: I may take a long or short position in GRPN over the next 72 hours based on the price movement.