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our membership renewal rates are so high and steady, I believe that it is important
for accounting to re¬‚ect future bene¬ts from spending money on membership ac-
quisition in the current period. While expensing these costs is conservative, it fails
to re¬‚ect their true nature.
In its accounting choice, CUC™s management could not obtain much guidance from
other companies™ practices. Magazine publishers typically expensed costs of acquiring
new subscribers, whereas insurance companies capitalized policy acquisition costs.
Safecard Services, Inc., a credit-card registration company which also incurred large
outlays for membership acquisition, capitalized its membership acquisition costs and
amortized them over a ten-year period.




CUC International
When CUC made the initial public stock offering, it had only a limited following
among analysts and institutional investors. As the company grew larger, it sought to
broaden its investor base. Some analysts, however, were concerned that capitalized mar-
keting costs would subsequently have to be written off as losses because of high uncer-
tainty about future renewal rates. They argued that deferring current marketing costs
lowered the ¬rm™s earnings quality.
Analysts™ concerns about the ¬rm™s accounting for marketing costs may have arisen
from their experience with Safecard Services Inc. Safecard™s capitalization of member-
ship acquisition costs had been the subject of considerable controversy in the ¬nancial
press. Safecard™s decision to write off deferred marketing costs in 1987 may have height-
ened analysts™ concerns about the value of CUC™s capitalized marketing costs.
By early 1989 the company™s stock had become a target of short sellers and its price
began to suffer. As shown in Exhibit 1, short positions in the company rose from approx-
imately 157,000 in November 1988 to more than 2,000,000 in March 1989.3 While the
stock market was generally on the upswing, CUC™s stock price declined from $19.3 at
the beginning of January 1988 to $16.3 at the beginning of March 1989. Exhibit 2 shows
the stock price performance for CUC relative to the performance of the value-weighted
OTC market index between January 1, 1988, and March 1, 1989. During this period
CUC™s stock price declined by 50 percent relative to the market. Value Line Investment
Survey commented in its report on CUC dated March 17, 1989:
CUC International shares have taken a beating. The stock has fallen more than
35% since our last report three months ago. Wall Street™s concern over the com-
pany™s accounting methods . . . contributed to the stock price decline.
Management believed that the decline in CUC™s stock performance could not be ex-
plained by either disappointing current operating performance or by forecasts of slower
growth. Quarterly revenues and earnings grew steadily throughout 1988, and were con-
sistent with Value Line analyst forecasts. In its March 18, 1988, report, Value Line fore-
casted that the company would have earnings of $5.5 million, $6 million, and $6.6
million in the quarters ending in April 1988, July 1988, and October 1988. Actual earn-
ings in these quarters were $6 million, $6.6 million, and $6.9 million, respectively. The

.........................................................................................................................
3. Source: Barron™s Financial Weekly (Down Jones News Service).
673
Corporate Financing Policies




16-23 Part 3 Business Analysis and Valuation Applications




company projected that its growth would continue in the future”sales were projected
to grow by 30 percent per year and operating cash ¬‚ows would grow by 60 percent per
year during the next ¬ve years. Finally, the ¬rm was able to fund its substantial market-
ing outlays solely from operating cash ¬‚ows during this period.


POSSIBLE MANAGEMENT RESPONSES
At least three options were available to CUC™s management in responding to investors™
concerns. One approach would be to adopt a more conservative policy to account for
membership acquisition costs. By writing off previously capitalized expenses and adopt-
CUC International




ing a policy of expensing future outlays as incurred, the ¬rm would eliminate the major
source of analysts™ criticisms. However, such a move would seriously affect the compa-
ny™s balance sheet and income statement. More importantly, the accounting change
would be unlikely to help management convince investors that current marketing outlays
have future bene¬ts.
An alternative strategy would be to provide expanded disclosure to justify the ¬rm™s
capitalization of membership acquisition costs. This approach would involve identifying
what type of information is likely to be most relevant and credible to investors. Further,
it would require assessing whether the additional disclosures would provide proprietary
information to competitors.
Finally, CUC could use corporate ¬nance policies to enhance its stock price. Investors
typically interpret cash payouts in the form of dividends and share repurchases as an in-
dication of management™s optimism about the ¬rm™s future cash ¬‚ows. Such payouts,
however, need to be planned in the context of the ¬rm™s investment needs for member-
ship acquisitions.
One of the items on the agenda of CUC™s upcoming board meeting was to consider
proposals for dealing with the ¬rm™s communication challenge. Stu Bell was wondering
which of the above options he should recommend.


QUESTIONS
1. What are the key success factors for CUC? How well does the company™s manage-
ment address them?
2. Is CUC™s policy of capitalizing membership acquisition costs appropriate? Does this
policy make the income statement more or less likely to reflect the company™s oper-
ating performance?
3. Evaluate CUC™s cash flow. Is the company financially healthy?
4. Why do you think CUC™s investors are so concerned? Is CUC™s stock undervalued?
5. What should Stu Bell do?
674 Corporate Financing Policies




16-24
Corporate Financing Policies




EXHIBIT 1
CUC International Shares Sold Short from January 1988 to March 1989


No. of Shares
in Millions

2.5




CUC International
2



1.5



1



0.5



0
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar.
1988 1989
675
Corporate Financing Policies




16-25 Part 3 Business Analysis and Valuation Applications




EXHIBIT 2
Cumulative Difference in Stock Returns for CUC International and the OTC Market
Index in the Period January 4, 1988, to March 9, 1989

20%


10%
CUC International




0%


“10%


“20%


“30%


“40%


“50%


“60%
Feb. Mar. Apr. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb.
Jan. May
1988 1989
676 Corporate Financing Policies




16-26
Corporate Financing Policies




EXHIBIT 3
CUC International, Abridged Annual Report for the Year Ended January 31, 1988
CONSOLIDATED BALANCE SHEET
January 31
....................................

1988 1987
(Dollar amounts in thousands)
.....................................................................................................................................

ASSETS
Current Assets




CUC International
Cash and cash equivalents $ 25,953 $ 14,810
Receivables, less allowance of $613 and $405 33,201 24,209
Prepaid expenses and other 3,468 3,288
Total Current Assets 62,622 42,307
Deferred membership charges, net 22,078 13,112
Prepaid solicitation costs 17,089 4,915
Prepaid commissions 6,267 8,127
Contract renewal rights, net 27,944 30,443
Excess of cost over net assets acquired, net 33,301 19,066
Properties, net 16,048 10,074
Other 1,519 4,416
Total Assets $186,868 $132,460

LIABILITIES AND SHAREHOLDERS™ EQUITY
Current Liabilities
Members™ deposits $ 4,997 $ 4,340
Accounts payable and accrued expenses 36,063 16,446
Federal and state income taxes 423
Current portion of long-term obligations 1,404 5,011
Total Current Liabilities 42,887 25,797
Convertible subordinated debentures 12,000 22,000
Long-term obligations 3,767 5,120
Deferred income taxes 14,624 6,073
Other 1,229 1,268
Total Liabilities 74,507 60,258
Shareholders™ Equity
Common stock-par value $.01 per share; authorized 50 million
shares; issued 19,683,567 and 17,820,338 197 178
Additional paid-in capital 82,271 59,550
Retained earnings 32,420 14,997
Treasury stock”398,230 and 398,091 shares, at cost (2,527) (2,523)
Total Shareholders™ Equity 112,361 72,202
Total Liabilities and Shareholders™ Equity $186,868 $132,460
.....................................................................................................................................
677
Corporate Financing Policies




16-27 Part 3 Business Analysis and Valuation Applications




CONSOLIDATED STATEMENT OF INCOME


Year Ended January 31

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