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Groupon’s Wild Profits Face Challenges

By YUNLANG LIU & BRIAN ZEN

A “wildly profitable” Groupon Inc. (GRPN) is the vision of the company’s chairman, Eric Lefkofsky. Questioned about his past record of start-ups and Groupon's viability, Mr. Lefkofsky responded with a touch of entrepreneurial drive: “I’m going to be in technology for a long time. I’m going to start a lot of companies. These are not sham companies. These are great businesses. InnerWorkings is profitable. Echo is profitable. Groupon is going to be wildly profitable.” But for now, Groupon is “wildly” burning cash to forge the viability of its business model.

Rosy projections retracted

Mr. Lefkofsky's "wild” statements were later retracted by the company after the SEC reviewed its filings and made comments, according to sources. Groupon explained, “You should not rely on a reported statement in a June 2011 news report by our co-founder and Executive Chairman in making your investment decision.” It goes on to say that Mr. Lefkofsky did not agree to be interviewed and that Groupon representatives had requested that the statement not be published. “The reported statement does not accurately or completely reflect Mr. Lefkofsky’s views and should not be considered by prospective investors in isolation or at all.” Along the same lines, Groupon CEO Andrew Mason’s letter to potential shareholders, which could be construed as overly positive, was moved from one of the first pages to page 32.

Founder's past start-ups

Mr. Lefkofsky, in his remarks to Bloomberg, referred to his mixed record in founding and running businesses. In 2001, he founded printing-service provider InnerWorkings (INWK), which went public in 2006. He also helped found Echo Global Logistics (ECHO), a shipping-technology company, in 2005. That company held its IPO in 2009. Lefkofsky also co-founded Starbelly.com, an online promotional-merchandise seller, in 1999 and sold it a year later to Ha-Lo Industries Inc. for $240 million. Ha-Lo filed for bankruptcy protection from creditors in July 2001 after writing down the acquisition.

Before Starbelly.com, Lefkofsky and his business partner, Brad Keywell, bought children’s apparel company Brandon Apparel Group. The company later faltered. “Along with our sales growth came lots of debt which eventually crippled the company when fashion trends changed in the late '90s,” Lefkofsky wrote in his blog.

Groupon's surge

Mr. Lefkofsky gave Mason $1 million to start The Point, a precursor to Groupon that began in 2007. It was created to help would-be activists raise funds and build petition lists by recruiting friends on the web. The Point inspired Mason to try a new site based around the idea of collective buying. It worked as consumers in more than 500 markets worldwide flock to daily discounts of up to 90 percent at hotels, restaurants and nail salons. Its success has inspired more than 480 imitators. “Groupon is a huge business,” Mr. Lefkofsky said.

The biggest shareholder of Groupon is Green Media LLC, which is owned by Mr. Lefkofsky and his wife, Elizabeth Kramer Lefkofsky. Green Media owns 21.6 percent of Class A shares and 41.7 percent of Class B stock.

Investors have every reason to be bearish on Groupon. While Groupon’s sales surged many fold to $644.7 million a recent quarter, the company has racked up operating losses of $540.2 million since its founding in 2008. That has left investors leery of owning the company’s shares. Burning more than $100 million a quarter, Groupon ventured into international acquisitions only to get even lower gross margin.

Despite all these, after the 90 days silent period, Goldman Sachs (GS), as a leading underwriter in this case, issued a buy recommendation, predicting 24% return potential for this stock.

Endorsements from Goldman Sachs

In its research report, Goldman Sachs listed some points to support its bullish conclusion: Groupon is by far the leader in the daily deal market, taking more than 68% worldwide market share, while most of its competitors are facing serious financing strains. It has leveraged vertically beyond the daily deals, recently launched Groupon Getaways, Goods, Rewards, Lives and many other branches. It is still capable of maintaining a high growth rate of subscriber base and revenue.

Most importantly, Goldman Sachs expect Groupon cut the size of marketing spending, from 93% of sales in fiscal year 2010 to 48% of sales in fiscal year 2011. According to their research, this cut could render Groupon a positive net income as early as the second quarter of 2012.

The bubble in daily deal websites

There is a major flaw in Goldman’s analysis. Daily deal business is just a $3.2 billion industry, while more than 600 Groupon clones are fighting for the small cake. Furthermore, the challengers include the recently launched Amazon Local (AMZN) and Google Offer (GOOG) from web giants with a lot more cash to burn.

The competitive landscape is not pretty due to the lack of customer loyalty shown by deal seekers. According to Yipit.com, over 170 of daily deal websites failed in 2011. Martin Tobias, a venturebeat.com contributor, thinks more than 200 of them will go under within the first six months of 2012. The group discount bubble could be ready to burst. The price war during this phase may bring down the profit margin of every participant dramatically. Yet in Goldman Sachs’ report, this trend was neglected. They expect the “take rate” (the percentage that Groupon takes from Merchant’s revenue) to decrease from 42% of fiscal year 2010 to 39% of fiscal year 2012. This projection seems too optimistic given the intense competition in the field.

Diversification and global expansion

For the last two years, Groupon has made 15 acquisitions globally, but so far the efforts are unprofitable. According to their SEC fillings, Groupon’s international division posted a net loss of more than $260 million for the first nine months of 2011.

Goldman Sachs used a quarter of its research report describing Groupon’s new products, including travel deals, event tickets and consumer products. By third quarter of 2011, these new segments had already grown to 9% of gross billing. However, Groupon faces fierce competition from entrenched companies in those markets, such as Priceline (PCLN) and Amazon (AMZN). Moreover, partnering with Expedia (EXPE) and LiveNation (LYV), Groupon will have to take a much lower take rate from these new product sales compared to the daily deal business. In the long run, a diversified Groupon will have a better chance surviving the downturns in daily deal business. But profit margin is not improving any time soon.

Bargain hunters moving to other sites

According to Goldman Sachs’ financial projection, Groupon will get a positive net income as early as second quarter 2012.



Q1 2011


Q2 2011


Q3 2011


Q4E 2011


Q1E 2012


Q2E 2012


Q3E 2012


Gross Billings


668.2


929.2


1157.2


1219.8


1223.7


1377.6


1505.2


Net Revenue


295.5


392.6


430.2


481.8


489.5


544.2


587


Cost of revenue


39.6


54.6


68


71.7


74.9


80.2


86.1


Gross Profit


256


338


362.2


410.1


414.6


463.9


500.9


SG&A


124.6


188.1


193.6


220.2


215.4


234


252.4


Marketing


229.6


212.2


170.3


161.9


154.1


159.7


167.1


Pre tax income


-98.1


-69.7


-4.6


18.9


44.3


70.8


82.5


















Net Income


-146.5


-107.4


-20.1


-41.2


-2


13.9


20.9


This projection assumes that Gross Billing will keep on growing while marketing expenditure stays at current level. But if we make a deeper examination of Groupon’s subscriber growth together with marketing expenditure, we can see three pretty scary trends: declining subscriber growth, rising marketing cost per subscriber and declining gross billings per subscriber.

614091765.jpg1162872203.jpg230334456.jpg

If we incorporate these trends into a financial model, Goldman Sachs’ rosy projections will be reduced from a steady trend of growing net income to unstable earnings in the future. In order to maintain its revenue growth, Groupon may have to spend even more money on marketing or acquisition due to bargain hunters’ shop-around mentality.

531654375.jpg

Daily deal model questioned but not doomed

Facing intense competition, Groupon won't fade away without a fight. And it has the cash to fight on for a number of years.

By returning merchant’s share of billing 90 days after collection, Groupon built itself into a reliable short-term financing vehicle on zero interest rate. Combined with $700 million cash from a successful IPO, Groupon is sitting on $1.1 billion of cash in the beginning of the first quarter 2012. Comparing that cash hoard to its competitors, Groupon has a much better chance at the fight for market share.

We all love a great deal. The daily deal business serves an important need and things can be done to fix its business model. Groupon’s challenge is its current inability to keep a large group of bargain hunters from moving to other sites.

Some users of Groupon are already not happy with the deals and the constant bombardment of email offers. Some of them stopped visiting Groupon. So the key question is, will Groupon be able to lure deal seekers back to its website, again and again, thus generating repeat revenue with less marketing costs?

(Disclosure: The authors have no position in Groupon.)

About the author:

Zenway Investing
Brian Zen, CFA, PhD, author of "Superinvestor Lecture Notes", serves as Chief Investment Strategist at Zenway Group, a New York-based registered investment advisory firm providing asset management services, training Certified Securities Appraisers (CSA), and teaching Graham-Buffett Value Investing. Previously, Brian served as vice president at JPMorgan Chase and portfolio manager at Prudential-Bache Securities and Janney Montgomery Scott, while teaching graduate-level investment analysis at St. John's University. Brian was a Bernard Baruch Fellow and graduated summa cum laude from Bernard M. Baruch College. He is also a graduate of Columbia University's executive program in value investing. Brian appreciates your feedback at: bzen@zenway.com

Visit Zenway Investing's Website


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