Groupon Is Going Down -- Here's Why

Three weeks after a limited public offering engineered a short-lived 40% pop, Groupon (Nasdaq: GRPN  ) closed below its $20 IPO price last Wednesday and remains there as of this writing. Thus, the company thought to be worth $30 billion in market value in June is now worth $11 billion.

That's $19 billion in market value gone. Poof. Up in smoke. Off to Never Never Land. Buried beneath Davey Jones' Locker. Will it resurface? Perhaps, but I'm making a CAPScall to the contrary. I believe that Groupon is the next Vonage (NYSE: VG  ) and will underperform just as badly, because it lacks a clear and compelling competitive advantage.

More groupies means more group buying ...
I'll get into the numbers in a minute. First, let's talk about how the business works. Groupon has subscribers (i.e., average Janes and Joes who get a daily email) and customers (i.e., those who've bought at least one Groupon). Growth in each category has been amazing.

Groupon's subscriber list is up more than 227 times over the past two years -- from 627,000 to nearly 143 million as of Sept. 30. The cumulative customer count is up 192 times over the same period. Gains have accelerated throughout, right up until the most recent quarter:

Groupons are also getting increasingly popular. More than 33 million were sold in the latest quarter, resulting in a record $1.16 billion in billings -- i.e., the gross dollars collected before payouts and other expenses. All signs point to outrageous demand for bulk buying of big discounts.

Finally, consider that Groupon is just as successful today at converting subscribers into customers as it was in its opening months. Between 23% and 24% of those that receive pitches ultimately buy. Better still, today's customers tend to spend twice as much as Groupon's early loyalists.

... But it doesn't mean more profits
So what's the problem? First, billings growth hasn't equaled earnings growth for some time now. It did in the beginning, though. Groupon was profitable in three of its first four quarters. All that changed when the calendar flipped to June 1, 2010. Groupon hasn't booked an operating profit since.

Analysts will tell you that heavy investments in growth are to blame for Groupon's lack of operating profitability, but I think competition has much more to do with it. Regulars now buy about one Groupon per quarter, down roughly 50% from the fall of 2009.

Alternatives are cutting into Groupon's sales, LivingSocial notably. Others include Google's (Nasdaq: GOOG  ) Offers service and a variety of just-in-time pitches that appear when you're near a store. Foursquare is particularly adept at delivering these sorts of offers thanks to its partnership with American Express (NYSE: AXP  ) .

The beauty, and danger, of the stiff-arm strategy
Higher billings have thus far allowed Groupon to keep growing even as rivals nibble at its franchise. Operating losses have shrunk over the past year while cash has continued to flow. Each Groupon sold generated $2.17 in cash in Q3, down slightly from $2.36 each in last year's third quarter yet still more than enough to cover the company's meager capital expenditures.

Cash generation may explain why Google originally bid $6 billion for the business. Or why secondary market enthusiasm pushed the company's valuation to $30 billion in June. Or why, the next month, CNBC reported that LivingSocial was seeking underwriters to raise as much as $1 billion in an IPO. Group buying was -- and arguably still is -- the Next Big Thing.

Even so, Groupon has been saying for months it wouldn't use the cash raised in a public offering. All proceeds were to be placed in a money market account alongside the $244 million in net cash and short-term investments held as of Sept. 30. (Groupon is debt-free.)

So that's good news. The bad? A large portion of Groupon's cash is borrowed, held back from merchants until the company is contractually obligated to release it. Here's the specific language, taken from page 15 of the revised prospectus:

"Our merchant arrangements are generally structured such that we collect cash up front when our customers purchase Groupons and make payments to our merchants at a subsequent date. In North America, we typically pay our merchants in installments within sixty days after the Groupon is sold. In our International segment, merchants are not paid until the customer redeems the Groupon." [Emphasis added.]

There's nothing sinister or untoward about this model. (Nasdaq: AMZN  ) has made a great living by getting customers to pay for goods upfront, kicking payments to suppliers only after orders are in hand. The staggered timing helps to produce billions in cash flow. Groupon's model is similar.

Yet there are notable differences, too. Time arbitrage accounts for about two-thirds of Amazon's cash from operations. Groupon's largest source of cash is per "accrued merchant payables," to use the company's specific accounting terms.

Groupon has collected $315 million in cash over the past nine months alone by keeping billings close at hand while delaying payments to merchants. The result? More than $129 million in operating cash flow for investing in infrastructure and other growth initiatives.

How this ends badly
Investors can hardly be blamed for getting excited by the big numbers. What troubles me is that the gains are dependent on Groupon's ability to negotiate and maintain favorable contracts in the face of extreme competition. How reasonable is it to expect merchants to wait at least 60 days to get paid if LivingSocial, or Google, or the advertising team at the local newspaper offers better terms? Does Groupon still maintain a brand advantage at that point? I'd say no.

If I'm right, cash will stop flowing as abundantly as it has. The balance sheet will get weaker. Management will raise funds from the outside, diluting existing investors. And profits will remain as elusive as ever. That's why I'm calling for this stock to underperform in my CAPS portfolio.

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Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Google at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google, McDonald's, and and creating a write covered strangle position in American Express. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (11) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 28, 2011, at 9:54 PM, ideaMan2000 wrote:

    The question is: How many times does each business (especially small to medium business) run a special? My guess is 1-2 times at the most. If I am right, this could be very limiting.

  • Report this Comment On November 28, 2011, at 10:03 PM, kmacattack wrote:

    I've bought both Groupons and coupons from Living Social, but I'll never buy anything else from Living Social again. I purchased some coupons which I was unable to use by the expiration date, and Living Social STOLE MY MONEY. They state that they intend to do so, IN STATES WHERE IT IS LEGAL FOR THEM TO STEAL, WHICH IS A LOT OF THEM. GROUPONS, on the other hand, only lose their disount on the purchase, you can still use the coupon for what you paid but don't get the half price disount, or THEY WILL REFUND YOUR MONEY or Let you re apply your 'Groupon at full value to another offer. What Living Social is doing may be legal IN SOME STATES, BUT it still amounts to stealing. These "coupons" are in effect pre paid gift certificates. I could never imagine being able to sleep at night if I did such a thing to one of my customers. Also, if you buy a Groupon for a business which later goes out of business, you will receive a refund or replacement. I can only imagine what Living Social's response to that event would be. Most likely "you should have known I was a snake when you climbed on my back for a ride across the river. I'm a snake, for gosh sakes". I bought two more Groupons last week, and have had nothing but good experiences with them. Their tie in with Expedia should be a great deal for both "partners" also. Customers will be able to buy a travel package to a resort, Cancun, for example, and get a great deal on the restaurants which are normally pretty expensive. They are spending a lot of money BECAUSE THEY ARE GROWING, hiring tons of salespeople, and want to be the dominant world wide player. When their infrastructure is in place they should do very well. I've never seen a post from an unhappy Groupon purchaser. If I owned a restaurant, I'll guarantee you I would tie in with Groupon for building a customer base. It's extremely low cost advertising, and you only pay for actual customers who come in to your business and spend money, and tip your wait staff. If they are happy with your product, they will not only come back, but they will tell their friends. It's a far more effective form of advertising than radio, TV or cat box liner (newspaper), or for that matter, mailed coupons which may or may not bring in business.

  • Report this Comment On November 29, 2011, at 12:27 AM, Virgilforex wrote:

    Sure there's competition. I use several of these such as living social, groupon, etc. you hear of many complaints from living social but have you heard any complaints from groupon customers? I live in LA, and it seems like more and more folks are jumping on board. Even older folks are coming aboard. In fact I was at was shoe store today and I over heard a rep explains to a group of elders about the groupon promotion they have going on right now. They never heard of it!! I'm a buyer in the $12-13 range in my Ira. Great long term hold in my opinion while the USA continues the recession for many years to come. Businesses need help via groupon to stay afloat and customers will become more frugal during these tough times. Only my opinion but interesting to see other view point.

  • Report this Comment On November 29, 2011, at 11:49 AM, mikecart1 wrote:

    You don't need an essay to explain why Groupon sucks. It is common sense. Too many times the technical investors waste too many words to explain why some company isn't performing now or in the future. The bottom line: Groupon sucks because it has a terrible business model, a terrible product that is only getting worse (why would I pay $80 instead of $160 to some dentist I've never met in my life at some dental office I can't find on a map?), and more and more competitors doing the same thing far more frequently. What does Groupon provide to anyone but more useless stuff in an even more useless world? I think I used them once and that was to get some gift card at some popular store. That day it broke the records or something. I forget. Anyways, until Groupon fixes its business model and stops selling products and services from shady places and then buys out the competition one by one, then and only then will it even have a shot at being even a $1 billion market cap business. At $10 billion market cap, Groupon represents everything that is wrong with the United States of America!

  • Report this Comment On November 29, 2011, at 1:50 PM, Peist wrote:

    A company that is debt free and with so much cash- on-hand and easily flip and make a profit if the cash is invested well. They say they are putting the cash in some money market but, if the money is invested with a 10% return, that can be pure profit. Who knows, they may just change their business model altogether.

  • Report this Comment On November 29, 2011, at 3:28 PM, kmacattack wrote:

    In answer to Mike Car, I've never bought a groupon for a dentist. I've bought several for use in restaurants, and Groupon makes it possible for a lot of people to eat out more often, or take a weekend vacation, etc. I'll never buy a day spa voucher, but there are people who will, and will be glad to do it at half price. For a hotel, for example, it costs about $8 on average to have someone stay in a room that would otherwise be empty for the night, so if a customer buys a $99 room for $49, the hotel is going to win and the buyer wins as well. If you forgot to take your groupon with you, the merchant often will have a list of groupon sales and can verify that you bought the groupon. I've had this happen before. If the merchant goes out of business, groupon will refund your money, or exchange for another groupon of your choice. If your groupon expires, you can exchange it, or you can still get your value paid, you just lose the discount.

    With Living Social, you just lost your money, period, tough luck sucker.

    And, like I mentioned earlier, with their partnership with Expedia, they are going to have a much wider variety of markets to sell groupons for, i.e. Hawaii, Cancun, Europe, etc. and the savings can be substantial.

    I don't see a downside at all. They will reach a point where expenses and overhead are covered, and the profits will be huge. I bought Sirius XM for the same reason, and have doubled my money in 18 months. For me as a customer, groupon is a great deal. For merchants with a high profit margin, i.e. hotels, restaurants, etc. it's a great deal, because the advertising produces a paying customer everytime. For a merchant selling electronics or major appliances, groupon will never work unless the discounts are a greatly reduced percentage on those products, because the profit margins are very low. If I owned a hotel or restaurant, I would be STUPID not to do business with Groupon.

  • Report this Comment On November 29, 2011, at 3:29 PM, Merton123 wrote:

    Today's Wallstreet Journal had an article about facebook going public. Will facebook face the same future as groupon or will it be the next Amazon?

  • Report this Comment On November 29, 2011, at 3:41 PM, morrisonms wrote:

    I haven't purchased a Groupon in about a year. I haven't seen anything that interested me but I haven't checked the daily emails on a regular basis, like I originally did. I was turned off when a restaurant, had no available reservations. They were booked for weeks and weeks. I tried again, after a while, and encountered the same thing. The experience was so frustrating, I vowed never to return to the restaurant and I gave up on Groupons too.

  • Report this Comment On November 29, 2011, at 4:05 PM, BetterThanGold wrote:

    why am i not surprised

  • Report this Comment On November 29, 2011, at 4:22 PM, sikiliza wrote:

    Groupon is simply an indefensible and unsustainable business model. That aside, I am very wary of a company where insiders cashed out even before the company went public. Finally, the CEO does not seem to either be smart or even smart advisers - hence no leadership at the helm. My take on the eventual outcome is that it will not be around in two years and there will be Senate Hearings to determine if it was actually conceived with intent to defraud the public.

  • Report this Comment On November 29, 2011, at 4:38 PM, danielonco wrote:

    @sikiliza if the insiders wanted to defraud the public, what's you explanation of them not selling to Google for 6 billion?

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