Why Groupon Still Can't Turn a Profit

Groupon (NASDAQ: GRPN  ) , famous for its popular deal-of-the-day app, has seen its stock go up more than 85% since January 2013. The company took the valley by storm in the fall of 2010, when after experiencing hyper-growth in its user base, it rejected a $6 billion acquisition offer by Google. Instead, Groupon decided to go for a public offering, disappointing investors after it reported a 2011 fourth quarter loss of almost $10 million. To improve its fundamentals, the company got a new CEO, started to diversify its business, and redesigned its website.

However, two years after going public, Groupon remains unprofitable. As Forbes contributor Joan Lappin notes, Groupon still remains as "an enterprise in search of a way to make its first dollar of real profits for its public shareholders." What are the reasons behind Groupon's weak profitability? Will the company manage to protect its market share in the fierce e-commerce world, which is dominated by tech giant Amazon.com (NASDAQ: AMZN  ) and auction king eBay (NASDAQ: EBAY  ) ?

Source: Groupon Investor Relations

Profitability versus growth?
Usually, companies in investment mode tend to sacrifice profitability to improve top line performance. This is the case of Amazon.com, which despite dominating the online retail landscape with more than $50 billion in product sales last year, has razor-thin margins. However, the company also has earned a free pass to report losses due to its amazing top-line performance and high capex expenditures. In the past five years, annual pending on capex grew from $333 million to $3.8 billion, as the company continues building new warehouses and storage facilities all over the world.

In the case of Groupon, both user base and top line growth have slowed down considerably in the past quarters, suggesting weak profitability may be not due to the usual revenue growth-margin expansion trade-off. Groupon's lack of profitability may be structural. Notice that despite the recent change in business strategy, the company's revenue only increased 5% to $595 million in the third quarter, well below eBay's 14% increase in revenue for the same quarter. However, the most worrying issue here is probably the decrease in Groupon's average user consumer spending, which could also lead to a top-line problem in the medium term.

The good parts
Although consumer interest for no-longer-novel daily deals is decreasing quickly, Groupon's database of users and merchants is still a powerful competitive advantage, especially at the local level. The company still has the power to drive customer traffic to local businesses, despite increasing competition from other apps, such as Living Social.

As merchants also become more aware of the disadvantages of deal sites, the supply side is also likely to experience contraction. However, there will always be a place for deals in the e-commerce world. And Groupon should protect its image as the best destination for online deals, just like eBay is the best place for auctions.

Groupon is also trying to add more diversification to its business model, to prepare in advance for a possible contraction in the number of merchants. For example, it is emphasizing its new coupon business, which despite being similar to the deals business, allows merchants to control demand better, and avoid unwanted surprises. One coffee shop in Oregon struggled with a sudden increase in customers for three months, after selling close to 1,000 Groupons in a single day.

Final Foolish takeaway
In 2011, Groupon asserted it would be profitable once it reached a given scale. Harvard Business Review blogger Rob Wheeler was smart enough to conclude, after observing the deterioration of the financial results of Groupon's traditional business in mature markets, that there was little reason to believe this. Groupon's business model, unlike eBay or Amazon, does not benefit from significant network effects. And the inability of Groupon to discover a viable, truly scalable business model before going public and expanding overseas, may be the root of the company's current tiny margins.

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