Growing Pains Bedeviling Groupon

By Stephen D. Simpson, CFA | August 14, 2012 AAA

What a difference a decade makes. Unlike the "what, me worry?" attitude that dominated the prior tech bubble, investors seem considerably more interested in the immediate financial performance of companies like Facebook (Nasdaq:FB) and Groupon (Nasdaq:GRPN). With Groupon once again disappointing the Street, it looks like management needs to rebuild its credibility with institutions, even if the long-term growth story looks interesting at these prices.

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Second Quarter Results Feed Bulls and Bears Alike
By no means did Groupon report a clean second quarter, but then again neither was it a disaster.

Revenue rose 45% as reported (about 53% in local currencies), missing estimates slightly on disappointing international growth. Although the take rate (the percentage of billings that Groupon recognizes as revenue) increased for the third straight quarter, billings posted a sequential decline (down 5%) and the active customer count increased just 3% from the first quarter.

Profitability was mixed. Gross margin dropped about two and a half points sequentially. Consolidated segment operating income (or "CSOI"), a weird financial metric that Groupon invented, came in at $72 million and also missed expectations. Although lowering marketing spend ought to have helped margins, the larger contribution of Groupon Goods (with its lower margins) didn't help.

SEE: Understanding The Income Statement

Guidance Calls For More Pain
Investors clearly didn't like what Groupon management had to say about the near future. Calling out badly-chosen deals as a contributor to disappointing international revenue, it looks like marketing expenses will have to head higher again. That is going to lead to some pretty significant (roughly one-third) cuts to CSOI expectations for not only the next couple of quarters, but likely for the out years as well. If nothing else, it seems as though analysts are moving more strongly to a "show me" attitude about this company.

The Need Is There, but What About the Competition and the Model?

I like the basic premise of what Groupon offers - it gives merchants a low-risk, theoretically high-volume means of acquiring new customers. Better still, it's a clearly measurable way of acquiring those customers. I also like the company's strong position in mobile, with roughly one-third of the company's transactions already occurring that way.

But while the service that Groupon offers may be necessary, that doesn't make it easy. Facebook, Yelp (NYSE:YELP), and OpenTable (Nasdaq:OPEN) have already backed away, and bears seem convinced that the market is there for the taking by Google (Nasdaq:GOOG) and Amazon (Nasdaq:AMZN). To that end, decelerating billing and revenue growth and lower margins don't offer a strong counterargument.

There are going to be some familiar bear themes repeated around Groupon. Can the company maintain adequate merchant satisfaction (perhaps already an issue in Europe)? Is the business model sustainable, and/or will the company ever be able to lower its marketing spend and leverage its margins? Will LivingSocial beat them at their own game?

The Bottom Line
I went into this expecting not to like Groupon and to find very little (or nothing) of substance to the model. I was surprised, though, to see just how much skepticism surrounds this name. I can understand the long-term margin worries, and I do share them, but I think the opportunity in customer acquisition is both real and large.

SEE: 5 Must-Have Metrics For Value Investors

You can get a double-digit fair value target on Groupon with a low-teens forward free cash flow growth estimate, which is quite a bit less than investors assume for the much-larger Amazon. There's certainly the risk that competition smothers Groupon's ability to grow its revenue and/or improve its margins, but it's pretty clear to me that today's valuation doesn't assume all that much future success for Groupon and patient bulls may get the last laugh here.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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