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Groupon: A Pre-IPO Analysis

ByChris Stuart, CFA, Research Manager

BOSTON (TheStreet Ratings) -- Groupon has been taken behind the proverbial woodshed to be roughed up. And deservedly so. The deal Web site's S-1 form released last week exposed many weaknesses, including a loss of over $400 million last year. After reading the registration statement, it's obvious the company is growing like a weed, yet has done so at a cost -- namely, huge marketing expenditures to acquire customers. I've broken down my observations from the S-1 and my own experiences to make sense of whether the Groupon IPO may be a good investment. There were some surprises -- both good and bad -- that other analysts haven't picked up on. And there's some real ugliness. The initial public offering is expected by the fall, following other hotly awaited IPOs including LinkedIn and Pandora . The good -- 83 million subscribers: Ignoring the fact that Groupon has been paying through the nose to acquire customers, we must still acknowledge one thing: It has a huge customer base. Whether the company can build a profitable business based on its existing model remains to be seen. Yet the company is taking steps to further leverage its impressive position. Groupon Now, which lets consumers search for deals within a certain proximity to a specific location, is one step in the right direction. The recent acquisition of Pelago, the creator of the mobile app WHRRL, looks to be a smart move as well, as Groupon is attempting to add social interactivity a la FourSquare into its deal model. And the moves to partner up with companies such as Live Nation and Expedia to expand into the concert ticket and travel verticals make sense. I would imagine both of these moves should help Groupon expand revenue in the near future. But what is Groupon worth? Is it worth the $20 billion-plus valuation being offered up as a potential value for the company? Let's look at Travelzoo as an example -- a company that has a business built on vendors providing up-front advertising expenditures. The company has formed a successful online travel business on the back of its now 20 million-plus subscribers. It recently reported record quarterly revenue of $37 million in the first quarter, equating to $7.80 per subscriber (on an annualized basis). Travelzoo, which is now profitable, is valued at roughly 8 times trailing 12-month revenue, or $50 per subscriber. Could we relate the same sort of valuation to Groupon? First, the business models are slightly different. Travelzoo releases a Top 20 Deals email in which travel providers pay a specific fee to be included on the list. Yet, Travelzoo has recognized the potential of the local deals market, and has ramped up this portion of its business aggressively. But, more importantly, Travelzoo is profitable, with no debt. Groupon, on the other hand, could effectively be considered insolvent. As of the most recent quarter, the company owed $290 million in payables to merchants, with only $209 million in cash on hand. But just for comparison sake, lets apply the $50 per subscriber valuation to Groupon, which gets us to $4 billion. And, as far as the revenue valuation goes ... well, that's a bit more complicated. See, Groupon reports revenue on a gross basis, meaning that on financial statements, the reported revenue totals include revenue gained from each deal, even though a significant portion of this is passed on to the vendor. Forget the reports of first-quarter revenue of $644 million. Instead, look at net revenue, which was $270 million. If we use the revenue metrics provided for the Boston and Chicago markets, which show more normal growth over recent quarters of around 30%, then we can assume that Groupon could earn nearly $1.67 billion in net revenue over the course of 2011. And at eight times revenue, this would equate to a valuation of around $13.3 billion. That valuation is optimistic, given that the company is still unprofitable, and that the balance sheet is ugly, to say the least. I'm sure once the IPO hits the market, these valuations won't matter, but I would say for any investor looking to capitalize on the growth in local deals, take a look at Travelzoo for a safer, longer-term investment. The bad -- customer-acquisition costs are out of control: Groupon is spending heavily to acquire customers. After laying out $240 million for all of 2010, Groupon spent $179 million in the first quarter of this year on marketing expenses. If we do some rough math, based on expenditures during the first quarter, and the increase in subscribers of over 33 million from the end of 2010 up until the end of the first quarter, Groupon spent $5.50 for each customer. In comparison, Travelzoo spends only $1.74 for new subscribers. The average price of a Groupon sold in the first quarter was $23. Groupon makes an average gross profit on this deal of 42%, or $9.66 per deal. So these acquisition costs would be perfectly acceptable if Groupon sold a deal to each customer, but that's not the case, since only 20% of Groupon's subscribers have purchased a deal. If we look at the change in actual subscribers who purchased a deal during the first quarter, Groupon's acquisition costs come out to $26.60 per paying customer. If we assume that Groupon makes an average (gross) of $9.66 per deal, then in order to meet these costs, they would need these paying customers to purchase nearly three deals to break even. Groupon is certainly banking on the future potential of these subscribers, and hoping to convert a higher percentage into paying customers. A recent survey of Internet users by Bank of America's Merrill Lynch found that only 37% of users subscribe to daily deal companies, and of those who are subscribers, 58% have purchased a deal. And 44% of the survey respondents expected to buy more deals over the upcoming year. Interestingly, 79% of subscribers to daily deal sites are Groupon members, followed by LivingSocial, at 45%. The ugly -- the business model is flawed: I've heard Groupon referred to as a "loan shark," and its service as mentioned as a "loss leader" for small businesses. Groupon, for example, sells a $50 certificate for $25, and provides the business owner with roughly $12.50. If an owner sells 1,000 so-called Groupons, it is, in essence, selling $50,000 worth of merchandise for $12,500. For some businesses, this might work. For example, a local bed & breakfast during a slow season may have rooms that might normally go unbooked; a Groupon deal might be the perfect remedy to bring in business (albeit at a lower rate) that might have never been there to begin with. Travel deals, however (for now), are a very small portion of Groupon's advertised deals. Most of Groupon's clients are restaurants and service providers. Many have probably heard the story of Jessie Burke and Posie's cafe. Posie's sold 900 Groupons for $6 each, offering $13 worth of food and beverages at the Portland, Ore., cafe. The deal turned out to be a disaster for Posie's, which had to take $8,000 out of personal savings to cover payroll and rent. The problem is that many small-business owners are blinded by the bright lights of Groupon and the potential to drum up big-time sales, while ignoring the inherent costs in providing such a discount. A study by Utpal M. Dholakia titled, "How Effective are Groupon Promotions for Businesses?" surveyed past Groupon business owners to discover the level of satisfaction. When asked if they would run another Groupon promotion, 42% of respondents said no. One restaurant owner from the Midwest had this to say about the experience with Groupon: "The return business has been non-existent. It was very harmful to our bottom line during the months we ran it. We still get people coming in to redeem their groupon even though the promo has been over for four months, and they are very upset they cannot get the full discount." And this, in my opinion, is truly the major flaw in the daily deal model. When running a discount, a restaurant, spa or other small business runs a promotion thinking that the deal, while possibly leading to short-term losses, will in the end produce new customers. The unrecognized, or ignored, issue is that the majority of Groupon's subscribers are deal-seekers, people looking to get the next groupon so they can save money on their next night out, haircut, massage, etc. If I spend $25 to get $50 worth of Mexican food at Joe's Cantina, what are the odds I return and spend full price at Joe's next time if I can buy the same type of Groupon deal at Jesse's Cantina? As for spas and salons, is there really any loyalty gained with these deals? One spa owner in the study by Dholakia wasn't impressed. "It is obvious that many Groupon users are only looking for deals ... not a business that they will return to many times. They buy the maximum number of deals allowed and then move on to another salon that has deals as well. The percentage of people actually looking for a new stylist was low and not many of them returned." So how long can this cycle play out? Not long. As more business owners connect and wise up to the financial destruction caused by these deals, the less frequently they will be willing to partake in Groupon deals. And with new competitors coming online every day, the margins will only get smaller for Groupon as time goes on. Google Offers and Facebook Deals are by far the biggest threats at this point. Both have leverage in the form of subscribers, and both will be able to provide deals at a much lower price point. If you are an investor considering partaking in the Groupon IPO, hopefully it's just to try and make a few bucks on a trade. While the company has quite a few things going for it, such as a wildly popular brand and huge subscriber base, the model has yet to prove itself over the long term. Be careful, as the valuation for the company will likely be extreme and not representative of the actual fundamentals of the business. Take a lesson from LinkedIn, which is a good business but overvalued. The stock, which soared past $100, is now trading at less than $70. If you're looking to get in on a deal, consider Travelzoo, which is rapidly expanding its local deals business and has consistently grown profits.

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