Since Groupon first submitted its S-1 filing in June, 2011, there has been a wave of negative sentiment around Groupon’supcoming IPO. Many analysts believe that not only is Groupon not a good investment at the approximate $20 Billion + that its IPO’s initial share price will value it at, butis in fact on the brink of insolvency. They are also some that do not believe that, in the long run, Groupon’s business model is profitable .
In an effort to determine whether Groupon is in facta raging buy or, as alternatively presented, on the verge of insolvency, I have undertaken an analysis of their latest S-1 , which was filed with the SEC on August 10, 2011. The document, which is required by all companies who want to file an initial public offering, comprehensively reviews its operations, long term viability, business risks (which are numerous) and its financial condition. Some of the more interesting discoveries, as they relate to the 6 months ending June 30, 2011, are presented below:
1. Key Financial Metrics:
The table below represents data for each of the last 3 quarters:
There is no doubt that Groupon has achieved extremely impressive growth in this period. In the first half of 2011, they have already sold $1.5 Billion worth of Groupons and boast 115 million subscribers. The major issue with this is that despite having sold such a large quantity of their product, they are still not profitable. Also, their rate of growth on all metrics presented, appears to be slowing so their path to profitability is even longer. Finally their gross margins are decreasing to incentivize new subscriberts, and interestingly the decrease in gross margin was also due to the increased revenue from our operations in the Asia-Pacific region, which has substantially lower gross margins and is the fastest growing region in our business globally.
Comparatively, Google had achieved $1.5 Billion in annual sales in 2003, for which their net income (profit) before income taxes was an impressive $346 million.
2. Accrued Merchant Payable:
The amount payable to merchants is perhaps the most glaring red flag in Groupon’s financial statements for a couple of reasons. First the S-1 filing emphasizes the importance of free cash flow from operations as a financial measure. Free cash flow essentially represents cash generated from the operations, while the net profit (calculate in accordance with Generally Accepted Accounting Principles or GAAP) represents the revenue less expenses. In Groupon’s case they generated free cash flow from operations was $58Million while their net loss (GAAP) was $225Million. In non accounting parlance, this means that even though they incurred a fairly large loss, they were able to generate cash from their core business. The problem with this metric is that Groupon was only able to generate cash flow because they many of their merchants have not yet been paid:.
As the table above demonstrates, whereas almost all of the cash was received for the deals sold, 43% of it has not yet been paid to merchants.
Groupon specifically addresses this as follows:
Our merchant payment terms and revenue growth have provided us with operating cash flow to fund our working capital needs. 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.
The second issue is that the accumulation of the merchant payable, has resulted in a substantial working capital deficit. Essentially, despite being cash flow positive in the short term, they are not generating enough to cover their operating expenses like the amounts owing to merchants, salaries, rent and other costs of running of the business. As such, without additional financing, they will not be able to meet their obligations. This is extremely serious and which is why many have analyzed Groupon as being on the brink of insolvency.
3. International Operations
I was surprised to note that 58% of Groupon’s sales are international. This is primarily a result of the acquisition of CityDeal, a company based in Europe that operated in 80 markets in 16 countries with 1.9 million subscribers at the time of acquisition.
Clearly their international operations have increased exponentially as has their North American subscriber base. However, as the table demonstrates, their net loss is significantly higher internationally. Additionally the size of their international sales force is 3,860 while their North American sales force comparatively comprises 980 sales reps. Per Groupon The number of sales representatives is higher as a percentage of revenue in our International segment due to the need to have separate sales organizations for most of the different countries in which we operate. Due to local economic conditions, however, the average cost of each sales representative is lower in most countries in our International segment as compared to the costs in our North America segment.
The expansion into foreign markets is actually an excellent strategic move for Groupon in that it massively expands their potential subscriber and merchant base. The downside is that there are a great many additional risk that come with this including regulatory issues, foreign exchange, global economic conditions, protection of IP and a host of other potential issues.
There is one notable difference between payments to North American merchants vs International merchants. Whereas the former are paid based on all the Groupons sold, the latter are only paid when Groupons are redeemed. As such Groupon benefits from a higher breakage rate (i.e. Groupons that are not redeemed) as they are allowed to keep the entire proceeds.
4. Adjusted Consolidated Segment Operating Income (ACSOI)
Although their most recent filing has removed most references, this particular metric of calculating net income has been much discussed and much maligned. In theory it is not as crazy as some have posited. Essentially Groupon believes that the costs ofacquiring new subscribers is similar to a piece of furniture in that it will provide long term benefits. They expect that, similar to a cell phone subscriber who sign up for long term contracts, the majority of subscribers will stick around and buy Groupons for several years to come. In other words many subscribers become recurring customers, for whom acquisition costs (online marketing initiatives etc.) will no longer be necessary. The problem with this is that Groupon is still in such an early stage (although it certainly has enjoyed stupendous growth) with profitability still being a long way off. Consequently they still have several years of significant acquisition costs ahead of them, which they need to continue to incur, at least until they start generating lasting profitability..
5. Competition/Gift Card Legislation
Groupon’s competitition is extensive and not only represents the dozens of similar online daily deal sites, but also includes any media organization that offers coupons. (Our major domestic competitors include Facebook, Google, Microsoft, Eversave, BuyWithMe and LivingSocial.) Groupon competes on the strength of its brand, providing relevant deals to customers and a large subscriber base. Additionally due to their presence in different markets and their sales infrastructure they are able to have a local presence and understand business trends. Being the largest kid on the block (for now) does have its advantages.
There are many markets that Groupon sells to that have gift card legislation designed to protect the consumer. Alberta has already invoked their gift card laws stating that Groupon have expiry dates which officials say contravene provincial legislation.. Groupon has acknowledged this as a risk factor.
There are fundamental problems with Groupon that have to be addressed sooner rather than later if they want to be viable in the long term. Very simply, they have to demonstrate that their business model is profitable. Their response to the criticism that has been levied at them recently is that they are concentrating on building scale first. Once they reach a critical mass, their subscriber acquisition costs will be substantially reduced at which point they will be profitable. The problem with this is that subscriber acquisition costs, although may decrease, will always exist ( as any cell phone provider can tell you).