This Is Not the Company You Should Invest In!

Mihir is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the last year, there has not been a single instance when I have skipped checking Groupon’s (NASDAQ: GRPN) website before taking out someone for dinner or buying myself a new wrist watch. However, it’s not just the reasonable prices that have kept me hooked on the site, but also a plethora of great products and services it has to offer. A very young company on Wall Street, Groupon got itself listed at a valuation of approximately $13 billion in 2011. Over the past couple of years, however, it has shed over fifty percent of the initial valuation due to concerns about its growth prospects.

Revenue is declining faster than expected

Groupon's quarterly revenue growth has been on a rapid decline, with the most recent quarter reporting a 7.5% growth in revenue on a year-over-year basis. One of the reasons for declining revenue can be fierce competition, but in Groupon’s case there is no visible competition from a global player.

Please mark the use of the word “global” because it faces good competition from local players in major countries. Let us take India, for example, where it acquired SoSasta.com in 2011 and re-branded it as Groupon India. While India does not enjoy the presence of huge global companies apart from Groupon, there are local websites like Snapdeal and Timesdeal that directly compete with the company.

International business is not picking up

Groupon’s international business has witnessed a bumpy ride in the last two years, as the management has desperately tried to bring it up to a level like in North America. In the fourth quarter of 2012, revenue from international operations declined by 15%, partially offsetting the gains achieved in the North American region.

It was disappointing to see such a considerable decline because the fourth quarter is the busiest quarter for sellers across major markets owing to the holiday season. Groupon’s top brass defended the poor performance by highlighting the lack of an adequate business structure in terms of network and third-party logistics as is present in the U.S.

Not the best business model

The company’s share price dropped to an all-time low of $2.60 in November, 2012 as investors were not happy with the falling sales and poor returns. As many business gurus have pointed out, a big reason behind Groupon’s steep downfall is its unsustainable business model. Groupon’s business model strives on two indispensable pillars: customers and merchants. In such a case, the only way to achieve success is in creating phenomenal value for these stakeholders. As a customer myself, I believe Groupon is the first choice for people worldwide for buying robust products at reasonable prices. However, the merchant leg of its business is the major cause of worry.

The company’s merchant group is mainly comprised of entities that are new to the market and comparatively smaller in size. In order to sell their products through Groupon, they have to offer discounts in the range of 50-70%, which eats considerably into their margins. On top of that, they need to pay a hefty commission out of the remaining profit, to the company. Being small players, they cannot afford to lose out a major share of their profit for creating brand awareness. Such low value proposition has compelled merchants to shift to other avenues for brand promotion including social media.

Focusing a lot on geographic expansion

Additionally, I believe that Groupon has focused solely on geographic expansion in the last few years rather than creating value for stakeholders and enforcing further partnerships. It has failed miserably to replicate a similar model as in North America, which has taken a toll on its revenue. In its efforts to become the biggest global player, Groupon failed to take cognizance of the fact that needs and structure vary from country to country. Instead of working on reach in a particular country, it went with the similar proposal to different places leading to a thin presence.

Even Living Social is failing

The claim that a business model similar to Groupon's is not sustainable is testified by Living Social, a website similar to Groupon, primarily funded by Amazon (NASDAQ: AMZN). Living Social has also been facing serious challenges in the industry, trying to find its way back to profitability. In the first quarter, it posted a net loss of $50 million, as compared to net income of $156 million. In 2012, Amazon wrote down the value of its investment in Living Social as it realized that such high valuation was not justified for the falling company.

The shares of eBay, Amazon's big rival, recently dropped on its CEO's warning about economic 'headwinds' in Europe & Korea. This could be hazardous for Amazon's earnings, which have been in bad shape the last few quarters. In spite of being a highly overvalued stock, Amazon has mystically rallied for a substantial part of the year. It will be interesting to see the market's reaction to its earnings (due shortly) amid challenging macroeconomic conditions and stiff competition.

Trying out something new

Reportedly, Groupon will be now be providing an online restaurant table booking service called Groupon Reserve, in order to supplement overall revenue. This initiative will mark its entry into a domain led by OpenTable (NASDAQ: OPEN) that follows a really simple and sustainable business model. The reason behind its success comes from the fact that it has focused solely on a single line of service, cutting out the clutter created by many products & services. However, such a model is not a completely desirable one because it restricts scope of further activity leading to limited growth. 

Analysts have downgraded OpenTable because of limited growth prospects. More than anything else, the company now needs to focus on structured international expansion, which will ensure further revenue channels. At a trailing P/E of around 59.3, the company is quite overvalued and could face a massive correction if it fails to meet earnings expectations.

Final words

While Groupon’s business model is not complicated, it is definitely unstable and unsustainable. It is now focusing on expanding horizontally by introducing new categories of business like the Groupon Reserve. However, I am not sure as to how much is this strategy going to compensate for the inherent drawbacks in its core business. In my opinion, the company should be targeting local commerce segment and making a move with particular markets to achieve sustainability.

Presently, the markets are witnessing higher volatility due to the Fed’s stance on the QE program, rally in the housing markets and other reasons. As such, it is prudent to invest in equities with a long term view and Groupon is not an ideal long-term investment because of various associated risks. Hence, I would not suggest making a new position in this stock.

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Mihir Mehta has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and OpenTable. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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