Groupon: A Bear's Rebuttal
Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Today’s write-up is a rebuttal to a fellow blogger who presented his bullish case on Groupon this week.
Let’s give you an early heads up. Groupon (NASDAQ: GRPN), touted as the fastest-growing internet company, which was priced at $20 when it went public in November last year, hit its rock bottom last week after second quarter earnings announcement. Veterans like Marc Andreessen have turned their backs on Groupon, Barclays has downgraded it to underweight and the biggest sell-off activity was seen last week (see trading volume in chart below). In fact, if you compare its stock price movement with that of Facebook’s (NASDAQ: FB) beleaguered stock, you can see how closely both are aligned. Both stocks have consistently declined from their IPO price.
Unsustainable Business Model
Groupon’s user reviews are coming out negative now. Groupon buyers complain of not receiving similar treatment as regular customers. Some of my friends who buy Groupons now complain that there haven’t been any good deals on the site lately. Businesses have incurred losses on their collaboration with Groupon because Groupon pockets 50% of the revenue that these businesses earn on an already 60-90% discounted deal. Some businesses now despise Groupon as they received negative reviews on user-reviews website Yelp (NYSE: YELP) despite their hefty discounts. Reason? Their inability to deliver to the Groupon-generated heavy traffic!
The problems with Groupon’s business model are numerous, and are piling up. As sustainability of its business model becomes questionable to investors, it’s hard to imagine why anybody in their right mind would want to bet on this deal even at the current discount (more than 80% discount to the IPO price). Yet, we find some who are bullish on the company.
Criticism # 1
Fellow blogger Ashish Sharma cites Groupon’s inability to meet revenue forecasts as a reason of its demise. He writes, “…the revenues of $568 million were $5 million short of Street expectations. We believe that the top-line miss was the main reason for the drop as investors failed to see the underlying fundamentals in work for Groupon.”
With all due respect, the investors do see the underlying fundamentals at work—they are negative. My fellow blogger used free cash flows as being the strong point for the company. But here’s the catch. Groupon’s free cash flows, despite being one of the most reliable metrics of company valuation, are deceiving. Break down free cash flows into cash flows from operations less fixed capital investment (its formula) and you’ll get my hint. Notice how cash flows from operations (CFO) have decreased over the past quarters. Bad sign!
If you look at the income statement, it’s even more shocking. Non-operations interest and other income was $57.37 million, more than income from operations of $46.48 million--one reason why Groupon was able to generate a net income in green as opposed to a red one last quarter. This "interest and other income" account consists of foreign currency transaction gains or losses, interest earned on cash and cash equivalents and other non-operational gains and losses. This account showed $1.5 million in income for the six months ended June 30, 2011. For the same period in 2012, interest and other income was up to a whopping $53.8 million! If you dig into the notes to the quarterly income statement, you’ll find that for the three months ended June 2012, the $57.37 million in non-operational income includes a $56 million pre-tax gain realized as a result of Groupon’s acquisition of E-Commerce King Limited, of which Groupon presently holds a 49.8% stake.
In a nutshell, cash flows are down, and so is net income if you exclude the tax gain from the acquisition.
Criticism # 2
My fellow blogger further writes; “As we remain confident on Groupon’s business model with high leveraging opportunities and high barriers to entry due to merchant relationships and accumulated technology, we rate Groupon as a buy.”
There’s something inherently wrong with this statement that Groupon’s business model has high barriers to entry. It’s actually the other way around. Groupon’s business model is so simple and operations require such minimal initial capital expenditure that it almost eliminates most barriers to entry. In fact, competitors like Google (NASDAQ: GOOG) with its Offers line and Amazon (NASDAQ: AMZN) with stakes in LivingSocial are two of the biggest competitors in sight. Facebook has also recently moved into the picture with its Facebook Offers.
When Groupon’s CEO Andrew Mason boasted two years ago, "We want to do for local e-commerce what Amazon did for normal consumer goods," he clearly overlooked the unsustainability factor of his business model. Groupon management is still of the view that the model will survive with the introduction of the new feature Groupon Goods that allows you to find deals on actual products on sale and not just services. Good product deals are mostly already sold out but that’s another issue. Goods or services, the underlying operational model is still the same. I say it’s merely a matter of time! Check out the declining revenue growth.
Buying Groupon would only make sense if Google brings its acquisition offer, which it made to Groupon two years ago, back on table. Otherwise, it’s counterintuitive to financial logic to wager on an unstable business as this one in the long run.
PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Facebook, and Google. Motley Fool newsletter services recommend Amazon.com, Facebook, and Google. 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. If you have questions about this post or the Fool’s blog network, click here for information.