How Groupon Can Survive and Prosper
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Shares of Groupon (NASDAQ: GRPN) hit a new low last Friday, sinking to $4.50 per share, a stunning 77.5% below the November 2011 IPO price of $20.00 and 85% below their $31 peak on that first day of trading. Evercore's Ken Sena downgraded the stock to a "sell" and slapped a $3 target price on the beleaguered daily deals pioneer.
Before discussing Groupon's business model and how I believe it can not only survive, but also prosper, I would point out that over the last three weeks, Evercore has gone from an overweight and $17 price target on the stock to an underweight and a $3 target, with each downgrade coming only after further stock price losses. So far he seems to just be adjusting his ratings based on how the stock is trading, rather than actually correctly predicting where it is going. Not much help for investors.
As I wrote in a recent post on my own blog, Groupon's stock price is getting close to a point where investors who believe they will be a survivor may want to take a closer look. With more than $2 billion in annual sales, actual earnings, positive free cash flow, and $1.2 billion in cash with no debt, the shares would be awfully cheap if they reach Evercore's new $3 target, which would represent a market value of $2.0 billion, or just $800 million net of cash in the bank. A multiple of less than 50% of sales for a growth company is pretty darn inexpensive. Of course, future operational successes will determine if Groupon can maintain its profit margins and grow from here. While it's very hard to say what will happen at this point, I figured I would give you an example that I think helps understand the bullish case for the Groupon business model, if one wants to even contemplate such a thing.
I recently moved out west to Portland, Oregon and have been getting Groupon daily deals delivered to my inbox (they are a great way to learn about local businesses in a new area). A new, state of the art movie theater chain, with a handful of locations here in the Portland metro area, offered a Groupon last Friday morning. For $19 they offered two movie tickets and a large popcorn or drink. By noon that day, they had already sold over 5,000 Groupons.
Let's think about this. In less than a day, Groupon made $50,000 simply by sending out a single email (assuming their cut was 50%). The theater earned the same amount. Now, you may have read a lot in the business press in recent months about how Groupons often turn out badly for the merchant, flooding their storefronts with discount-hungry customers who inevitably engage in money-losing transactions for the business. While this is certainly true in some cases (established merchants with limited new customer potential and high variable costs, such as restaurants, for example), for a high-fixed cost business like a movie theater, a Groupon promotion like this can be quite profitable. Let's think this through in more detail.
The theater is only collecting $9.50 from a couple coming to see a movie using this discount, but their marginal cost to provide the service is extremely low. The theater would be open whether they came or not. The ticker counter and refreshment stand employees would be there too. The movie itself would be shown regardless of whether the theater was 10% full or 80% full. The only material variable cost for the theater in this case is the large popcorn or large drink they have agreed to throw in as part of the deal. How much does a bucket of popcorn or a cup of soda cost them? A dollar at most? They collected $9.50 from the customer, so those are fat profit margins!
Now, it is also true that if the theater sold enough Groupons they might have to open another refreshment line, or another box office window to sell tickets, but it would likely take a lot of Groupons to require this (say, a traffic increase of 25% or more). A mere 5 or 10% traffic bump is unlikely to cause a major issue with under-staffing at the theater. And even if on a weekend evening the theater owner had to add a few staff to accommodate the crowd, the extra cost is easily covered. The cost of paying an employee for an hour's work can be covered from the profit of two movie goers, even after accounting for the cost of the couple's popcorn. I suspect this is why this particular movie theater chain has run two Groupons like this since I moved to Portland less than two months ago (and yes, I have purchased one both times -- The Dark Knight Rises was excellent if you have not seen it yet).
The bottom line for me is that businesses with very high fixed costs and minimal variable costs (movie theaters, hotels, etc) are likely seeing very strong ROIs from Groupon promotions. Add in brand new businesses, which can use them to boost awareness since nobody knows they exist yet, are two very large segments of the small business market that I believe Groupon could, and should, be targeting. As the recent movie deal in Portland showed, there can be big money in sending out emails. And just because not every type of business in every market will benefit from using Groupon's service, I do not think we should write the business model off completely as ineffective.
A lot has been made of the fact that Groupon's business model seems easily copied and many conclude that the barriers to entry are very low. These criticisms may seem valid, but the idea that a new company could come along and easily attract tens of millions of email subscribers with little effort or money I believe is misguided. Even big players with deeper pockets like Amazon (NASDAQ: AMZN) with its AmazonLocal deals or Google (NASDAQ: GOOG) with its Google Offers service have not been able to catch Groupon in terms of customer base. Google Offers, in fact, has had so little traction that the company has yet to take the product out of beta. Why would Google have offered to buy Groupon last year if they thought they could easily surpass them on their own? Being a first mover here does seem to have its advantages.
If businesses are smart about how they use their advertising dollars, and Groupon is diligent in targeting and explaining to certain segments of their merchant base how to maximize the return of such campaign, I see no reason why Groupon can't survive and prosper, and prove the current Wall Street naysayers wrong. It is certainly speculative to etch their success in stone at this point, which is why the stock even at $3 or $4 is definitely a risky proposition. But the upside potential is certainly there if they understand their business model and can execute well with their merchant customers. Wall Street right now seems to be throwing in the towel and pronouncing them dead. That may just turn out to be premature. Time will tell.
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