Groupon- Creating Competition in Margin Compression

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Groupon (NASDAQ: GRPN), whose shares have tumbled by more than 75% this year, has been on a roller coaster ride since it first announced the intention to replace its much criticized co-founder and chief Andrew Mason, and then the board subsequently voted to retain Mason, sending the stock back down below $4.  So, all of that served to do little more than induce some short-covering.

Earlier this year, Groupon revised its 2011 financial results, which raised several eyebrows regarding the company’s financial governance and controls, prompting the U.S. Securities and Exchange Commission (SEC) to start an investigation into the company’s accounting practices, particularly those related to coupon refund. On Aug. 2 and Sept. 25, the SEC asked Groupon to reveal more bookkeeping details.  The company has since added several high profile executives to its board such as Daniel Harry from American Express, Robert Bass former vice Chairman of Deloitte LLP and Brian Stevens, a former KPMG executive.    

Groupon’s poor performance is not unique to itself. Instead it is tied to the slowdown in the American economy, which has prompted several industry pundits to ask if the daily deal business model is sustainable.  The better question is not sustainability, but rather lack of exclusivity.  What’s to stop someone else building a similar business and turning the entire ‘industry,’ and I use that term loosely, into a commodity-level advertising engine, which is exactly what has happened.  However, Groupon and its rival, LivingSocial, are the two big names that can claim the dubious title of industry leader.  At least LivingSocial is partly owned by the internet retail giant Amazon (NASDAQ: AMZN), which invested nearly $200 million in the daily deal firm, not that that investment has lit up Amazon’s bottom line.

Amazon’s Q3 financials revealed a higher than expected loss of $274 million because of a $169 million impairment charge related to LivingSocial.  LivingSocial itself had lost $566 million in the quarter, although more than 95% of it is attributed to non-cash items.  In fact, it was the first time in four years that Amazon reported a quarterly loss.

Daily deal websites attract price sensitive customers who go after the best deals that can they can find, be it on Groupon, LivingSocial, or any of their numerous smaller rivals. There is very little customer loyalty here, not the market’s most desirable demographic.  However, more importantly, the businesses are increasingly finding out that daily deals are not their most lucrative option. New research from MIT Sloan Management Review that tracked three companies which offered daily deal coupons found that it would take them from 1.5 to 8 years to recover the amount of lost profits from coupons, and those coupons did not act as loss-leaders to fuel customer loyalty.  If anything the whole experience was a net negative, as existing customers feel betrayed when a new one is offered greater discounts than they are. 

Customer acquisition costs improperly modeled are the death of many a seemingly no-brainer startup. The whole model is alienating customers willing to pay a premium – desirable customers—who now also go to Groupon, which translates into even more lost profits.  The whole industry then becomes a race to the bottom, which is only made worse when economic conditions are poor.  When people have more money than time they spend money.  When wages are contracting, the opposite is true.  When people have more time than money they will search out the best deal, as opposed to making the quick sale of their favorite item from whatever vendor is most convenient.

Groupon’s business model could work during a recession, as weak demand and high inventories can be bled off at discounts, but only as advertising for this situation.  Those types of sales won’t build customer loyalty and margins for everyone will be slim, especially the middleman.  When an economy is growing demand is high and Groupon can function as an advertising agency. Therefore, I believe the business is not going to get rid of its problems by hiring new executives or removing Mason.  The model is designed to drive margins down, not up.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Groupon</p> </td> <td> <p>Amazon</p> </td> <td> <p>Google</p> </td> </tr> <tr> <td> <p>Stock YTD</p> </td> <td> <p><strong>-79.93%</strong></p> </td> <td> <p><strong>+45.68%</strong></p> </td> <td> <p><strong>+8.11%</strong></p> </td> </tr> <tr> <td> <p>Enterprise Value</p> </td> <td> <p>$1.52B</p> </td> <td> <p>$108.92B</p> </td> <td> <p>$192.76B</p> </td> </tr> <tr> <td> <p>P/E</p> </td> <td> <p>N/A</p> </td> <td> <p>3,000.60</p> </td> <td> <p>21.88</p> </td> </tr> <tr> <td> <p>EPS</p> </td> <td> <p>-0.08</p> </td> <td> <p>0.08</p> </td> <td> <p>31.91</p> </td> </tr> <tr> <td> <p>Yield</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>ROA</p> </td> <td> <p>3.51%</p> </td> <td> <p>1.58%</p> </td> <td> <p>10.50%</p> </td> </tr> <tr> <td> <p>ROE</p> </td> <td> <p>-4.26%</p> </td> <td> <p>0.52%</p> </td> <td> <p>17.18%</p> </td> </tr> </tbody> </table>

About two years ago, Google (NASDAQ: GOOG) was willing to purchase Groupon for $6 billion before its IPO, but this offer was flatly rejected by Andrew Mason. Back then, the business was dubbed as “the fastest growing company ever,” but now its current market cap is just $2.72 billion and it has an enterprise value of $1.52 billion. I’m sure Mason and the board are wondering just what they were thinking turning that offer down. 

 


PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Google. Motley Fool newsletter services recommend Amazon.com 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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