Leadership Strife Masks Groupon’s Fatal Flaw

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After reporting disappointing results for its final quarter, Groupon (NASDAQ: GRPN) announced that it was looking to oust the company’s much criticized CEO Andrew Mason. His departure has been in the cards since the company announced its dismal third quarter results – which I have also discussed in a previous article. During Mason’s absence, Chairmen Eric Lefkofsky and Ted Leonsis will be running operations as management hunts for a new leader. However, leadership is the least of Groupon’s problems.

The fourth quarter results were particularly disappointing as the business widened its losses despite increasing its sales by 29.7%, wiping out goodwill and short covering gains made in the previous few months. Mason’s departure was warmly welcomed by the market.

My previous analysis of Groupon’s new products and business model has borne fruit; the company’s margins were destroyed, which was reflected in the most recent results, while its core business remains soft. This is a company designed to create margin compression, which is good for consumers and horrible for stockholders.

Groupon’s main business sales dropped by 13% year-over-year to $413 million. On the other hand, Groupon Goods sales increased by 1,549% YoY and 56% sequentially to $225 million. This low margin segment contributed 35.3% to total sales whereas its contribution in its first year, 2011, was just 2.7%; this is the primary driver behind the company’s drop in margins. Gross margins plummeted from 80% in Q4-2011 to 56% a year later.

Slowing revenue growth mixed with severe margin compression has me thinking, “Iceberg Dead Ahead!” Groupon is rapidly shifting from a growth stock into a value play that doesn’t create much value.

The main problem with Groupon remains its business model, which is surprisingly easy to imitate. LivingSocial – financially backed by Amazon (NASDAQ: AMZN) -- is already creating problems for Groupon as it generated $8.6 million revenues on March 5, thanks to a promotion with Sam’s Club. In its last earnings release, Amazon revealed that LivingSocial’s annual sales more than doubled from $250 million to $536 million, but it incurred huge losses due to massive write-downs as its operating loss also doubled to $905 million. On the other hand, Groupon has finally become operationally sustainable with an annual operating profit of $98.7 million versus losses of $233 million in 2011.

For the current quarter, Groupon has given a revenue estimate of $560 million to $610 million, which, even at its higher end, is $40 million below market expectations. If the company achieves revenues of $585 million in the current quarter, which is the midpoint of its range, then it would indicate a significant decline in YoY revenue growth to just 4.6%. If it manages sales at the higher end of its estimate of $610 million then that would show a 9.1% revenue growth. In essence, even in the best case scenario, a double digit revenue growth is going to be nearly impossible and we should expect margins to shrink again.

To change this course will first require strong leadership and a different approach. Bloomberg reported that Groupon is now going for an outside hire for the top role. A new person could fill the position within the next three to six months. Analysts are expecting the COO Kal Raman, who has worked with Amazon and EBay before, to be the new CEO, but nothing has been set yet.

In the last one year, Groupon has shed $7.3 billion in market cap, while Amazon’s stock has been up more than 45% in that period and is obviously willing to absorb the hit to the balance sheet caused by LivingSocial’s spool up. With Groupon’s revenue growth approaching zero-bound, Groupon’s margins are also evaporating. The only growth area is its non-core operations (Groupon Goods), which will turn Groupon into a wholesaler.

There’s some symmetry with LivingSocial making a splash by partnering with Sam’s Club. This calls into question all the criticism that has been heaped on Andrew Mason. If there is a fundamental flaw in the current business model, which the management is unwilling to change, then there is very little a new CEO can do; maybe that is why the Board has not been able to secure new leadership.

Peter Pham has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and eBay. The Motley Fool owns shares of Amazon.com and eBay. 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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