Description

Short: Groupon (GRPN) is about to experience a much larger slowdown in revenue than expected due to a large and recent decline in deal quality which will drive lower deal volume, which should be apparent in the next quarter or two.   As such, I expect the P/Revenue to compress from 3 to <1 as the growth premium goes away ($6.5B market cap to ~1-$2B, or $1.5-$3/share).  Due to tight borrow, I’m recommending the Jan 13 Put ($10 strike) at $2.65, which is the midpoint between the bid/ask spread.  While GRPN stock is down to $10 from $25+, this put price was the same in Dec 2011 and mid April 2012, when the stock was at $23 and $13, respectively, so you haven’t necessarily “missed it.” 

My thesis is that individual markets/cities follow an “up then decline” revenue curve, as merchants readily try the service and drive volume up over ~24 months, only to be very disappointed with the product and then they stop running deals.  I believe the core “daily deals” market for domestic was probably close to flat last quarter, were it not for other product lines, a far cry from the days of 50%/quarter sequential growth, and negative growth is perhaps here due to a sharp decline in recent (1-2 months) deal quality.  International should follow domestic with a ~1 year lag since Groupon entered int’l ~1 yr post domestic, so we should expect the whole business to start declining in revenue by early next year as opposed to projected 29% growth for 2013. In order to combat this, Groupon is diversifying into all kinds of competitive markets which it has no advantage in.

Background:  Groupon is in the daily deals market.  Groupon's direct sales force will convince a merchant to give a ~50% discount to customers, and Groupon will then send that merchant offer to their customer list via email, and take ~1/2 of the value sold, netting the merchant 25%.  

Customers will buy a 50% discount from a good place all day long, but the trick is getting merchants that customers want to buy from to provide a great offer.  Big discounts like this are sold to merchants, not bought, since merchants that stay in business don’t normally discount 75%.  Smartly, Groupon pioneered the use of a talented and street savvy direct sales force that is their main competitive advantage and their innovation in this marketplace.   Other new things they did is the “tipping point” feature of a minimum deal size or the deal doesn’t start (which gives merchants confidence in a large turnout or no deal), and the time limits such as “2 days only left” in the deal that causes customers to act quickly.

Merchants have signed up in droves, as this is had been of the few alternatives to getting new customers apart from advertising in newspapers, radio, Yelp, or other venues which require large up-front spend with unclear returns.  Groupon salesforce promises:   1) We’ll pay YOU upfront before the customers walk in the door 2) we’ll fill your place with 100s of new people, and many of those folks will return 2) you won’t lose money (e.g. cost of food is maybe 25% of revenue) 3) people will spend extra money at full price.  The pitch sounded even better in the recession, as restaurants were desperate for any way to fill their place.  Frankly, it is a compelling pitch, if it was true, and one can see why Groupon exploded on the scene and kudos to them for good execution.

The problem with the Groupon sales pitch is that it doesn’t work for merchants for the following reasons, which is why good quality merchants are stopping Groupon offers:

Reason #1: There are very few repeat customers, since most users just hop from Groupon deal to deal, rarely offering repeat business.   My wife and I are Groupon junkies, which means that instead of purchasing 1-2 Groupons per year like most people, we purchase 30,40,50+ Daily Deals per year (no joke).  Think of it like an excuse to try new places on the cheap.  Groupon says that about half of customers only purchase one Groupon per year, while the median customer purchases about 5, so could say that half purchase 1, and half purchase 9. I’d guess the top 10% account for most Groupons bought, at 30+/year/per person, and this group just hops from deal to deal, never returning.  I've talked to several other people who historically have bought 1 per week (52/year).

Reason #2:  People rarely spend more than the value of the deal.

Reason #3:  Groupon customers are typically lower quality than normal customers (what discount seekers aren't?), and the rush of people coming in destroys good will from existing full-price customers.  Studies have shown that Yelp ratings decline significantly after a deal, as these customers provide lower ratings.  Also, once a place has run on Groupon a couple of times, I would never pay full price there again, but wait for a new Groupon.

As you would expect with an offering that doesn’t provide a return (or provides a loss), merchants will try a Groupon (or 2), and then decide it doesn’t work.  This is showing up as

1)      Decline in merchant quality.  My qualitative survey across four cities I know shows a huge decline in quality the last couple of months.  I was buying a Groupon a week but it’s been a month since I’ve bought anything.  A quantitative survey showing Yelp ratings of 12,000 Groupon merchants shows moderate but real and steady declines over time.  Basically, the only merchants signing up to give 75% off now are merchants that are desperate for business at any cost, which will lower customer uptake.

2)      Merchants changing behavior to trick the Groupon crowd:  you used to see a $40 coupon for up to 2 people, when the average bill per person was $20, which was a good deal.  Now you see many Groupons for a $30 credit, so it forces people to spend more than the face value of the coupon.  Also, you are seeing more restrictions such as no take out, no weekends, etc.  Or, you see something worth $1000 such as a mattress where Groupon offers a “$200 off for only $50”, which amounts to a 15% discount to consumers.  Or, my favorite, 50% off a “special deal” at my local car wash which is double the price of any other comparable service and so in reality you end up paying the same as you would if you came in and ordered a different service. Either way, consumers should respond by buying less over time.

3)      Negotiating better terms – instead of a 50% cut to Groupon, why not 40%?  With several competitors out there, this seems to be happening in small quantities.

If you talk to merchants, you’ll hear that they get calls weekly from one of Groupon’s many competitors (aka the Groupon Clones), and “Daily Deal Fatigue” is entering the vernacular, although many clones are going out of business.  Still, people are sometimes desperate, and a friend who runs a spa-type place needed the business, although he was dissappointed with the results and won't run another deal.  Daily Deal (Groupon, Google) salespeople I talked to said the job went from being fun a year ago to getting hung up on all the time.  Another person who talked with several Groupon salespeople in April 2012 said, “Since about November of 2011 onward, all of my peers in sales were just like ‘Deals aren’t selling worth a sh** anymore.’ And management ignored it. I think about deals for hair salons that would bring in $10K in 1 day in late 2010, and since then, the same salon has been featured on Groupon 12 times and now brings in $1K when it runs. This was happening across ALL merchant categories.”   My personal experience is exactly that – in the 4 markets I track and personally know, you are seeing the same old tired and poor offers over and over.  Without good offers from merchants, Groupon doesn’t work as customers won't buy.

Note that I didn’t mention officers leaving, accounting issues, the CEO’s antics, Directors leaving, the fact that competitor Living Social is losing money, that there are many competitors, etc.  While not good, I’d guess these are already in the stock price since they have been well publicized.

What is the bull case/why is this still valued as a growth business?

Bull Case #1:    “GRPN can expand into new businesses”, such as goods (selling anything under the sun), Travel/Getaways, Quick Deals (Now!), Rewards, Payments, and probably many others.  They all have in common that they don’t use the GRPN salesforce of 5+thousand people where Groupon has both experience and an advantage, but instead are trying for areas where they have little to no experience, where the keys to success are different, or where margins are much lower and competition is often super high.   While it’s possible Groupon could sell goods better than retailers such as Amazon, but I wouldn’t bet on them doing it very profitably.   As an example, Quick Deals (Groupon Now!) is now maybe 1% of sales after a major push in mid 2011 (called “Groupon’s most important innovation to date” by the CEO in 2011), and competitor Living Social recently got out of the segment due to poor results, and my experience is that only the worse of the worse merchants use Quick Deals/Groupon Now!

On an interesting note, Groupon’s Chairman has started funded a competitor to Groupon's push in the loyalty space (name is Belly) which one prominent investor in both Belly and Groupon called “The Anti-Groupon”.

Bull Case #2:  “Marketing can be pulled back, to lower costs and hit profitability”.  Well, it’s only 20% of last quarter’s % of net revenue, down from 78% this time last year, so only so much to go.  That said, perhaps they can bring it down more, but they have to spend something to get new customers. 

As noted earlier, getting good merchants to give 75% off requires a sales job with a talented direct sales force, and as you’d expect SG&A as a % of sales hasn’t really changed as a % of revenue, nor do I expect it to.  That said, I’d expect them to try and drop commissions (as is happening some from what I've heard) and see if a lower quality sales force can still sell it.  

Bull Case #3:  More targeted deals will drive more uptake.  My thought is that if merchant offers are declining in quality, then more targeted bad offers still equals a bad offer.  Also, targeted offers typically have lower volumes, which doesn't mesh with the fixed-cost salesforce model of Groupon, and the "serve yourself" model tried in the Groupon Now! model hasn't worked.

Competition:  I believe Groupon has the largest customer base and therefore exposure to more customers, which is worth something, but their terms are worse (for instance, merchants get 1/3 upfront with Groupon, and get much more with Google Offers).  Not sure what matters more.  On a side note, Groupon used to give ½ of the deal's take upfront and the rest at 30 and 60 days out, and now gives 1/3 upfront, which is interesting since Groupon has relied on a float of keeping parts of the merchant's take to fund growth, but if growth reversed this could cause some funding issues.

Valuation/Estimates:  While I'm not offering firm estimates, I do believe domestic revenue will flatline Q/Q either in Q2 or Q3, or close to it given that new product lines adds a little revenue.   While international is maybe 1 year behind domestic due to a later entrance, the market should extrapolate this slowdown to the whole business and really contract the multiple.

With marketing already down to 20% of net revenue, COGS flat to increasing (at least partly due to increased refunds), net margins (gross/net revenue) likely to decrease a little due to competition and increased merchant bargaining power, and SG&A flat to increasing as a small deal costs the same to sell as a large deal, and you could project that Groupon won’t ever make meaningful money.

Risks:  Takeout.  Google offered $6B when Groupon had much lower sales, and Google Offers is not doing that well.  This seems to be a mantra among retail investors who are long the stock, that “Google offered $6B (~$9/share) when Groupon was much smaller.  However, an informed source said that a factor in Eric Schmidt’s demise at Google was his offer for Groupon which others didn’t want.  If true, then surely that offer wouldn’t happen again.  Other risks include a promotional management which will keep the dream alive.

Catalyst