Description

Groupon (NASDAQ:GRPN) is an interesting case study of network effects working in reverse. Users are abandoning the Groupon site/app in droves, which makes merchants less committed to having a presence on the service, which in turn makes Groupon less useful for the next user. Just as network effects drive explosive outperformance for successful Internet marketplaces, the same phenomenon is happening to Groupon here in the other direction. I think GRPN will continue its long-term trajectory of market cap declines and see 40%+ downside from here.

What is Groupon?

Groupon connects customers and merchants via its two-sided marketplace website (groupon.com & international replicas) and mobile app (note: mobile represents 75% of transactions). The core business involves local businesses – primarily those that operate in the health & wellness, “things to do”, and dining categories – posting enticing daily deals on Groupon to attract customers. The merchants then pay Groupon a cut of revenue generated from each successful advertisement.

Groupon’s differentiation from other digital advertisers was historically “inspiration” instead of “destination” browsing – users come onto the platform with no particular activity in mind and follow the most intriguing deals.

Groupon operates in 3 verticals:

·         Local

o   What I described above – digital coupons

o   ~35% take rate on core daily “Deals” offering as described above

o   Starting to push into “destination” offerings with “Offers” service

§  I.e., merchants can post more offerings that are less discounted with a lower take rate to GRPN

o   Bread and butter offerings: spas/massages and family activities

o   75% of 2020 gross profit

·         Goods

o   Typical ecommerce a la Amazon

o   For a while, GRPN actually held and managed its own inventory, but Goods is transitioning entirely to third-party sellers this year

§  GRPN intended to get out of non-3P ecommerce earlier in 2020, but halted plans and continued to sell goods to generate more cash flow through COVID

o   Primarily sell electronics

o   22% of 2020 gross profit

§  % of revenue is less meaningful because Local is reported on a net (commissions only) basis whereas Goods revenue includes GMV for non-3P sales

·         Travel

o   Discounted hotels, airfare, packages, etc.

o   Competes with OTAs

o   3% of 2020 gross profit

What’s going on with the business?

Groupon’s business model was flawed from the start. Daily deals are exciting for customers because the merchants are taking a deep loss on them – merchants often sell these services for ~30% of typical list price, which means they can’t generate margin – in hopes to earn a new repeat customer. However, both sides end up disappointed:

·         From the merchant’s perspective, there is no way to guarantee that you aren’t simply cannibalizing your existing customers at lower price points OR that customers would come back to you with no discount

o   Rice University study found that only 20% of daily deals customers come back to the merchant in a full-price capacity

o   The bargain hunter that frequents a daily deal website is inherently a lower-value customer, since he or she is more price sensitive and less sticky than average

·         After the merchant realizes they can’t justify significantly marked down daily deals, they resort to more modest deals, disappointing the deal-hungry users

So merchants either retreated or posted more modest deals, user count deteriorated (only somewhat offset by new users – GRPN was spending $300mm+ per year on marketing prior to COVID but still losing users), many merchants opted to prioritize some of the countless alternatives they have to advertise their business (Facebook, Google, and Yelp to name a few digital options), and the flywheel spun in reverse.

To add to Local’s fundamental problems, GRPN spent resources expanding in two hypercompetitive categories, ecommerce and travel, where predictability they are reversing course.

These dynamics are no secret as the stock is a tenth of its IPO price and has underperformed the S&P consistently.

What happened in 2020 – why the pop following Q4 earnings? Why is now a good time to short?

The setup that intrigues me today is the divergence between GRPN’s post-COVID operating performance and stock performance. The stock is within 10% of pre-COVID levels, yet the fundamentals are a lot worse:

·         Billings, revenue, and active users fell off a cliff in 2020

o   Yes, COVID was a headwind for the Local segment and some of that will recover

§  Yet Yelp managed much better performance vs. GRPN Local

§  It’s easy to forget how hard small businesses have and continue to get crushed by COVID

·         E.g., local spa and massage facilities are hurting. It remains to be seen whether they can afford cash burn associated with Groupon discounts

o   Ecommerce categorically saw 5+ years of growth accelerate into 2020, yet GRPN Goods gross profit was down 22%

§  I don’t think anyone reading this would disagree that Groupon has no business competing in ecommerce – they are exiting it for a reason

·         Active users, which is the single most important value driver for this company, were down 32%

o   Merchants are equal-opportunity advertisers: they simply go wherever the demand is

o   Despite the interim CEO’s narrative about prioritizing its merchants, GRPN depends on healthy user engagement to drive its business

o   Internet habits are fickle, so I do not expect many of the attrited users to return to Groupon following COVID

The stock has rallied over the past 6 months, particularly following Q3 and Q4 earnings (+70% over 2 weeks following release). Why? EBITDA came above expectations.

In response to COVID, Groupon embarked on a large cost cutting program targeting $225mm in annual savings. The main features of the program were headcount reduction – they laid off a third of their workforce – and marketing cuts. Yes, the result was positive EBITDA in the full year 2020 IF you allow SBC as an addback. And these cuts do make their 2021 EBITDA (+ SBC) target of $100mm feel achievable. I'll spare you the SBC rant and point you to Buffett's instead...

Management is telling the street “oh if we just get to 80% of 2019 gross profit, since we fired everyone, we should be able to post pretty high EBITDA numbers”. Then analysts say ok let me give them credit for $200mm EBITDA, since this thing is back to EBITDA growth let me give it a 10x multiple, so this is a $2bn company or ~$2.4bn market cap.

But both the $100mm and $200mm numbers are ephemeral because the fundamental driver – users transacting on the site – will continue its downwards trajectory, probably more quickly than people expect. Starving the business of talent and marketing is not a sustainable strategy in the hypercompetitive world of Internet marketplaces and advertising.

After reading through the last several management transcripts you will see management is doing nothing to address the attrition problem – their turnaround strategy is all about prioritizing merchants and the Offers offering. In other words, the strategy is to make Groupon less of a daily deals site and more of a regular marketplace. Users simply have better options for basic local business discovery.

Go-forward Expectations

Here’s some simple math to show you why the entire bet here is that GRPN’s user count will continue to deteriorate.

Per the red dashed box, gross profit per active user has been steady over time. It declined quite a bit in 2020 but I’m giving full credit for a recovery and even a fair amount of growth to all-time highs thereafter. Note that this is probably illogically bullish (conservative since this is a short) since they are expanding into Offers which has a lower take rate. I’m giving them benefit of the doubt to illustrate that the key unknown is active users and your view on which direction it will trend determines if this is a long or short.

Shorts need this 5-year chart to trend the same way. Longs need it to reverse.

“Groupon” Google Trends, trailing 5 years up until April 2021. Note that App Annie shows similar trends for mobile downloads.

My thesis is simply that user count declines will continue because of the network effects unwind, challenges w.r.t. core GRPN merchant categories, massive cuts to marketing spend, and GRPN’s shift away from daily deals diluting the user experience.

Survey detailing expected change in spending habits POST-COVID. Many of GRPN’s key categories are impacted.

Valuation

GRPN traded at 0.5x revenues prior to COVID. Its revenue multiples have expanded significantly, and some of that lift is merited since they are shedding low-margin Goods revenue. Note that this is based on consensus estimates which I believe are too rosy.

Ever since GRPN stopped growing users in 2017-2018, it rerated to about 5-7x forward EBITDA. I think this is an appropriate range for an ex-growth business, driving my 6x multiple. Remember that the 6x is being applied to an EBITDA that is almost 40% SBC addbacks.

Risks & Considerations

Shorting is hard. Shorting a volatile Internet stock is harder. The good news is that short interest here is low at 1.5%. Yes, there is a nonzero chance this becomes a meme stonk (however it is better that the nominal share price here is $50 instead of <$10 like many of the other targets). Nonprofessional trading activity declines in March 2021 should make you feel a bit better about that.

The bigger issue is volatility and timing. GRPN may just rally with the rest of the QQQ and it is hard to pinpoint an attractive short entry point. If they report higher EBITDA in the near-term, maybe the stock pops again. That’s why I recommend people think about partially hedging this short against a basket of stocks with the same drivers, e.g. “re-opening trades + Internet advertisers” such as Yelp and OTAs.

I like this short because the best bull cases argue that GRPN can post a year or two of solid EBITDA from further cost-cutting. This is the risk in the short-term but I am confident that the strategy is unsustainable. The Internet is way too Darwinian and fast-moving to cost cut your way to greatness. Would love (not being sarcastic) for someone to point me to an Internet comp where negative growth + cost cutting led to good shareholder returns over a 2-3 year horizon.

Another consideration is M&A risk. I do think there is some floor to value since GRPN becomes really interesting to say Yelp as an acquisition target at a $700mm market cap...Yelp can just redirect Groupon users to their website or something. This risk drives my recommendation to exit at $25-30 per share (GRPN traded in that range for a while in the latter half of 2020 and wasn’t approached by a corporate…primitive analysis I know).

Catalyst

• User count continues to dwindle through 2021
• 2022 guidance comes below the $200mm bulls are calling for