Genny Konz - Senior Director of Investor Relations
Eric Lefkofsky - Executive Chairman of the Board, Interim Chief Executive Officer
Jason Child - Chief Financial Officer
Kal Raman - Chief Operating Officer
Ted Leonsis - Vice Chairman of the Board, Interim Chief Executive Officer
Ross Sandler - Deutsche Bank
Mark Mahaney - RBC
Gene Munster - Piper Jaffray
Nathaniel Brogadir - Stifel Nicolaus
Justin Post - Bank of America Merrill Lynch
Heath Terry - Goldman Sachs
Brian Pitz - Jefferies
Arvind Bhatia - Sterne Agee
Groupon Inc (GRPN) Q1 2013 Earnings Call May 1, 2013 5:00 PM ET
Good day, everyone and welcome to the Groupon's first quarter 2013 financial results conference call. At this time, all participants are in listen-only mode. A question-and-answer session will follow the company's formal remarks. (Operator Instructions). Today's conference call is being recorded.
For opening remarks, I would now like to turn the call over to the Senior Director of Investor Relations, Genny Konz. Please go ahead.
Hello and welcome to our first quarter 2013 financial results conference call. On the call today are Eric Lefkofsky, Co-CEO, Kal Raman, COO and Jason Child, CFO. Ted Leonsis, Co-COO will join us for part of the Q&A session.
The following discussion and responses to your questions reflects management's views as of today May 8, 2013 only and will include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results is included in today's press release and in our filings with the SEC including in our Form 10-K.
During this call, we will discuss certain non-GAAP financial measures in our press release and our filings with the SEC each of which is posted on our Investor Relations website. You will find additional disclosures regarding non-GAAP measures including reconciliations of these measures with U.S. GAAP. Finally, unless otherwise stated all comparisons in this call will be against our results for the comparable period of 2012.
Now, I will turn the call over to Eric.
Thanks, Genny. We are encouraged by our performance in the first quarter of 2013. Gross billings growth of 4% year-over-year was driven by 23% growth in North America. Revenue growth of 8% was driven by 42% growth in North America. Sequentially, operating income improved by $34 million in the past quarter.
We are pleased by these results particularly when considering the tough prior year comparable on our European business was larger but we have a lot more work to do especially in our international business. At times as an organization, we have spread ourselves too thin and failed to focus on the things that will have the greatest impact and at times given the complexity and evolution of our business it's been difficult for you and others to gauge our progress. As we start a new chapter, we intend to be more focused and endeavor to provide additional insight along the way.
Before I provide some color on our results, I'd like to take a giant step back to give you some more context at where we've been and where we're headed. I have been involved with new Groupon since the very beginning. When Andrew and I couldn't find the business trying to change the world, we collected social action. We decided to try and find one by saving people money via collective buying power, and in a flash, Groupon was born.
Groupon invented a daily deal space and with it a means of revolutionizing local commerce for consumers and merchants. By using the power of the deal, we found a tool that hundreds of thousands of merchants could relate to as a way of tapping into the internet and attracting customers.
From 2008 to 2011, we focused on expanding our geographic footprint and increasing our customer base. We grew from one city to over 1,000, from a few customers to over 41 million. As we began to push the limits of that expansion, we realized the global brand we built to support far more than just local deals, so we decided to expand horizontally by adding new categories such as Getaways, our travel business, and Goods, our product business as well as expanding our local category to include Live, our events business.
We were pleased that our customers instantly fell in love with our new categories, which grew from zero to about 40% of our business in less than two years. In 2012, we devoted lots of e-mail real estate to these new categories and they flourished, and today because of that we have a business that is far more diversified than it was in 2011. But by Q4 of 2012, the overall mix shift toward these new categories impacting our margin and operating income. In Q1 of 2013, that mix rebalanced as our local business experienced solid sequential growth both, in terms of billings and take rate, which contributed to our improved operating margins for the quarter.
We are a local company. At our core, our mission is always been the same, to bring the power of the internet to local commerce by offering our customers unbeatable deals that they discover when they are out and about. Every day, we offer you something great to do, see, eat or buy and make it available at the best prices.
Everything we do is with local in mind. Our Live business features local concerts and events, our Getaways business features local hotels. And as we continue to expand our Goods business, we are mindful of our local limits. How can we tap in the local inventory, can our customers get same day delivery, or go to a store nearby to trying them on before buying it, can boutiques use the power of our platform to compete with mass merchants. We think that local on a broad context. We think that it is a marketplace that has evolved by virtue of the fact that people are increasingly using mobile devices as a means of interacting with their local surroundings. A marketplace in which people travel around, carrying the power of desktop computer in their pocket giving them instant accessed information with faster discovery, and in this marketplace, Groupon has inherent advantages, we are highly curated and cover a wide array of local categories, we are geocentric in nature, buying and using of Groupon is both easy and instant. We are social and that people often use Groupon with friends and loved ones and our customers trust us.
You can use Groupon when you are out to do almost anything from making a spa appointment, to buying a T.V., to replacing your mattress, to booking a hotel, to buying dinner and so on. As a result, our mobile business has skyrocketed from about 20% of our North American transactions two years ago to 45% in March. More than 40 million people worldwide have downloaded our mobile app so far. Over 7 million downloads in Q1 alone.
Mobile is only one facet of our business that's evolving. We are also midstream in building a marketplace, which we believe will fundamentally alter the way our customers interact with Groupon. Just a few years ago, our business was predominantly driven by daily deal e-mail. In the first quarter, less than 45% of our North American transaction came from e-mail. Mobile and search accounts were increasing percentages of our total business. To understand the evolution of our Groupon, it's important to understand why.
The answer lies in the amount of hard work that we've done before I especially joined the team 10 weeks ago, so the combination of deal bank, our proprietary inventory system and smart deals are proprietary relevance engine. We built the foundation of a marketplace we call pool. Pool enables customers to search among thousands of categories in our top markets and find relevant deals that they can buy and use instantly.
Type in Italian food in Chicago or deep tissue massage in New York, or yoga class in Austin, and up pops relevant deals that you can pull down and use instantly. No other company has the combination of our breadth of local deals, our expensive customer base and the necessary data to build the bridge between the two.
At the time of our IPO, we were featuring off these 1,000 deals worldwide. At the end of the first quarter, we were featuring almost 40,000 in North America alone. As a result, over 50% of our local transaction volume in North America comes not from new deals that we feature on any given day, but from our deal bank inventory.
When we launched this effort, our greatest concern was naturally whether merchant will be willing to participate. It's one thing they asked me to discount their services for one day to attract customers and quite another customer do it every month. As the science support for Groupon, the merchant community embraced the concept with open arms. In March, over 60% of the merchant contracts we signed in North America, refer this model. Imagine that.
Groupon's business has evolved across local, mobile and our new core marketplace. As we've evolved, so too the metrics that we we've aligned to measure our progress. There are eight key metrics that we are focused on right now. Four are non-financial, active deals, active customers, spend per customer and units, and the other four are financial, gross billings, gross profit, segment operating income and free cash flow.
One of our biggest challenges today in light of our growth in geographic diversity, there are some steamy operational advantages we enjoy in North America for all our global markets, an initiative we call one playbook. As we unify our processes and technology globally, we rely on these eight metrics to further guide our efforts and gauge our success.
I want to turn over to Kal Raman, our COO to talk more about some of the work going on our international business, and then Jason Child, our CFO, will offer more detail on our performance in Q1, and our expectations for the rest of 2013.
Thanks, Eric. As we have said, we have a tail of two Groupons. My main focus has been on improving the operational efficiencies across our business globally. Our North American business has seen steady and strong top and bottom line growth, while our international business has struggled.
Q1 also was the perfect example, with North America billings growth of 23% compared to 9% decline in International. And our segment operating margin of about 12% in North America compared to 4% in International.
While the updates are different, to put relevant deals in front of our customers and make Groupon work, requires balancing lots of variables, deal density, weighted average takes point, category mix, deal quantity, customer demographics, proximity, merchant quality, e-mail and website impressions, purchase flow, redemption are few things we need to care about.
In North America, we have spent more time and devoted more resources to building the necessary infrastructure to do this efficiently for our customers, our merchants and for Groupon, but our international markets are still behind.
Last year, we began a project called one playbook, which when completed will create a single operating platform of Groupon worldwide. Our goal is to have our largest markets and all of EMEA on one platform by the end of this year.
Some might ask, why this is taking so long. The reality is that when we are making strides towards the unification of the back office systems, our internal tools set is far more complicated than many realize. But the good news is, in Q1 of this year in an effort to catch them up, we made solid progress on the following initiatives as part of one playbook.
SmartDeals, our personalization algorithm, which is now launched in the U.K., Italy, Spain, France, the Netherlands and Brazil. As a matter of fact, we have begun our rollout in Australia. As we increase the number of deals in our deal bank, the relevancy should raise over time, which we believe will improve sales.
Our merchant facing return on investment calculator, we call it Coffee, now has been deployed in all 48 countries. So our merchants can now understand that return on investment of the deals they are running in a very crystal-clear fashion.
Through deal factory, we are now standardizing the workflows and getting deals on the site faster and more accurately around the world and are then migrated to our North American instance in the first quarter and the United Kingdom and the other big countries are on their way.
Our lead management system is now in 36 countries allowing us to better manage which merchants to contact and when to contact them. We have also developed a next generation lead management tool in North America called Quantum Lead which we intend to deploy internationally in 2013.
Deal Wizard, our capacity management system is being deployed in the top European markets as we talk, allowing our reps to automatically estimate deal capacity. As we aim to further improve efficiency and productivity, we will continue to rollout these and other tools both domestically and abroad.
In addition to our platform work, we have made continued progress in elevating our customer and merchant satisfaction score internationally. So while we are nowhere close to be done, we have certainly made great strides both domestically and abroad in improving our processes and becoming a more efficient global organization which we call as One Playbook.
Now, to discuss the results and our progress, I will turn the call over to Jason.
Thanks, Kal. As we work to provide additional financial details on our business, we have introduced quite a few new disclosures this quarter. In addition to metrics for our direct and third party businesses which shed light on the accounting implications of each we are now also disclosing financial information for all of our categories for the first time.
With the details available in this afternoon's press release, I am going to run through the highlights of the quarter and then provide our outlook. Note that all comparisons unless otherwise stated refer to year-over-year growth.
In summary. Gross billings increased by 4% to $1.4 billion. North America gross of 23% was offset in part by an international decline of 9%. Sequentially gross billings declines by $113 million related entirely to $149 million decline in our goods category due to the holiday season. This was offset by growth in local and travel.
Revenue increased by 8% to $601 million. North America growth of 42% was offset by an 18% in international. Sequentially, growth in local and travel driven by increased billings as well as higher take rates was more than offset by the goods decline.
Gross profit decreased by 14% to $379 million. Sequentially gross profit increased $23 million driven predominantly by a mix shift towards local, particularly given the improved take rates.
Operating income, excluding stock-based compensation and acquisition related costs, was $51 million, declining $16 million year-over-year, but improving $37 million quarter-over-quarter with both segments contributing to the increase.
It is important to note that for international, Europe drove the sequential improvement and contributed only a small portion to the year-over-year decline. International profitability continues to be impacted by investment in our emerging markets.
Additionally, we are introducing adjusted EBITDA this quarter, a non-GAAP metric commonly viewed by both our peer group and the analyst community as a good proxy for measuring the financial health of young technology company. Adjusted EBITDA, defined as operating income excluding stock-based compensation and acquisition related costs further adjusted to exclude depreciation and amortization was $72 million in the quarter decreasing year-over-year by $7 million and improving sequentially by $42 million. GAAP EPS was a negative $0.01 and EPS excluding stock compensation and acquisition related expenses was positive $0.03. Both included a $6 million negative impact from foreign currency transaction losses.
Trailing 12 month free cash flow calculated as trailing 12 month operating cash flow less CapEx and capitalized software was $95 million. For the quarter, free cash flow was negative $6 million due primarily to higher merchant payments related to the seasonally strong fourth quarter. The balance sheet reflects a $51 million reduction in accrued merchant payables quarter-over-quarter. Finally, as of March 31, we had $1.2 billion in cash and cash equivalents.
Turning to the four key non financial metrics that Eric mentioned. Total units, defined as vouchers and products ordered before cancellations and refunds, increased 4% year-over-year to 45 million units. North American units increased 37% and international units decreased 18%. Our net active customers increased in the quarter by about 700,000 to 41.7 million worldwide. Our North America active customer count was 80.2 million. For international, it was 23.5 million.
Trailing 12-month billings per average active customer was $138. Sequentially, customers spend declined coming off a seasonally strong quarter with North America flat and international declining $9. Active deals increased to nearly 40,000 in North America. Active deals include merchants that are featured in our pool marketplace.
As Eric mentioned, in March over 60% of all merchant contracts in North America opted to feature in our pool marketplace with a monthly recurring deal which fueled the growth in our active deal count.
Given the abundance of new disclosure that we provided for our categories, I am now going to speak to the highlights. Local gross billings, which is made up of local lives declined 7% globally year-over-year to $830 million, yet increased sequentially for the second quarter in a row by 4%.
North America grew 5% both, year-over-year and quarter-over-quarter. International decreased 19% year-over-year, but increased 3% quarter-over-quarter. As we further rollout the North American playbook, we expect that international performance will improve.
Local gross profit decreased 14% year-over-year to $281 million and increased 15% quarter-over-quarter, the sequential increase was due to a 300-basis point improvement in take rates, primarily in North America. Goods gross billings increased 37% year-over-year to $392 million and decreased 28% quarter-over-quarter, as expected, due to the holiday season.
About 90% of North American Goods billings are recorded on a gross basis, which we refer to as direct as compared to international, where the inverse is true with only 6% of billings recorded direct.
As we build out our global supply chain infrastructure, you should expect the mix of direct to increase. Goods gross profit decreased 18% year-over-year to $59 million and decreased 25% quarter-over-quarter due to seasonality. Recall, that our presentation of gross profit includes direct cost such as inventory, shipping and warehousing, as well as certain allocated expenses like credit card processing fees and editorial costs that some e-commerce companies classify below the line in SG&A.
Because of the relatively high mix of direct revenue, it's helpful to look at goods gross profit as a percentage of goods gross billings. On this basis, gross margins were 15% globally, 8% in North America, and 21% in international. The North America number reflects a higher mix of direct, which include significant shipping, warehousing and other expenses.
We expect our margins will improve over time as we begin to scale our shipping and infrastructure cost. When you step back and look at our pure product margin in goods in North America, which is defined as sales price less the price we pay our direct suppliers, it was in the low 30s. This gives you the sense of the healthy margins that our categories can produce, which is one of the reasons we have devoted so much time and energy to expand them in the past year.
Travel and other gross billings increased 7% year-over-year to $186 million and increased 3% quarter-over-quarter. In both cases, the growth was driven entirely by increases in North America. Gross profit for travel and other decreased 9% year-over-year to $39 million and increased 15% quarter-over-quarter.
Before I provide our outlook, I am going to spend a moment on marketing. Marketing expense for the first quarter was $50 million, or 8% of revenues. It is important to keep in mind that we spend marketing dollars in a variety of ways. Not all of which hit the market expense line item on the P&L.
For example, order discounts, free shipping and take rate reductions assist in our overall marketing efforts yet are recorded as contra revenue or cost of revenue. Finally, turning to our outlook, we have decided to make incremental investments in the second quarter of approximately $15 million $30 million between customer incentives and increased marketing spend, which will have a negative impact on both, revenue and operating income in Q2, but we believe will benefit us in future periods.
As such, for the second quarter of 2013, we expect revenue of between $575 million $625 million and operating income excluding stock-based compensation and acquisition related expenses of between $20 billion and $40 billion. We estimate that stock compensation will be approximately $30 million for Q2, and taxes will be approximately $25 million.
For the full year, we reaffirm our guidance that the full year 2013 GAAP operating income will exceed $100 million. As always, our results are inherently unpredictable and our actual results may vary materially from guidance.
With that, I will turn the call back to Eric.
Thanks, Jason. Its hard to believe that Groupon is only four years old. We are still a toddler despite our size and scale, but its even harder to believe is that international business is younger still. Just a baby by comparison without a lot of the infrastructure enhancements that have sustained performance in North America. With time, we are confident we will get them on the same path. In 2009, our first full year as Groupon we did just $35 million gross billings. Last year, that number was $5.4 billion. With unprecedented growth comes unprecedented volatility and Groupon has certainly produced its fair share of them.
At times the focus on our growing pains has overshadowed our achievements. We built a world-class brand that is crossed over 41 million customers worldwide. We sold about 4 million Groupons in four years. We have expanded to new categories like goods, getaways and live. We have developed a thriving mobile business that now accounts for nearly half our North American transactions. We have launched payments and POS platforms that serve as a base for a broader operating system for local commerce. We have laid the foundation for our new Pull marketplace that has the potential to fundamentally change how consumers interact with Groupon.
One of our proudest achievements the economic boost we provide to the local merchants. Not only do we funnel billions of dollars into our local merchant community, but based on surveys of nearly 2 million Groupon customers in North America, over 80% of the customers we sent to merchants are either new or not been to that merchants in the prior three months. Groupon can be a powerful force of customer acquisition and financial returns for small businesses.
With Andrew's vision, Groupon has created an entirely new category for local commerce and today we believe we are better positioned than anyone to redefine one of the last great wide spaces on the internet by plugging local commerce into the web. It feels good to once again be able to make the investments necessary to further our long-term mission which we will do in Q2 by increasing our marketing initiatives to drive future growth. The opportunity in front of us is vast. There are 60 million local merchants in the world and despite our size, we still only do business with about 1% of them. We have the people, the strategy and the rare opportunity to define a space that’s emerging before our very eyes.
I want to thank my Co-CEO and Vice Chairman, Ted Leonsis, who serves as an invaluable resource and a source of great wisdom to every one at Groupon. Just having completed my first quarter in this role, I am energized by what I see and honored and privileged to join Ted and the rest of the senior management team on this part of Groupon's Journey.
With that, we will take some questions.
(Operator Instructions).Our first question comes from the line of Ross Sandler from Deutsche Bank.
Ross Sandler - Deutsche Bank
Two questions. First off, thank you for the slight new disclosure. Very Helpful. The first question is on international. Second one is on the take rate trends. So, on the international segment, Jason, can you give us some color on the decline you are seeing from international local billings? Are we at a stabilization point of that segment or do you see more downside from these levels?
Then the international segment margin increased sequentially. Do you feel like you have turned the corner on margins in that segment? Is a function of the increased take rates or is it the automation stuff? Then I have one follow up on the take rates.
Hi, Ross. I hope you don’t mind if I answer the question. Thanks for asking the question. As you mentioned, our operating margin improved by 500 basis in the international segment, which is predominantly driven by the continued acceleration of our local business for the second quarter in a row and also driven by the increased take rate of 300 basis points in international Q2.
The beauty of our international is that the rollout of One Playbook, it kind of reinforces the fact that merchants lover Groupon. Our active deals are going up, merchant satisfaction scores are going up, and the number of merchants who want to do business with us is increasing, our returns on investment is increasing. Those are all the input variables we look at and they are in the right direction but our take rate, the long-term guidance we have given which is 30% to 40%, we are going to maintain it. But we are going to flex it in such a way that we can continue to attract and retain as many merchants as possible to give great top rated deals to our customers.
Ross Sandler - Deutsche Bank
Okay. Great. Then, on the take rate topic, it looks like take rates are up sequentially in almost every category, so do you think that this is the result of your scale starting to come through our has the competitive intensity in the market been reduced enough, so you can sustainably increase take rates and still grow billings. Any color there would be helpful.
Ross, we rarely talk about competitors. We focus on controlling the controllable and we focus on our consumer experience and merchant experience. And, in most of the international countries, we are number or number two in market segment share. We invest a lots of money in building these 48 countries and we are proud of our investment, proud of the management team we have built, I am proud of our market leadership position and as we continue to execute on our one playbook, which we have recently started which I discussed in the call script few minutes back, that is playing a humongous role and including our efficiencies and including our ability to pass the sales tax to the customers and our ability to attract high quality merchants and retain them on the platform, so this is just not even day one. It's our one of day one in revenue slice in the local commerce, we still have a long way to go. We are very happy with the progress we have made and we also know very clearly that we have a long way to go.
Ross Sandler - Deutsche Bank
Great. Thanks, guys. Nice job this quarter.
Thank you. And, our next question comes from the line of Mark Mahaney from RBC.
Mark Mahaney - RBC
Great. Thanks. I'll ask two questions. One, just some updated comments on the CEO search. Eric, you did a nice job on the earnings call. Any interest in sticking around and doing that operational role? And then secondly on the mobile usage, what can you tell about those customers? Are those more likely to be new to Groupon, are they more like to be people who have already used Groupon in the past, desktop customers so what are you seeing with mobile usages and expanding spend per active customer or is it a draw of new customers or is it a mix of both? Thanks.
Thanks. So, if you don't mind, I'll actually take the second point first, which is the mobile piece and then maybe let Ted weigh in on the CEO search.
In terms of mobile, we are thrilled that our mobile business has growth the way it's grown over the past certainly several years and several quarters it has accelerated. I mean, we had 5 million downloads in Q4, increased to 7 million downloads in Q1 of 2013. We are now at a point where 45% of our North American transactions are mobile. And for us, this is part of a very cohesive strategy to try to grow our mobile business which really serves as a foundation of a larger marketplace opportunity we call pool.
We see a fundamental consumer shift of consumers who are used to being pushed deals everyday that hopefully will start more and more to Groupon and pull down deals that they find when they are out about and so a cornerstone of this is the fact that you are now carrying the power of the PC in your pocket, which is the smartphone and the adoption codes happen to be fantastic, and so Groupon is ideally situated to I think take advantage that.
And, we also have seen that our mobile customers are more active, healthier and they buy more, on average more than 50% more. So, this too is a trend, so you should continue to see us make significant investments in mobile to gain more and more adoption. And we are chartering and we are going on charter territories. We've become, I think, the first company of scale that will one day be predominantly mobile. That's an exciting new space to be in. In terms of the CEO, stop. Maybe Ted, do you want to weigh in for a moment.
Sure, Eric. While the search is underway, the boards formed activity and we have started the process. The business is complex and we are learning a lot, so we don't expect this to be a simple search. The good news is, we are not in a hurry. Leadership team is very, very strong and is [showing] very, very, nicely and that's afforded us some flexibility to take our time to find the ideal long-term CEO.
Mark Mahaney - RBC
Thanks, Ted. Thanks, Eric.
Thank you. And, our next question comes from the line of Gene Munster from Piper Jaffray.
Gene Munster - Piper Jaffray
Good afternoon. Is there engagement number that can share whether it's either on the user side you talked about the total number of active customers for the engage as far as the probability that they are repeat customers. You also mentioned the retention rate among some merchants is going up. Is there any, I guess, specific trends that the second quarter in a row that's gone up and any other numbers around that. Then a follow-up question.
So lets break that down. So the first question, I think the first part was how our customer cohorts are holding up and the second part was how our merchant cohorts are holding up. So maybe I will take the first part, customers and Kal weigh in on the second. The customer cohorts have been thoroughly stable. If you look at, for example, North America, on a quarterly basis, over the past four quarters the spend has been $37 in Q2 of last year then $36, then it spikes to 43 in Q4 of last year but that was predominantly due to the holiday season and its at $39. So the long-term trend netting out the holiday season is very strong.
We actually see a pretty good trend internationally. We have the big dip from Q1 to Q2 of last year when the business declined in EMEA. But it has been pretty stable from that point on. It was $33, I think, in Q2 of last year then $29, then it spiked again to $34 in Q4, also based on the holiday season and it is back at $31.
But the good news is that the trends are pretty stable and again I think what's important to notice, our business today, even though we are highly correlated to mobile, it is still largely a push business where we are either pushing push notifications, we are sending out email we are sending them in the morning and saying hi, you know, would you care to buy some pizza or a skydiving deal or go to the spa at seven o'clock in the morning. Its been a compelling business but the opportunity to reach people not at seven o'clock in the morning when they don’t want dinner but at seven o'clock at night when they do want dinner is just opens up a whole new pool of demand.
So we are very focused on that. The good news is that our customer cohorts are stable and I think the other good news is that there is huge headway.
Let me take the question on the merchant side. The Pull inventory, we call it G2, the option of that in March is get in at 60% of our merchants putting their inventory to be purposefully available at least for a year or more on Groupon which is a great progress we have made and the reason they do it, 80% of the customers, we sent to every single merchant as per our survey, they are either new to that establishment or they haven’t visited the establishment in the last 90 days. So Groupon has proven to be good to our merchants in attracting new customers, not just one time, month-after-month-after-month. That’s what is demonstrated in the adoption we are getting and people putting their inventory available all the time.
To combine with that, our ability to retain merchants is greater than 50% and that is the merchants we want to retain. If we really let everybody come and do with us, that number would be a lot higher. We need to care about the deal mix and deal quality. So we need to make sure that we get the right merchants retained. Overall, our deal count is going up across the globe. So is our merchant satisfaction which has made tremendous progress both in the U.S. and internationally.
Gene Munster - Piper Jaffray
That’s helpful, thanks for that clarity. Then just a follow-up to previous question in terms of the take rate. You mentioned the word flex in there. Just wanted to be clear that should we expect some variation in take rate quarter-to-quarter going forward that can go down and up? Or is there going to be more of a linear trend up? Thanks.
So we have given a long-term range of 30% to 40% of take rate in the local business. We would definitely be in the range. Our take rate flexing, we will predominantly do it just to attract extremely high quality merchant on to our platform. You need to remember, our core value proposition of curated deals, which are going to be surprising to our customers but we are also focused on making sure that there is a return on investment positive for our merchant partners. That is only reason we will flex take rates. As the take rates we have given, we are sticking to it. As you saw in the last quarter, we are not only able to increase the take rate globally, we are able to attract more merchants, we are able to retain more merchants and accelerate the local business.
Thank you. Our next question comes from the line of Heath Terry from Goldman Sachs. Mr. Terry, your line is open. Please check your mute button. He may have stepped away from his phone. We will move on. Our next question comes from the line of Jordan Rohan from Stifel.
Nathaniel Brogadir - Stifel Nicolaus
Thanks. It is Nat Brogadir in for Jordan. Just two quick ones, if I may. First on the third-party Groupon Goods, North America down 30% sequentially, how much of that is seasonality? Do you expect it to pick up? And then secondly, incremental margins have been coming down now in fact being negative in first quarter? How does Groupon plan on adding businesses that earn positive incremental margins going forward? What next needs to happen? Thanks.
This is Jason. I'll take the question. So, in terms of margins in the Goods business, because we have to make sure of third-party, which is recorded on a net basis and revenue on a net revenue recognition basis and then direct of course on our gross, we look at it as a percentage of gross billings which is the best way to kind of show apples-to-apples. And, looking at it in that way, you do see a little bit of movement, which is typically due to product mix, especially Q4 and Q1, however if you look at the overall margins, you will see that the U.S. which has a very high ratio of direct has the much lower margin which is down in the 7%, 8% range in total and actually the direct business about 7%.
As I mentioned in the prepared remarks, if you want to think about a take rate for the Goods business, it's really what we call pure pocket margin, which is just the direct cost of the item, so we have very healthy take rates in Goods of about 33% for example in North America.
Now, because we have not really spent a lot of time and really as a young Goods business, our fulfillment and shipping and infrastructure costs are very high. They are all outsourced and even then the volume has risen quickly and so you should assume that there just hasn't been a lot of negotiation on using kind of some of the leverage that we should be able to yield that volume as a result, we are paying significantly more than you'll see one else pay.
For example, a typical ecommerce company will have usually run a 15 to 25 percentage point spread between the pure product margin and their operating margin, and for us it's obviously quite a bit larger than that. so with kind of the increased focus on shipping cost, you will see those margins improve over time, but I want to make sure it's clear. We are going to continue to optimize for growth since it's such a young business started and two years old and over time you will see margins improve.
Thank you. And, our next question comes from the line of Justin Post from Bank of America Merrill Lynch.
Justin Post - Bank of America Merrill Lynch
Thank you. Over the last many quarters, you've been really able to cut your marketing spend. Are you seeing efficiencies there and any plans to kind of move that forward just start reinvigorate in customer growth. And, when you look at international billings per customer, looks like it's come down, but maybe the rate of decline is a little bit lower. Do you think you can start to see that stabilize and start to grow again and what will it take? Thank you.
This is Jason. On the marketing side, let me cover that. So, marketing was down as a percentage of revenue to about 8% in the quarter. However, as I mentioned in the prepared remarks, we do look at other aspects that we think has a similar ways to grow customer engagement overall new customers, which is not recorded in the marketing expense line. For example, order discounts which will be activation deals ways to get a customer to make their first purchase or free shipping which in the Groupon Goods business of course is the significant driver as well.
If you are able to add those two items and assume they were our marketing cost, it would actually take the percentage of revenue to total cost as a percentage of revenue up over 400 basis points incremental, so it takes it from about 8% up to about 12% to 13%. And, so that's still below the long-term target that we've given of 20% on a third-party basis, or 8% on a direct basis, but certainly closer to those targets.
In terms of the specific investments in Q2 that I mentioned in guidance, so $15 million to $30 million of incremental investment to drive new customer growth and overall customer engagement, we'll be doing that through a variety of mechanisms and at this point we are not ready to say what's going to be marketing versus [contra-]revenue or cost of revenue.
Justin Post - Bank of America Merrill Lynch
In terms of the customer stability you mentioned on the international side, we saw a pretty big decline between Q1 of last year and Q2 when we both reduced our marketing spend and also had some the issues in EMEA where the business was strong quarter-over-quarter. But it has been relatively stable since from that point on, especially when we look at the local businesses. As I mentioned earlier, when you look at the quarter-over-quarter spend detail, I think it was 33 in Q2 to 29 to 34 to 31. So it has really held up pretty well.
Thank you. Our next question comes from the line of Heath Terry from Goldman Sachs.
Heath Terry - Goldman Sachs
Great, thanks. Apologies. Technical difficulty there. I was hoping you could walk us through a little bit more detail on the free cash flow shift this quarter. Obviously as some merchant payables, to what extent is that sort of part of the underlying strategy in improving merchant relationships? Jason, if you could give us an idea of where you expect the general free cash flow trend in the business to be over the next few quarters?
Thanks, Heath. So the overall in the quarter, the actual merchant payable was actually down about $50 million quarter-over -quarter. So you saw cash flow negative. However, it you just take cash minus accrued merchant payable, you would actually see that net cash would be up about $7 million or so quarter-on-quarter. The reason why you saw merchant payables come down quarter-on-quarter is because we were paying all the vendor payables related to the seasonally strong Groupon Goods business in Q4.
So you are basically starting to see a trend that looks more like a typical e-commerce company where you have strong cash flow in Q4 and then you will effectively have a lower cash flow in Q1 because of the timing difference.
Now I think in terms of overall AP days, you would actually see that AP days were very consistent. They were actually up very slightly from the last quarter. It used to be, a year ago that we had big difference between the U.S. and in international. In the last year you have seen international come down and the U.S. go up a little bit Now we are between $50 million and $60 million, between the two segments. We think that is a good place to be.
So, while you are seeing cash flow come down a little bit over the last couple of quarter because of the working capital pieces. We feel like it is a pretty good range now and going forward. In the long-term I would encourage you to look CSOI as really the number that will approximate what cash flow is going forward.
Heath Terry - Goldman Sachs
Great, thanks. Kal, if you could give us a sense, if behind the operating system strategy, what you see being the key products, components issue areas that you plan on investing in. It would be great if you could rank quarter payment fulfillment but the areas that you see being the main focus behind this operating system strategy?
So if you look at our core business, about curating the deals and then in a scientific way targeting the right merchant in a very systematic way determining the deal structure because pricing is nothing but a statistical equation of supply and demand. Then sending the right deal to the right customer. So you look at them in terms of two big areas. One is the clues related to supply, everything from Quantum Lead to Sales Workbench to Coffee to Deal Wizard. As I said in the record of (inaudible) you listened to a few minutes back, we are making significant progress in that in the international. As a matter of fact, between now and the rest of the second half there, we would have all these tools rolled out in majority of all the international countries this year.
That will give us never aging deal productivity, deal quality and cost efficiencies. On the demand side, the most important thing is SmartDeals. SmartDeals is our proprietary IP we have built in targeting the right deals to right customer at the right time of the day. We have rolled it out to all the major countries like, U.K., France, Italy, Spain, Netherlands and we are in the process of rolling it out in Brazil and Australia. We are making phenomenal progress. That team is doing a fabulous job. We are lucky to have the team and they are so dedicated and focused. So we will make significant progress in that this year too.
Those are the core business areas I am focused on. When it comes to the local operating system, which is related to payments and point-of-sale, I would ask Eric to give you an update on that.
Yes. So as you know, we began making some investments about a year ago into what we call the operating system for local commerce, and essentially it's a bundle of investments around point of sale systems, payment systems, loyalty award systems and all of which we view as kind of critical to the long-term mission of making it seamless for our customers to come and be able to redeem their Groupons and interact with the merchant and have that entire process be frictionless.
We also, because we are for many, many merchants, hundreds of thousands of merchants, we are largest source of new customers. We also at times can be a pain point in that. We are sending all these customers and we want to help merchants manage that process and we want to help them determine how best to target these customers as they come back on a repeated basis, and so we realize that we needed tools inside the merchants shop, because the view that has the investments we made.
These are longer term investments. I think, you shouldn't expect them to have an impact on our performance next quarter, but these are still things we very much believe in and we think long-term that will be big business for us and they are all on track. All doing well.
Heath Terry - Goldman Sachs
Sounds great. Thanks, guys.
Thank you. And, our next question comes from the line of Brian Pitz from Jefferies.
Brian Pitz - Jefferies
Thanks. I may have missed this, but what were the drivers behind the Q1 18% decline in international unit growth, and just a follow-up on your payments comment. Any specific merchant feedback so far in terms of using the product enhancements you might be thinking about going forward etcetera? Any commentary or additional thoughts? Thanks.
Let me take the first question. The 18% decline is driven by tough comps we had from last year. Last Q1 was the highest point of our European business in our very sharp [operator this week], so we had tough comps started and also you need to remember the goods business, which is seasonal from Q4 to Q1 have big additional units, but the thing which is very encouraging for us is the acceleration of our merchant business in international, which is now happening for second quarter in a row.
I know two quarters is not a trend, but it was a good beginning of a trend, so I had focused on controlling the controlables, which is all about input variables of getting high quality merchants, retain them, great deal structures, continue to actual more customers and derive them with great deals, provide great customer service, which could be measured in output variables like merchant satisfaction and customer satisfaction, deal crowd and merchant retention and customer retention and which will all be done through the one playbook implementation and we are making progress like I told in the script as one of the questions I answered. We are in the right direct, but we still have a long way to go, but we are very positive about the progress we have made so far.
Second part of the question, I will let Eric to answer that on payments.
Can you just repeat the question as we got bit kind of bit (Inaudible) at the end.
Brian Pitz - Jefferies
Yes. Sorry. Just in terms of merchant feedback in terms of using the product, any enhancements, people requesting just general thoughts or commentary on the payments products.
Yes. I would say the feedback has been quite positive. I mean, I would encourage you to actually try the product. It's pretty remarkable how good our payments product is and there is actually some new enhancements coming out this month that I think we even make it stronger, but it's a great product and we have a very interesting strategic foothold in that. As I mentioned a second ago, we are such a large source of revenue for so merchants and so could be able to offer them a payments product and help them save money and help them improve their operations, it's a great position to be in especially when we have one of the lowest rates in the market and one of the best technology stack, so I think try the product and you will have a great view of it.
Brian Pitz - Jefferies
Thank you. Our final question comes from the line of Arvind Bhatia from Sterne Agee.
Arvind Bhatia - Sterne Agee
Thanks for taking the question. Congratulations on the quarter. I wondered if I could ask two quick ones. One, as we think about Groupon two to three years out and imagine your international business at that point is running well, profitable, where do you think the company's EBITDA margins can be or EBIT margins can be two to three years out?
Then my second question is more in terms, we've talked a lot about the international trends and you've put some good numbers on the profitability side internationally. Should we think of the first quarter margin internationally at sort of the trough with some improvements throughout the year or is that going to fluctuate as well?
I will go ahead and I will take the first question. So on the long-term targets. You said two to three years out. Unfortunately, I am not going to answer your question as to what two or three years will be. I will tell you that our long-term targets are for the third-party business to be at roughly 25% to 30% CSOI margin. So that would actually be a little lower than adjusted EBITDA which of course excludes depreciation and amortization in addition to stock-based compensation and amortization related expenses.
The first party or direct business has a long-term margin assumption of high single digits. Keep in mind on third-party, when I say 25% to 30%. That’s on, if you were to convert that to a billings basis to make it apples-to-apples to the goods business or the direct business, it would be somewhere in the 8% to 12% range. So overall we are certainly in North America we are progressing towards that target where we are actually at about 13% or 12.7% margin in the most recent quarter. International (inaudible) away because of the investment that we are making certainly in One Playbook and also just the investments we are making in growth. But those are all long-term targets. But again I can't time down those to be two to three years at this time.
On the second question, I would just like to add a statement here. So as I said in the script, our operating margin for North America is around 12% this quarter compared to 4% in international. As we continue to rollout One Playbook, as we continue to work on delighting our customers and making the relationship profitable and flourishing for our merchant partners, the operating margin in long-term in international should be very much like the United States. Because it is the same business, same playbook, same customers because it doesn’t matter where you live, customers want great deal at great prices and merchants want them profitably.
Thank you. That concludes our question-and-answer session for today. We thank you for your participation. You may now disconnect.
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