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I started reading Groupon's (NASDAQ:GRPN) 10-K this spring when it was trading around $5.50 a share. I put it down to focus on studying for my CFA and since then it's rallied an impressive 68%. Though I realized it was probably an exercise in futility, I decided to pick up where I left off and see if there was anything left on the table.

The verdict; I'm passing on Groupon and here's why:

Financials

The company is running at about break-even and if they wanted to, could run the business to make money (reduce marketing expense and expansion). For now however, they appear to be happy flirting with profitability and hoping that a maturing operating strategy leads to bottom line improvements.

As for growth, revenue is still growing but its higher margin local business has slowed. And while gross deal margins or "take" in the parlance of the cognoscenti are stable at 30%-40% for now, there doesn't seem to be any guarantee they will stay that way. My guess would be that they head lower.

On the plus side, the brand is definitely worth something and it is not expressed in the balance sheet. I think you could estimate the brand value at $1-3 billion dollars.

The Model

I have to admit that at first, I thought their model would be easily replicable and that they would soon be out of business. But it seems like, despite serious attempts by both Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG) to enter the market, their biggest competition is a private company called Living Social. To me this would seem to suggest that people think of a Groupon and/or its offering structure as a unique product type that they really only want from a specialty provider. Otherwise, why wouldn't they use the sites that already have authenticity and their credit cards (Amazon & Google)? This is the value of Groupon's fist mover advantage, its aggressive growth, and its franchise.

Distinct from the question of whether the model can work for companies, is the more interesting question of whether it will work in the long run for their merchant customers. The simple answer is that it will work for some businesses and not for others. The better answer is I don't know, and neither does anyone else. What I do know is there was definitely a fad element, which led some businesses that weren't savvy, and some that weren't the right type, to do deals that had bad economics. There was also fault on Groupon's side, being a young company, it hadn't and probably still doesn't know the optimal deal structure for each merchant it deals with. It will probably take another few years to settle this question, but in the meantime, I think it's fair to assume that the firm is still benefiting from a newness factor and that growth will slow, if only marginally.

In addition to the social deal structure that made the company famous, Groupon has been branching out into the direct goods business, and trying to sell itself to Wall St. as becoming "the operating system for local commerce." For my money, as long as Jeff Bezos is still at Amazon the company will only make a small dent in the low margin business of direct goods. As for the operating system of commerce, I feel very comfortable assuming Google has them beat.

Management & Ownership

Looking over the management structure, I quickly ran into this quote in an article by the AP,

But according to Groupon's SEC filings, $810 million of the $946 million it raised went to early investors and insiders. That includes $398 million to Groupon's largest investor, shareholder and executive chairman, Eric Lefkofsky. - New York (AP)

This was the nail in the coffin. You don't have to work on Wall St. to know that this is not a good sign. 85% of the IPO proceeds going to early investors and insiders is not capital raising, it's a massive trade and the worst kind.

The fact that the founders effectively cashed-out at the IPO would have made me nervous enough on its own but then when I read on about co-founder Eric Lefkofsky, and his exploits at other companies, my uneasiness morphed into plain distaste. This guy seems like a stock promoter of the first rate. I also can't help but be suspicious that they used the eccentric Andrew Mason as the fresh face for their promotional ventures and let him take the fall when things went south.

Having said that, I should say that I am sure there are hard working people at Groupon focused on creating a lasting brand that will change the world. I just don't think Eric Lefkofsky is one of them. And though he owns 16% of the company, after the money he's already made it's more like a free option than an ownership stake.

Funnily enough, the antics of the founders and weak ownership actually make me think that a takeover is more likely should the company continue to flounder. The logic being that when management gets sick of the hard work of actually running a business, they will be happy to sell it off to a big corporation and take whatever money is left. Unfortunately, that is not a sufficient basis for an investment, at least for me.

In Sum

All things being equal, I think Groupon was an attractive play under a $4.5 billion market cap, despite the issues with management and profitability, mostly because of its franchise. And though I wouldn't be surprised if it popped up into the $8-9 billion range, I don't feel that you are being sufficiently compensated for the downside risk at these levels.

P.S. With the stock approaching the IPO valuation I will be very interested to see if insiders begin selling shares again.

Source: Groupon - Any Room Left In This Deal?