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Last year Groupon, Inc. (GRPN) stock crashed from an IPO of $20 a share to a low of $2.6. The company's share price has since tripled, and is currently trading at just above $9. This increase poses two questions; does Groupon's performance justify the rise, and will it continue?

Financial Performance

The company generated approximately $2.3 billion in revenue during 2012, up from $1.4 billion in 2011. For the three months ended March 31st this year Groupon, Inc. reported $601 million in revenue, an 8% increase on the same period last year. Net losses for the three months ended March 31st 2013 fell to $3.9 million from $11.6 million for the same period in 2012.

If considered at face value these figures could be seen to suggest that the company's performance justifies the share price increase, but closer analysis suggests otherwise.

The quarter-over-quarter increase in revenue is due to an increase in Groupon's direct revenue, which increased from $19 million in the first three months of last year to $162 million in the same period this year. In contrast, indirect revenue from Groupon's core coupon business fell from $540 million for the three months ended March 31st 2011 to $439 million for the same period this year. Profit margin on the direct revenue is much lower than on the indirect revenue, meaning Groupon's gross profit fell quarter-over-quarter from $439 million to $379 million.

These figures suggest that while the top line increase in Groupon's performance indicates a successful half year, the underlying figures that support this revenue increase do not.

Upside Potential

Estimates indicate that Groupon's current operating profit margin is 15% in its indirect business, and negative 18% in its direct business.

This year the company reported long-term operating profit margin targets for its indirect and direct business at 25% and 8% respectively. Analysis suggests that if sales grow at 12% a year, and Groupon hits these targets by 2016, the resulting free cash flow discounted back at 10% implies a value of $9.70 a share.

This means that even if the company meets its targets and sustains revenue growth over the next 3 years, the share price that this performance justifies is only about $1 higher than at present.

Expansionary difficulty

At an operational level, Groupon's growth prospects also seem limited. The company is competing with eBay Inc. (EBAY) and Amazon.com, Inc. (AMZN) for its direct revenue, which makes gaining a sizeable market share difficult. This leaves its coupon derived, indirect revenue. The daily deals industry is still growing, and is forecast to continue to do so, but analysts expect this growth to slow. A research organisation suggests that while the industry is unlikely to collapse, it is due to undergo a correction. The increased uptake in daily deals that occurred over the past 4-5 years resulted from a global decline in real disposable income. As personal income levels stabilize, industry demand will diminish. This will reduce the size of the industry and limit Groupon's potential revenue growth in coming years.

Legal Dispute

Adding to Groupon's problems is the legal dispute it faces towards the end of this year. Blue Calypso, Inc. is a company that specializes in social media marketing. To date the company has filed three suits against Groupon suggesting it is infringing upon a number of patents.

The patents in question protect the use of computer based technology to facilitate advertisers' targeting of consumers based on geographical location. In addition, they protect the provision of promotional content to consumers intended for referral to others via mobile communication devices.

Targeting consumers based on personalized criteria such as geographical location, and the peer-to-peer promotion of content, is Groupon's core business. Earlier this year the company announced an updated search system, which enables users to find deals based on location, and is basing a large portion of its growth estimates on expansion of its mobile operations. This suggests that the ruling will affect a substantial amount of Groupon's current, and future, operations.

The scheduled venue for the hearings is East Texas. The East Texas District is popular amongst patent dispute plaintiffs because of the historic reluctance of its judges to rule at summary hearings. An out-of-court settlement serves to mitigate the risk of harsh jury judgment, and as a result is often the outcome of such disputes. Settlement could include both compensatory payment to Blue Calypso, and licensing agreements to avoid further infringement. A number of similar cases brought against Groupon concluded in this manner in the past couple of years.

If subject to expensive licensing agreements, Groupon will require increased operational efficiency to generate any retainable earnings in the future.

Customer value

Another problem Groupon faces is the value that its core business offers to its customers. Repeat business is crucial to long term growth, but many of Groupon's customers use the company on a one-off basis and then discontinue the associated promotion. In addition to this, many companies cannot afford to offer their products or services at a discounted rate for extended periods of time. This makes it difficult for Groupon to secure long term deals with its clients.

Without repeat custom or long term deals Groupon's growth potential is reliant upon its ability to attract new business at scale. This again puts pressure on operational expense, and will make it difficult for the company to generate retainable earnings in the future.

Conclusion

A number of factors suggest the rise in Groupon's share price could be coming to an end. The company's core business may be sustainable at its current level, but legal costs, retention problems, and industry contraction all limit Groupon's growth potential. This, in turn, limits any further upside to its share price.

Source: Why Groupon Might Struggle To Justify Any Further Increase In Its Share Price