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Groupon (NASDAQ:GRPN)

Q2 2014 Results Earnings Conference Call

August 5, 2014, 5:00 p.m. ET

Executives

Genny Konz –Investor Relations

Eric Lefkofsky – Chief Executive Officer and Director

Jason Child – Chief Financial Officer

Analysts

Heath Terry - Goldman Sachs

Mark Mahaney - RBC Capital Markets

Paul Bieber - Bank of America

Douglas Anmuth - JPMorgan

Ross Sandler - Deutsche Bank

Brian Fitzgerald - Jefferies

Arvind Bhatia - Sterne Agee

Ken Sena - Evercore

Operator

Good day everyone, and welcome to Groupon’s second quarter 2014 financial results conference call. [Operator instructions.] For opening remarks, I would like to turn the call over to the VP of FP&A and investor relations, Genny Konz. Please go ahead.

Genny Konz

Hello, and welcome to our second quarter 2014 financial results conference call. On the call today are Eric Lefkofsky, CEO; and Jason Child, CFO. Kal Raman will be available for questions during the Q&A portion of the call.

The following discussion and responses to your questions reflect management’s views as of today, August 5, 2014, 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 our Form 10-Q.

Groupon encourages investors to use its Investor Relations website as a way of easily finding information about the company. Groupon promptly makes available on this website, free of charge reports that the company files or furnishes with the SEC, corporate governance information, and select press releases and social media postings.

Our results for the second quarter reflect the acquisitions of TMON and Ideeli since their respective dates of close in January. We will, at times, discuss performance including and excluding the impact of the acquisitions for comparison purposes. Additional detail regarding the contribution of each to the quarter will be included in our 10-Q.

On the call today, we will also discuss the following non-GAAP financial measures: adjusted EBITDA, non-GAAP earnings per share, and free cash flow, as well as FX-neutral results. 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 2013.

Now, I will turn the call over to Eric.

Eric Lefkofsky

Thanks, Genny. We made good progress in the second quarter. Our local marketplace of over 240,000 deals continued to gain broader awareness. We reached another all-time high in mobile transactions, as nearly 92 million people have now downloaded our app, and our international business continued to stabilize and is now contributing nicely to our bottom line.

Q2 was another record quarter for Groupon. Gross billings increased 29% to $1.82 billion, and revenue increased 23% to $752 million. Adjusted EBITDA came in toward the high end of our range at $59 million, up from $40 million last quarter, and non-GAAP EPS was in line with our expectations at $0.01.

Demand remains healthy in North America. Billings grew 12% to $799 million, led by a 26% year over year growth in our goods business and 44% growth in travel. North American revenues also increased 12% to $424 million. Gross profit was about flat sequentially at $180 million, and segment operating income was $15 million, up from $11 million in Q1.

EMEA billings were about flat with the prior year, at $483 million, also reflecting strength in goods, which grew 14% year over year. Revenue growth was 42%, as the mix of direct revenue was higher in the quarter. In addition, we generated $28 million in segment operating income, up from $19 million in Q1, as a result of marketing reductions.

After much work, EMEA has now seen two quarters in a row of year over year customer growth after a few quarters of decline, and remains profitable and on stable footing. Rest of world grew 145% in billings largely driven by the acquisition of TMON.

Excluding our Korean business, rest of world grew 17% on an FX-neutral basis. Revenues grew 40%. The large difference between billings growth and revenue is related to TMON’s deal margins, which have historically been in the low teens, as are typical for large Korean ecommerce companies.

The rest of the world segment operating loss was $18 million for the quarter, reflecting continued investments, largely in TMON. While these investments are larger than we originally anticipated, they have driven significant growth that has, and continues to exceed, our expectations. Excluding TMON, our losses improved by about $5 million year over year, which is on track with our plan to generate positive segment operating income by Q4.

In light of the good progress we’ve made in rest of world, Kal Raman is transitioning from COO of CEO of APAC, so that he can focus all of his energy on continuing to unlock value in our high-growth Asian markets. I want to thank Kal for all the great work he has done building our infrastructure as COO. He has built a strong team that positions us for success going forward. Kal will continue to report to me in his new role.

Recall that for 2014, we have three primary objectives. The first is to reaccelerate our local growth in North America and abroad. Second is to improve the gross margins and operating efficiency of our goods business. And third is to continue to achieve stability in our international operations and reduce our losses in rest of world so that every region in which we operate is generating positive segment operating income by year-end, excluding any impact from acquisitions. We continue to believe we’re on course to achieve all three objectives by the end of 2014.

Let me start with the first. Our North American local billings growth reaccelerated in Q2, albeit only slightly, after two quarters in a row of deceleration, from an increase of 1.4% last quarter to 1.8% this quarter. We believe one of the main drivers of this is that redemptions have appeared to stabilize.

The average number of unused Groupons per customer, which is a good indicator of people’s willingness to buy more, has declined by more than 25% in the past year. That number has now been stable for the majority of 2014, which leads us to believe that we’ve seen the bottom.

As redemptions stabilize and other improvements we’ve put in place take hold, we expect local growth to continue to accelerate. The acceleration of our local business continued to grow robustly in July, which we believe is another sign that we’re on track to deliver double digit year over year billings growth in North America local by year-end.

That said, our take rates in North America local decreased by roughly 300 basis points compared to last quarter, predominantly driven by an increased proportion of sales for high-quality, lower take rate merchants in the quarter. In addition, we’ve increased site-wide sales and order discounts over the past few quarters in an effort to drive adoption of our marketplace.

Until now, we’ve absorbed the impact of these discounts ourselves. Going forward, we intend to pass on a portion of these promotional discounts to our merchants. As these efforts unfold, we believe that take rates in local will improve and remain within the range we’ve seen over the last couple of years going forward.

Our second priority is to improve our goods margins, particularly in North America. Our costs have historically been almost 2x that of other comparable ecommerce companies. To address this, we’ve made some significant changes, including shifting more of our business to drop ship, moving more fulfillment to our own distribution center in Kentucky, and increasing units per order.

We’re pleased with the progress we’ve made to date, with gross margins in North America increasing over 400 basis points quarter over quarter, from 5% in Q1 to 9% in Q2, and we believe we’re well on track to achieve our goal of double digit gross margins in North America by year-end.

Our third priority is to continue to improve our international operations and reduce our losses in rest of world. We made significant progress in the quarter, reducing our total segment operating loss from $25 million in Q1 to $18 million this quarter.

As we continue our regionalization efforts, and as APAC growth gains momentum, we expect continued improvement in Q3. Given our progress to date, we expect to generate positive segment operating income by Q4, excluding TMON.

As we shared last quarter, we define long term success as both gross billings and gross profit growing at least 20% annually over the next five years. We’re focused on the operating objectives I’ve highlighted, because we believe they are the purest drivers of gross profit dollar growth over the long term.

We also advanced our strategic objectives in the quarter. First, mobile. Mobile remains over half our business worldwide. Mobile mix as measured by transactions continued to increase in Q2, reaching yet another all-time high. As we said last quarter, we are no longer becoming a predominantly mobile business, we now are a predominantly mobile business.

Nearly 92 million people have now downloaded our app, and by most reports, we are now the most mobile large-scale ecommerce company in the world. Yet activations remain behind web, so while people are engaging with Groupon through their mobile devices, we have yet to optimize the customer experience. Each quarter, we make progress, and we’re inching our way closer to parity over time.

Second, local. Local and mobile are converging. Local is all about geography, and mobile is all about proximity. Both are intertwined, which is why our mobile business has grown so fast. That said, we have yet to truly deliver on the vision of Groupon, the vision of a world where all merchants and consumers are connected in real time, through a network that allows every merchant to attract the very best customers and allows every customer to find the very best deals.

What we’ve learned over the past year is that in order to win, we need Groupon to become an integral part of our customers’ lives, a daily habit. To achieve that, we need to make the experience of buying and redeeming a Groupon as easy as pulling out your credit card or buying an app on your phone.

When people use their Groupons, they buy more. When they don’t, they buy less. To close the loop and get more people using their Groupons, we need to connect merchants to our customers in real time, making the Groupon experience seamless, frictionless, and fun.

After years of work and significant investment, the tools we’ve built to close this loop are starting to hit the market with the rollout of our local commerce platform, which I’ll discuss in a minute.

Third, marketplace. When we began, our reps only had one product to sell, a daily deal email featuring one business at a time in a given city. When we built the first version of our marketplace, we needed a new product that would allow merchants to be on Groupon more regularly, so we created an inventory system allowing merchants to reduce the number of units sold on the first day and instead sell a designated number of units every month.

Today, over 75% of our North American merchants opt to be in our marketplace on an ongoing basis. Recently, we enhanced our product, allowing merchants the ability to offer deals that vary, based on both time of day and day of week, which allows us to attract a whole new range of merchants that historically couldn’t work with Groupon, because they have times when they’re just too busy to take on more customers.

They can now block those times off, or reduce the discount rate to more tightly control the flow of customers that Groupon delivers. But even with these enhancements, we still only offer a little over 105,000 deals in North America, out of a pool of nearly 7 million targeted merchants. Even with all of our effort, our marketplace is still only covering a small slice of the market.

But what if virtually every local business had a presence on Groupon? What if this was a customizable, and more importantly, transactable space where merchants could not only put up deals on our site, but also post their specials directly to our customers? And what if customers could search these sites and find a wealth of other relevant information including tips and reviews in addition to amazing deals, offers and specials?

As our marketplaces evolve, we’ve come to realize that despite the gains we’ve made, and continue to make in expanding our supply, having less than 5% of the available merchants on our platform is insufficient. We need a solution for the other 95% of merchants that don’t work with us today.

To address this, we’re launching two new products, Pages and Genome, that together, enhance our local offerings and allow us to connect the last mile of local commerce. Pages create a web and mobile presence for every local merchant, filled with useful information for our users, including contact information, maps, time of service, recommendations, tips, and most importantly, a wider variety of discounts. We’ve already built pages for millions of merchants in North America, and expect to begin rolling them out in the coming quarters.

Genome is our new operating system for merchants, whether they’re running a deal or just looking to claim their merchant page. We believe Genome bridges a critical gap for us, putting us right inside our merchants. Wrapped inside an iPad Mini with a credit card swiper, Genome offers merchants seamless redemption, enabling customers to redeem their Groupons without ever taking their phone out of their pocket.

It also offers a digital cash register that vastly improves workflows, a lightweight and elegant point of sale system that captures item-level detail, and full payment processing at some of the best rates in the market. In addition, customers can leave tips and reviews right on Genome. We’ve now deployed Genome in over 75 cities in North America and expect to continue the rollout throughout the rest of this year.

When you combine Genome with the nearly 92 million people that have downloaded our apps, you can begin to see the foundation of a true local commerce network unfold, a network where users and merchants are continuously connected, allowing consumers to explore the world around them and save money while they’re at it, and allowing merchants to offer real-time discounts and incentives to get the right customers coming in their doors at the right times.

While these new products are ramping up, we’ll continue to build additional supply and demand to accelerate adoption of our marketplace. Searchers accounted for 10% of our overall traffic in North America in June, with customers who searched continuing to spend materially more than those that did not.

Our marketplace is doing well, but with Pages and Genome, we believe we can take it to an entirely new level. Overall, we’re pleased with the progress we’ve made across all of our initiatives this quarter. We remain focused on execution, both in North America and in our international markets via our One Playbook initiative that is entering its most exciting stage through the final unification of our American and European technology stack.

With that, I’ll now turn the call over to Jason to discuss our financial progress in the quarter.

Jason Child

Thanks, Eric. With the details available in this afternoon’s press release, I’m going to run through the highlights of our performance and then provide our outlook. Note that all comparisons, unless otherwise stated, refer to year over year growth.

Let me run you through the numbers. Gross billings increased 29% to $1.82 billion. North America grew 12%, EMEA was about flat, and rest of world increased 145%. As Eric mentioned, TMON has and continues to run well ahead of the expectations we had at the time of the acquisition, contributing $317 million to billings in the quarter.

Excluding TMON and FX, and further taking the exit of Groupon’s legacy Korea business into consideration, we were pleased to see rest of world growth for the second quarter in a row increasing 17%.

Revenue increased 23% to $752 million. North America grew 12%, EMEA grew 42%, and rest of world grew 40%, lower than the 145% billings growth as a result of the substantial addition of lower margin TMON billings to the mix.

Gross profit was $390 million in the quarter, compared to $385 million last year. Gross profit growth lagged billings growth due to a greater mix of direct revenues. North America in particular was also impacted by continued investments in quality as well as order discounts to drive awareness of our pull marketplace. Given our focus on growing gross profit dollars, we were pleased to see the slight increase quarter over quarter, even in light of these investments.

Adjusted EBITDA was $59 million in the quarter, down $21 million compared to last year, primarily due to an approximately $30 million increase in SG&A related to TMON and Ideeli. Note that we also had a $26 million increase in marketing and order discounts to drive awareness for pull.

As you think about the relative profitability of our segments, it’s important to keep in mind that the North America segment reflects almost all of our technology costs, so as we’ve invested heavily in global product and technology over the past year, it has had a short term impact on North America’s profitability.

GAAP loss per share was $0.03. Excluding stock compensation, amortization of acquired intangible assets and acquisition-related costs, all net of tax, non-GAAP earnings per share was $0.01.

Free cash flow was negative $54 million for the quarter, resulting in a trailing 12 month free cash flow of $41 million. Free cash flow in the quarter was impacted by payment timing as well as a few key strategic investments including the shutdown of Groupon Korea. We expect free cash flow to pick up materially in the back half of the year as it did in 2013.

As of June 30, we had $868 million in cash and cash equivalents after spending $106 million in connection with our share repurchase program. Including the 17.2 million shares repurchased in the quarter, we repurchased a total of 24.7 million class A common shares under our existing authorization for an aggregate purchase price of $182 million.

Approximately $118 million remains available under our existing repurchase authorization, which will expire in August 2015. The timing and amount of any repurchases will continue to be determined based on market conditions share price, and other factors.

Trying to a couple of notable highlights of our nonfinancial metrics, active customers reached 53.2 million worldwide for the quarter. Customer growth accelerated for the second quarter in a row, and excluding acquisitions, was the strongest growth we’ve seen in the year. Notably, EMEA customers increased year over year for the second sequential quarter.

Customer spend, as measured by trailing 12-month billings per average active customer, was $137 compared to $132 last quarter, driven by the addition of TMON.

Moving on to our categories, local gross billings increased 6% to $859 million , with continued growth in customers, units, and active deals. EMEA declined 6%, and North America increased 1.8%, a slight increase over Q1.

Rest of world grew 48%, driven by TMON. Local gross profit decreased 8% to $169 million, with billings growth and lower cost of revenue more than offset by take rate declines. The reduced take rates reflect an increased proportion of sales for high-quality merchants and the impact of order discounts as we focus on marketplace adoption in North America, as well as the increased mix of lower margin TMON revenues.

Before I move away from local, I want to touch on EMEA, where local billings declined 6%. While in North America, the overall profitability of local is higher than that of goods, the economic health of these businesses in EMEA is more similar, given that our goods gross margin in EMEA is roughly double North America’s. As a result, we’re more agnostic on category mix in EMEA, but we do expect local billings to return to stronger growth by year-end.

Goods gross billings increased 65% to $720 million, with all segments contributing to the growth, even after excluding the impact of acquisitions. Goods gross margins were 11.5% globally, reflecting a greater mix of direct and lower margin TMON revenues, most of which are recognized on a third-party or net basis.

Direct margins increased 100 basis points year over year to 12.2%. With nearly half of our goods billings now direct, the dollars in aggregate continued to move in the right direction, and as Eric mentioned, with continued focus on the reduction of shipping and fulfilment costs, we expect to see continued improvement in gross margins this year.

Finally, travel gross billings increased 44% to $240 million, with North America growth accelerating to 44% in the quarter.

Before I close, let me provide some additional color on a few specific items. Marketing expense was $64 million in the quarter. In addition, we invested over $24 million in order discounts, taking our net investment up to $88 million, a $26 million increase compared to a year ago.

We invest marketing dollars in a variety of ways. We spend money to acquire subscribers and app downloads, which tend to have longer term payback horizons. We invest money in order discounts, which drive billings growth and awareness, but obviously come at the expense of margins. And we invest money in transactional advertising, such as search and display, which has a shorter-term payback than acquiring a subscriber, but still can extend out several quarters.

It’s in this last category that we’re just beginning to make real progress and see some improvements in ROI. As our efficiency of spend continues to rise, we are likely to continue to invest heavily in this area throughout the balance of the year. Together, we believe these investments will produce long term benefits.

Secondly, we’ve entered into a three-year, $250 million revolving credit facility. While we have no immediate plans to draw on the line, we believe this will provide us with additional balance sheet flexibility going forward.

Finally, turning to our outlook, for the third quarter of 2014, we expect revenue of between $720 million and $770 million; adjusted EBITDA between $50 million and $70 million; and non-GAAP EPS, excluding stock compensation, amortization of acquired intangibles, and acquisition-related costs, net of tax, of between $0.00 and $0.02.

As it relates to the full year, we are revising our outlook and now expect adjusted EBITDA to exceed $270 million, as opposed to $300 million. Although we continue to have the opportunity to reduce our marketing investments, including in TMON, over the remainder of the year to achieve a target in the $300 million range, we don’t believe that this reduction makes sense based on the ROI of our recent investments and their potential impact on 2015.

As always, our results are inherently unpredictable and may be materially affected by many factors, including the high level of uncertainty surrounding the global economy and consumer spending, as well as exchange rate fluctuation.

With that, I’ll turn the call back to Eric.

Eric Lefkofsky

Thanks, Jason. We believe Groupon has an opportunity to become the starting point for local commerce. We’ve now built the foundation for Groupon to become a true platform. As we approach our sixth birthday in November, we believe we have an opportunity to connect the last mile of local commerce in ways that were never before imagined.

With the deployment of Genome, we intend to provide our merchants with a suite of tools that connect them to our community of over 200 million subscribers, nearly 92 million app downloads, and over 53 million active customers. Merchants will finally have technology that allows them to manage the inflow of customers, and customers will finally be able to explore the world around them and save money while they’re at it. And we believe this all will happen seamlessly, anytime, anywhere, with the phones in their pockets and the tablets on their counters.

Our local mobile and marketplace investments together with Genome represent the culmination of years of hard work and significant investment, which we believe firmly positions us to realize our vision of connecting local commerce.

With that, let’s take some questions.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from Heath Terry from Goldman Sachs.

Heath Terry - Goldman Sachs

Do you have a sense of, [unintelligible] the early adopters for Genome, whether it’s being used to replace existing payment systems completely? Or is it at least just now being used primarily as a system for redeeming Groupons? And then secondly, how do you think of the strategy for reaccelerating North American growth? Do you believe that the improving economy is leading to a less promotional local ecommerce environment that’s limiting the number or type of merchants that are willing to use Groupon? Or is this something that can be fixed through the strategy that you’re putting in place?

Eric Lefkofsky

Let me start with the Genome. First and foremost, Genome is our operating system for local merchants, and it certainly serves as a redemption device. I mean, it’s actually a beautiful redemption device. Customers can walk in and basically redeem their Groupon seamlessly, frictionlessly, without even pulling their phone out of their pocket.

And it’s also being used by a meaningful percentage of our merchants as a payment device, because we offer some of the best payment rates in the market. We don’t quote what percent that is, but it is certainly a significant percentage of people who are trying us for payments and we’re excited about that.

It’s also being used by many people as a point of sale device, because roughly 60% of our merchants don’t have a point of sale device. And they’re longing for this kind of item-level detail so they can figure out how to attract more customers and how to maximize the yield.

So you know, Genome is rolling out. It’s in about 75 markets today. And you know, our long term goal is to get every merchant that we work with, and certainly every merchant that we contact, to take a Genome device. So I would say we’re excited about the payment prospects, but it’s still early days to kind of quote exact statistics.

As it relates to local growth, we’re very focused on executing kind of both parts of our local growth strategy in North America. One is obviously getting our pull business right, and the other is getting our push business right. Our push business, which is all about sending better emails and attracting higher-quality merchants, we’ve made some great strides. And in our pull business, which is our marketplace, we continue to see that business move up and to the right. You know, it was about 8% of transactions a few quarters ago, and then 9%, and now 10%. The adoption hasn’t been as strong as we would like, but it is making great progress.

And we’re excited that after two quarters in a row of our local business decelerating, this quarter we actually saw that trend reverse, and the local business began to grow again in North America, albeit slightly, from about 1.4% growth to 1.8%. A big part of that being the fact that unused Groupons and redemptions have now started to stabilize.

And most excitingly, I think, for us, we’ve seen some real acceleration in our local business in North America, in the later part of Q2 and then rolling into July. We’ve seen robust growth. So we feel like we’re very much on track in getting that business back on track and hitting the goal that we had stated, which is double-digit growth by year-end.

Operator

Our next question comes from Mark Mahaney from RBC Capital Markets.

Mark Mahaney - RBC Capital Markets

Eric, you talked about making improvements to the mobile product. Could you kind of draw those out a little bit? User interface improvements? Marketing improvements? What do you think you need to do to improve the mobile offering?

And then could you just clarify a little bit more, these recent returns on marketing investments, and I think you mean that the returns have been improving, but could you draw that out? Why have the returns on the marketing investments been improving? Is it better use of channels, less competitive pricing environment? If I interpreted that right, could you just draw that out a little bit?

Eric Lefkofsky

Let me first provide a little bit of context before I get into the mobile piece. Groupon is very much a business in transformation. Over the last year, we’ve invested a tremendous amount of time and energy into expanding just beyond a daily deal email business. We’ve been investing in building this mobile marketplace that people come to and search for deals.

And we’ve made some really amazing progress over the past year. Now, over 50% of our business is mobile worldwide. We’re, again, at an all-time high. 92 million people have downloaded our app, another all-time high.

And yet we have yet to really fundamentally shift consumer behavior. And I think there’s two parts of it. One is the actual inventory that’s in our marketplace. We still, despite the fact that we have 105,000 merchants offering deals in North America, are servicing less than 5% of our target market. And we need to service the other 95%. You know, if you went to search for something and only found an acceptable result 5% of the time, you would stop searching.

The second part is the user experience. It’s not beautiful and elegant yet, to really search among our deals and explore your local market. And in part, it’s because all of this is relatively new. We’ve only been in the marketplace business for the last year or two. And so we’re still trying to find a way to figure out that most optimal user experience.

Ideally, you want that nearby tab on the mobile to be intuitive. You want it to know what’s around you and almost be like 3D glasses that show you all the merchants that are nearby you, and who’s willing to offer a special or a deal to get you to come in.

And if you look at the strategy we’ve put in place by creating merchant pages, it’s all about getting that additional inventory onto the platform. It’s about finding a way to service not just 5% of the market but 95%, so that our customers get used to checking Groupon first, opening up the app, all day long. And that’s how you really create this local commerce platform or this local commerce network.

So that’s the mobile piece. In terms of marketing ROI, when you spend money on marketing, you’re principally trying to drive billings growth. And we just had two quarters in a row of record billings growth, a lot of $1.8 billion last quarter, $1.82 billion this quarter. And if you look at it on a year over year basis, including acquisitions, our additional marketing spend in marketing and order discounts was maybe $26 million. It lifted our billings by well over $140 million. So our spend is certainly delivering some of the results that we want.

But as always, when we spend money on marketing, even though the returns are exciting and are getting better all the time, it is, in the short term, dilutive to earnings, and over the long term, it’s obviously accretive. Because what most companies, like us, our marketing can tend to have a payback of three quarters or four quarters. It’s not all paying back intraquarter.

And so we feel like we’re in a good place in that we can double down on some of these marketing investments in light of the return we’re seeing, and not just focused on reducing marketing by $20 million or $30 million to hit one quarter, but really focused on how do we create that kind of double digit long term growth both of billings and gross profit, not just at the end of the year this year but really rolling into 2015.

Jason Child

Just to add a quick clarification, the marketing plus order discounts was up $26 million year on year, and that’s for both Groupon and our recently acquired companies. And the billings increase was about $400 million, and then revenue increase was about $140 million.

Operator

Our next question comes from Paul Bieber of Bank of America.

Paul Bieber - Bank of America

Can you provide some color on the adoption rate of the coupon business that you launched? And then secondly, last Q4 you were pretty promotional in the goods segment. What should we expect in terms of the goods gross margins as we head into the holiday season? [unintelligible] you said double digits, but should we expect the same level of promotional activity as last year?

Eric Lefkofsky

I’ll take the coupon piece, and Jason can take the goods margin piece. We launched the coupon business, for those that don’t know, called Freebies, and we launched it because we have this very large community, over 200 million subscribers, over 53 million customers, over 92 million people who have downloaded our app, and they’re constantly coming to our site looking for amazing things to do and things to discover.

And we’ve always had a very good relationship with large national retailers. Going back even five years ago, when we ran The Gap or Nordstrom or some of these real big deals that we ran, our customers find it exciting. To them, that national retailer is a national chain, but it’s in their local community. It’s a block down the street or whatever it is. We’ve always offered deals for those folks.

You know, we’re pleased that our Freebies business has really come out of the gate and is thriving. We have over 30,000 coupons on the site today, from over 6,500 stores, over 200 leading brands. So we really have kind of jumped into that market in a big way, and we’re thrilled with how it’s growing.

That being said, we have yet to provide details beyond that, other than to say it’s doing super and we’re thrilled at how that product has been adopted by our consumers.

Jason Child

And related to goods margins, if you go back to Q4, while we were somewhat promotional in terms of the total [landed] cost, in terms of free shipping, etc., we do expect to do that again. But the pure product margin was actually very solid. So pure product margin, which is basically just the cost of the product or what we sell it for, less the cost of the product, excluding any other costs.

So that’s been in the kind of 30-ish percent range, and it’s been stable, actually, going all the way back to middle of last year. So the issue that we saw in Q4 had much more to do with a much more intense peak demand than we had expected, which caused much higher shipping costs and even some refund costs when we hit our capacity much earlier in the holiday period than we wanted. So what we’re doing this year, to account for that, is just have a much more robust logistics and warehousing plan that will enable us to handle that peak.

And so as a result, you saw significant increase, 400 basis point increase, in margins, from Q1 to Q2. You should expect to see continued improvement and should expect to see us hit the double digit gross margin in direct goods in North America by Q4.

Operator

Our next question comes from Douglas Anmuth from JPMorgan.

Douglas Anmuth - JPMorgan

Eric, I was wondering if you could elaborate on merchant Pages a little bit? How much of the content will be consumer generated? How will they be marketed to users, how will they be monetized? And maybe you can talk a little bit about the volume of reviews you’re collecting today?

Eric Lefkofsky

Pages are essentially, for those that haven’t seen them, mini sites that live on Groupon on the web. If you want to see one, you could go to Google and type in “flying fish Groupon” or “flying fish Seattle.” It’s a restaurant in Seattle. Or you could go to Groupon and type it in our search box.

And you’d see a merchant page. These pages essentially allow merchants to access our large community of people looking to buy. And they have two primary purposes. One is merchants can put up the kind of information that consumers want to see. We have maps and content and terms of service and contact information.

We also allow our customers to leave tips. They can say, “Hey, this is the best burger in Seattle,” or “When you go to the restaurant, you ought to try this.” We have a very large community, and so we’ve been accumulating a significant number of reviews. And these pages have been highly interacted with by our consumers, and we expect that to only grow over time as we roll them out.

We’ve launched them in a few cities. We expect to launch them throughout the rest of the country over the next several quarters. But the bigger opportunity, besides the content, which I think is going to be amazing in light of how big and active our community is, is that these are places to transact.

So merchants can put up the kind of specials they put up on their chalkboard. They can put them up on their merchant page and all of a sudden there’s this huge community of people that can be enticed to come in, because the merchant is offering some kind of unique deal, even if the deal is not as large as one of our normal deals that we email or push out to people.

So it’s a huge opportunity. I mean, just in the time we’ve launched these pages, we’ve had tens of thousands of people that click the request a deal button. An enormous amount of people have left tips and the like. And so we think these are really going to add to our marketplace and help round it out.

Operator

Our next question comes from Ross Sandler with Deutsche Bank.

Ross Sandler - Deutsche Bank

Eric, we’ve recently seen Open Table, [unintelligible], [unintelligible], and a number of other players in the local enabler space be acquisitions. Just wondering if the market doesn’t appreciate the potential at Groupon, would you consider alternatives? And for Jason, your guidance assumes around $115 million of EBITDA in Q4, which is double the Q3 level. So what’s giving you the confidence in that EBITDA guide?

Eric Lefkofsky

Let me start with the first, and then maybe Jason and I can both jump onto the second. So the first is, our heads are down, we’re focused on Groupon. We have an enormous amount of work yet to do here. That being said, if you guys are offering to buy the company, we’re happy to entertain anything. We don’t think about that kind of stuff. We think heads down, run the business well, and we don’t tend to spend a lot of time speculating about people who might knock on our door.

In terms of guidance, look, we feel confident, I’ll let Jason weigh in in a second. We obviously feel confident. Maybe I’ll speak to some of the macro drivers and he can speak to the specifics. Last quarter, we laid out three operating objectives. The first is we wanted to have our rest of world losses go down, we wanted to have our goods margins go up, and we wanted our local business to reaccelerate.

And we made great progress on two of those. Obviously, rest of world losses improved dramatically in Q2. Goods margins are up 400 basis points. And our local business, which had decelerated for two quarters in a row, has kind of turned the corner, and we’ve seen really strong growth over the last few months, especially into July.

So we feel like we’re executing as well as we can in light of the fact that we’ve got a business in transformation. But all the leading indicators we see lead us to believe that we’re doing the right things by continuing to make these investments, and it’s going to pay the dividends we want. You know, active customer growth, spend per customer, units, traffic, all that stuff, moving in the right direction.

Jason Child

In terms of how the numbers work, that’s why we gave the forward views on some of the key financial drivers of the business for Q4. And that is, if you model local growing at double digit rates in North America by Q4, and at the current take rate range, which over the last three quarters, has been somewhere between 35% to 38%, in that range, with that growth, you’re going to see pretty significant flow through on local.

You’ll see in all categories, but especially in goods, and you actually apply a double digit margin to that, unlike the 7% or so that we saw in direct in Q4 last year, and you take the improvements that we see in EMEA as well, where they actually hit nearly 20% double digits in the most recent quarter, you will also pretty significant flow through there.

And then lastly, when you take the rest of world business, that lost $24 million or so back in Q1, and then now it’s reduced to about $18 million, and then flow that now down to breakeven, actually by year-end, that’s also a pretty significant contributor as well. So the three of those combined are the things that give us confidence that the guidance range we have is reasonable.

Operator

Our next question comes from Brian Fitzgerald of Jefferies.

Brian Fitzgerald - Jefferies

You just reported very nice gross margin improvement for goods. My question is, do you think you already have the fulfilment infrastructure to service this business efficiently? Or is there need for more investment?

Eric Lefkofsky

I’ll maybe say a word and then have Kal say a word as well, because obviously he’s been knee-deep in that for the past several years. But we’ve made significant investment. We recently opened up our own distribution center, I think in Q4 of last year. And the team has made a significant number of investments that give us confidence that we have the kind of capacity we need going into the holiday season, along with a network of [three PLs] that we have in place, to be able to handle the volume.

And this has been a maturing process for us. I’ll thank Kal for doing an amazing job, and the team that we built underneath Kal that can carry on that work going forward. They’ve really done an amazing job. If you look at 400 basis points of improvement just in the last quarter, you can start to get some idea of us really getting our hands around this business and making sure that we’re doing the basic blocking and tackling well.

Kal Raman

Thanks, Eric. Like Jason said, pure product margins have been pretty stable. And the vacillation we had in gross margin is driven by warehousing and fulfilment costs, which was twice what normal ecommerce players spend. And we have been diligently working on fixing our warehousing and fulfilment costs by putting them through our facility where we have got reduced cost of operation. And we are also shifting, in a very sensible way, a bunch of our inventory to drop shippers.

And we are doing all that without hurting our customer experience. It’s about doing those things diligent way, in [unintelligible] again and again. And we have already seen 9%. We feel very comfortable that we’ll get double digits, but by focusing on the basics, you know, one transaction, one order at a time, in the way we have done so far.

Operator

Our next question comes from Arvind Bhatia of Sterne Agee.

Arvind Bhatia - Sterne Agee

Eric, you talked about the three goals again for the fourth quarter, and I also heard you talk about 2015, in general, as a growth year. But can you talk to the next year, and relative to these three goals, do you see a continuation of these trends? Or do we see seasonality? How should we think about the overall goals for 2015?

And then perhaps longer term, how are you viewing your long term margin goals, long term billings targets, say over the next two to three years? And then last question is on competition. Maybe if you could address what you might be seeing in the marketplace today?

Eric Lefkofsky

Let me start with the three goals. These are very big goals that we put in place a quarter ago, and I think looking at the numbers a quarter ago, I think a great many people thought we would have a very hard time achieving them by year-end.

We’re reducing our losses in rest of world to basically zero, getting our goods margin, which had been hovering around 5%, to double digits, and most importantly, improving our local growth, which has been hovering around 1-2% to double-digit growth by year-end in billings, was, I think, lofty.

We felt confident that we had been doing a bunch of work behind the scenes that had not really translated into the external results you see, and that we could achieve all three of those. We’ve made some significant progress on two of the three, and we expect that by next quarter we make even more progress.

And so at the end of the day, we feel very good. And once these things are in place, once you have appropriate goods margins, once you have every reason, which we operate, making money, once you have a local business that’s growing at healthy rates again, and we’d like to see that low double-digit work its way to 20% plus over time. And so once those things are happening, the business will generate some great leverage, we believe.

So that’s what we’re focused on. We’re not here to provide 2015 guidance at this time. We’re only here to say that these fundamentals, these ABCs, are in place, and we’re making good progress, and if we achieve the goals we set out, we’ll set ourselves up for even greater growth in 2015.

In terms of competition, then I’ll let Jason handle the margin question, we are a business in transformation. This is a market in transformation. The daily deal email business exploded five years ago. It was cloned by almost every major technology company in the world, and we have fared well against that group over the last several years as we’ve been gaining market share and other people have been exiting the business or have not had those same gains.

In large part, it’s because we got very focused on mobile, we got very focused on building a marketplace, we got very focused on creating a solution that would appeal to people that are basically consuming on the internet in a different way. And our main focus today is to go even beyond that. We’ve made huge strides in mobile and huge strides in building a marketplace, and now we’re trying to go one step further and actually connect and build a platform, and really get not just 100,000 merchants, but hopefully one day a million merchants or 2 million merchants or more, that are connected to Groupon all the time.

And so in that journey, we’re a pioneer. We don’t really have a direct competitor, and so we don’t spend a lot of time thinking about the competitive landscape.

Jason Child

And in terms of the long term targets, we have not changed our long term targets - and that is on a billings basis, because of the composition of direct and third-party, I think it’s best to look at it on a billings basis - we think the long term CSOI margin targets are actually about 8% to 12% for the local business and high single-digits for the goods business. If you want to convert that to an EBITDA basis, you would just add about 200 basis points to that number, if you exclude D&A as well.

In terms of time bounding, we haven’t said when we think we’ll hit those long term targets. It’s somewhere probably beyond next year, though.

Arvind Bhatia - Sterne Agee

Can you speak to maybe the top line level that you would need to achieve to get those kind of margin levels?

Jason Child

No, the problem is that, like you see with other ecommerce companies, it depends on what your confluence of investments versus mature business is. And so it’s very hard to do.

Eric Lefkofsky

What I will say is that we are very focused on growing billings, and we are very focused on growing gross profit dollars. These are the things that we are very focused on, and we have said we want both of those growing at 20% plus. An we’re going to work tirelessly until we get there.

You know, if you look at Q2, we invested in margins, we invested in basically kind of getting quality merchants on the platform and putting up some site-wide sales to drive awareness to our pull marketplace. So we make investments from time to time, and as Jason mentioned, we’re going to continue to do that. But we’re very focused on getting billings to where we want to get it to, and having the gross profit dollars that flow from that business going up into the right materially on a quarter over quarter basis.

It’s a huge category. We’re in a trillion dollar worldwide market, multi-trillion dollar worldwide market, and we are focused on getting it right.

Operator

Our final question for the session comes from Ken Sena from Evercore.

Ken Sena - Evercore

On the Genome and Pages, you have some major competitors there, and I know that many of them are offering POS and info listing on local businesses, and even deals. Can you maybe speak to your differentiation there? And is it purely through deals? You mentioned reviews and tips, but how confident are you that reviews on a deals site won’t end up being problematic?

Eric Lefkofsky

The first thing I’d say is, look, if you think about Groupon’s core competitive advantage, it’s the sheer volume of transactions occurring on our platform. We just did $1.8 billion last quarter. We probably sent 50 million plus people to local merchants to actually buy stuff. We are, for many merchants, their largest source of new customer acquisition by miles.

And so that’s the market in which we play. It’s a local transactional market. It’s local commerce. And yes, there are people who offer POS systems, and there are people who have review sites, but that’s not our primary competitive landscape. Our competitive landscape is basically driving commerce inside those local merchants. And obviously, in that, we are, by far, the leader.

And then I think it’s going to be our sustainable advantage, which is also why we don’t think about Pages a review site. The informational aspects of a page are simply there to make our users have a better experience. They’re there to leave tips and other comments that our users can find helpful as they’re looking to make a purchase.

That’s basically what we want to drive. We want merchants using our platform to optimize yield. We want them using our platform to get the right customers coming in their door at the right times. And again, in that space, we just don’t have competitors of our size and scope today.

Ken Sena - Evercore

And on the reviews?

Eric Lefkofsky

On the reviews, again, the way we think about it, we think more about consumers leaving tips than we do think about building a review product to compete with other review products in the marketplace. We’re not here to kind of create a giant review site. That’s not our primary purpose.

Our primary purpose is to create transactional pages where consumers can find amazing deals and kind of decide where to go, plan their day, make last-minute decisions based upon which merchants can entice them to come in.

Because obviously, the additional cost per merchant that’s empty that hour or has people sitting around, or has food that they’re not going to cook is very low. And so getting yield right in local commerce is a big deal. That’s what these pages are focused on. So the fact that we are collecting a significant amount of reviews and tips on these pages is something we’ll manage carefully, because that’s not our focus.

Our focus is not to kind of create this open platform where people are leaving negative reviews and somehow causing us any harm. Our purpose in life is to create a transactional space where consumers can find amazing things to buy and discover around them and access our merchant community that way.

Operator

Thank you. Ladies and gentlemen, that does conclude our program for today. Thank you for your participation, and have a wonderful day.

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Source: Groupon's (GRPN) CEO Eric Lefkofsky on Q2 2014 Results - Earnings Call Transcript
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