Is Groupon an Overvalued One-Trick Pony?

| About: Groupon, Inc. (GRPN)

The moment Groupon goes public later this year, it becomes a takeover target -- it can't happen too soon, given the latest turn of events. The daily deal wonder has effectively created a booming industry from scratch at a time when financially withering consumers are showing renewed reluctance to spend.

While Groupon scrambles to innovate ahead of the pack and explain its creative accounting to prospective IPO investors, the biggest risk to its sustainability is the uncertain economy. What good are deals without buyers?

Even as it plans to go public in a deal that could raise as much as $3 billion, giving it nearly a $30 billion valuation (more than what Google's IPO was worth in 2004, according to Bloomberg), Groupon fever is being dampened by sobering facts.

Groupon's success depends on consumer discretionary spending. Although global Internet traffic is expected to quadruple by 2015 to nearly 3 billion people, or 40% of projected population according to Cisco (per Mashable), not everyone will be wildly spending online. Among the many alarming deteriorating statistics is a sharply widening gap between consumer discretionary spending and consumer staples.

Put another way, the continued decline in household debt (steadily contracting since early 2008) indicates that consumers -- including the nation's 24 million underemployed and unemployed -- are struggling to pay off debt and save rather than spend to fuel economic growth.

An eye-opening report by Bernstein Research analyst Craig Moffett, based on proprietary research, puts a fine point on such troubling economic trends. They have serious implications for media, cable and other related companies he tracks -- and most certainly for Groupon.

The bottom 40% of U.S. households has already exhausted all of their disposable income, leaving nothing for discretionary cable, phone, clothing and debt service. While retailers and advertisers in general can play to the top 20% households (who account for 40% of retail spending), companies relying on universal economic support in highly competitive markets are headed for rough times.

Groupon's typical age 18-to-34, female user (as defined by eMarketer) is hardly insulated, given that the U.S. youth unemployment rate stands at more than 18%, or double the overall rate.

The current trending toward a second recessionary dip could see merchants avoiding subsequent deals and consumers unwilling to return to the deal well, except for the most relevant and justifiable reasons. Experts say there are signs that consumers suffering from deal fatigue are becoming more selective, and that only merchants with perishable inventories and a large fixed cost base are willing to engage in deep discounts. Increasingly, merchants prefer to more tightly control deals in their own space, on their own sites and apps.

Some of this reality was reflected in Groupon's first quarter numbers. Revenue per Groupon deal fell 8.7% to $22.95 last quarter, compared to the prior year period. The number of Groupon deals per merchant declined 21% to $612 from the year-earlier period. Although Groupon reported $645 million in first quarter revenues, up 1457% from the previous year, its overall operating metrics are trending downward. Groupon's gross profits fell to 42% last quarter from 45.2% the first quarter of 2009, according to Wedbush Securities Internet analyst Lou Kerner.

While LivingSocial is the only real close competitor, daily deals are destined to develop into more of a long tail endeavor that can be whittled away by companies of all size playing to their own loyal customer base and specialized needs.

The daily deal space has been embraced by vertical deal sites (OpenTable), publishers like Daily Candy and The New York Times, consumer services (Gilt Groupe, TravelZoo (NASDAQ:TZOO), CityPockets, Lifesta) and aggregators such as Yipit. There is an active subset of exchanges that transfer daily deals from merchants to sales forces and publishers, and so-called white label providers focused on publishers with access to select consumers.

Groupon is answering the onslaught by accelerating its acquisition and consolidation of smaller deal providers. It's aggressively marketing past the $263.2 million it spent in 2010 on online advertising and subscriber e-mails, compared with just $4.5 million the year before.

Despite efforts to expand internationally, grab more real-time business with its new Groupon Now app, and move into new loyalty card memberships (to compete more directly with Foursquare), Groupon eventually may need to sell out to a dominant, broad-based player to remain relevant in a rapidly changing new market sector,

Acquirers could include online retailer Amazon (NASDAQ:AMZN), which just launched the members-only MyHabit deal-maker for designer duds, social media monster Facebook or advertising-based search giant Google (NASDAQ:GOOG), which offered a measly $6 billion to acquire the Chicago-based company earlier this year).

As Groupon's asking price swells, its market share is squeezed and constituents retreat in a slowing economy, leading players will seek less costly, organic ways to scale daily deals.

The deal darling's vulnerability to deteriorating economics is being overlooked by the media in favor of more sexy issues, such as the apparent cashing out of key Groupon executives, including its largest shareholder and co-founding chairman, Eric P. Lefkofsky. He is the focus of an unflattering Fortune write-up that has fanned the flames over Groupon's financial soundness.

Groupon's filing argues that its costs should more accurately be adjusted to exclude its exploding marketing costs, other future operating expenses and non-cash charges, since it is a growing concern.

Analysts also have been quick to take Groupon to task for reporting first-quarter revenues of $645 million when the company only really pocketed $270 million due to its generally 50/50 split with merchants. In its SEC filing and amid declining margins, Groupon warns investors that it cannot guarantee it will be profitable any time soon. It lost $413 million in 2010 as it intensifies its marketing spend to grow its 83 million subscriber base.

Ultimately, it will be up to Groupon to demonstrate that it can be more than a one-trick pony. LinkedIn and Facebook, which could be valued at around $80 billion as a public company, have much more defensible, unique value propositions and market shares. You don't need to look much past your own pocketbook for the answer.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.