In the recent past, the most common way for a consumer to guarantee a future promise from a merchant was to pay. For example, pay $20 today and get a $20 gift certificate as a promise for a future performance. Since the recession and credit crisis in 2008, merchants in need of advertising and working capital have the option to sign an agreement with Groupon (GRPN) who will distribute promises through the internet at a discount. For example, a $20 promise for a restaurant meal is sold for $10 to a consumer. Groupon retains a fee of $5, and then forwards the remaining $5 to the restaurant owner. Groupon emails the electronic promise for $20 to the buyer.
Merchants love it. Groupon claims that there is a 9 month waiting list to be featured in their daily deal email. Consumers love it. In Groupon's first year, it bought $213,600 in promises in 2008 and is on pace to buy $9,200,000,000 in 2011. Indeed, issuing promises is a big business! Groupon CEO David Mason states in its pre-IPO roadshow:
So this gets into the next major investment highlight beyond the model which is the size of the market, again, measured in trillions not billions of dollars. Eighty percent of commerce is still off-line and local commerce is our bread and butter. That's what we're going after. It's the largest market out there and we're the largest business in it.
Trillions? Is it the largest of the largest? Does even Google (GOOG) or Walmart (WMT) ever say “trillions” in an investor presentation? The only thing that I know is measured in trillions these days are currencies and sovereign debts. Groupon, in fact, has a lot in common with both.
For every $25 Groupon receives in net revenue, it issues what I refer to as “Groupon Dollars” worth about $114 that costs it almost nothing to issue via email. In fact, Groupon multiplies money just like our fractional reserve banking system except there is no central bank and no deposit insurance. Groupon explains the Groupon Dollar printing process in animated advertisements. Below are two sequential scenes from a Groupon ad recently running on CNN.com.
Unlike legal tender, Groupon Dollars often expire in less than one year and the party guaranteeing the face value, merchant or Groupon, is unclear. The money-back Groupon Promise will refund the consumer if the merchant's service level was unsatisfactory or if the business closes. These amounts are reserved under accrued expenses as “Refunds Reserve.” However, there is a hornet's nest of state's escheat laws regarding abandonded property for any unused Groupon Dollars which are not represented in Groupon's financial statements. Therefore, the most important question for Groupon investors is to ascertain what percentage, if any, of the $9,200,000,000 promises made in 2011 alone should Groupon (just like a bank) be recording as a loss reserve liability or accrued expense on its balance sheet. Total equity is already negative, but how much more negative could it be? From pg. 19 of the S-1, this risk is acknowledged as follows: “If we are required to materially increase the estimated liability recorded in our financial statements with respect to unredeemed Groupons, our net income could be materially and adversely affected.”
Fortunately for consumers and prospective Groupon investors, there are a quite a few laws about the expiration of promises. Unfortunately, Groupon, in practice, barely acknowledges that its Groupon Dollars are in fact highly regulated and utilizes the heading “Legal Stuff We Have To Say” in its disclosure to purchasers of vouchers. Harvard Business School assistant professor and attorney Benjamin Edelman has published an insightful working paper on many of the consumer protection issues which Groupon is now facing. John A. Biek, a tax attorney, has also reviewed the relevant case law as it pertains to daily deals and consumer protection and unclaimed property. The references therein these two reports address several material legal topics that relate to Groupon. In particular, Edelman reports that Groupon ran afoul of regulations in Massachusetts which restrict discounts on alcoholic beverages. Twenty-seven other states have similar laws regarding alcohol discounts. Groupon employs 10,000 people and would seem to have the resources to assist merchants in complying with state laws on all issues regarding discounting and the issuance of promises, but in practice Groupon uses generic language in its contracts with largely unsophisticated merchants suggesting that they “comply with any and all Laws.” Despite the contractual effort by Groupon to shift liability to the merchant, the consumer is not necessarily aware of the specific agreement between Groupon and the merchant. Consumers, however, will notice that Groupon is the merchant of record on their credit card statement.
The “CARD Act” of 2009 in particular addresses the issue of expiration dates and provides a federal prohibition against expiration periods of less than five years, which is in addition to restrictions already imposed by 27 states. Sixteen class action lawsuits have been filed and are currently being consolidated. Groupon's basic defense may likely claim that its “Groupon Dollars” are exempt because they are “a loyalty, award, or promotional gift card.” There are several disclosure requirements that Groupon may not currently satisfy to win this exemption and there may be sufficient evidence that the short expiration period was marketed as a profit enhancer to merchants who were relying on a certain percentage of offers not being redeemed (i.e. “breakage”) prior to expiration. Although short expiration dates were used to enhance redemption rates by creating a sense of urgency by the buyer, they were also used to suit the operating or staffing needs of the merchant who may have been willing to accept a temporary increase in discounted sales but not after the expiration date. Whatever the motivation, the CARD Act protects the rights of the consumer who tenders prepayment.
However, even if Groupon receives a favorable ruling, avoids fines, and short expiration dates are allowed, Groupon may have failed to record substantial liabilities since under the state's unclaimed property laws, expired Groupon Dollars become custody of the state on behalf of the owner until such claim is made, if at all. In addition to expiration, breakage can arise due to any life situation which deters or prevents the consumer from redeeming the offer. Breakage rates are difficult to ascertain because they are very offer-specific but are generally assumed to range from 10-30%.
For simplification, a model that estimates unclaimed property assumes the following:
- All offers expire after 5 years. From this point of view, liabilities could be treated as a maturity schedule of long term debt.
- Each state enforces similar unclaimed property rules.
- Liabilities are calculated as a function of the purchase price of the offer, not the face value. This generates a smaller liability.
- Only includes estimates of liabilities from 2011 revenues of $4.05b. Liabilities from 2009 and 2010 would also be material and would have an earlier maturity schedule.
To model the sensitivities of these liabilities, the key variables are as follows:
- Breakage rates (5-30%)
- Liability allocation between Groupon and/or merchant. (0-100%)
Click to enlarge
Assuming a breakage rate from 15-20% and Groupon's share of liability in the range of 40-60%, the liabilities range from $243m to $486m (see yellow area), which equates to $4.9m to $9.8m per state, assuming equal sales for each state. Historically, the ability of states to collect unclaimed property from small merchants was limited by the each merchant's record-keeping regarding the issuance of gift certificates. It may have been too costly to pursue collections from thousands of merchants individually. Since Groupon maintains centralized and standardized records, the ability of the states' departments of revenue is significantly enhanced since full records of merchant identity as well as the name, address, amount, and date of purchase are available from Groupon or to some extent the merchant, which also receives certain reports on the offers sold.
Suffice it to say that state revenue needs will likely remain high into the foreseeable future and the relative ease with which these records can be obtained may make abandonded property a likely source of revenue. Investors may consider adding these liabilities, which are not currently found on the balance sheet, in estimating Groupon's shareholder's equity, enterprise value, and coverage ratios.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GRPN.
