3 Challenges For Groupon Investors

Nov. 7.11 | About: Groupon, Inc. (GRPN)

On Friday, Groupon Inc. (NASDAQ:GRPN) officially debuted as a public company. The first day of trading was a major success with the stock closing 31% above its offering price.

Groupon’s successful IPO pricing is a good indication that investors still have a robust appetite for speculative growth opportunities. So despite the major macro risks in play, institutional investors are willing to allocate capital to promising companies that have yet to actually turn a profit. This is a pretty bullish indicator (at least for the short-term).

On the other hand, bearish investors can point to the fact that the IPO transaction was effectively engineered so that the stock price would rise on the first day of trading. An intentionally low share count, and a very attractive offering price, created a natural environment for a “successful launch.”

According to a Wall Street Journal article, the Groupon management team was intimately involved in the decision of who received the initial shares. Allocations were primarily given to large mutual fund managers “who appeared to understand the story in one-on-one meetings with Groupon executives during the nine-day roadshow.”

So while most road shows are offered with the intention of drumming up interest in an IPO offering, this particular road show appears to have been for the purpose of Groupon executives to identify the best prospective INVESTORS for their stock.

Now that the shares are being actively traded, we’re watching the stock to determine where trading opportunities will emerge. While the first day of trading was definitely a bullish event, I see three significant challenges that Groupon will have to overcome for the stock to be attractive for long-term investors.

1) Competitive Challenges

Groupon’s growth strategy has been successful because of the company’s ability to rapidly expand their geographic market share …

Each time Groupon enters a new city, their sales staff blankets the metro area – reaching out to business owners with the gospel of “social media marketing.” By expanding to new cities, Groupon is able to increase their user base, their merchant count, and by extension their revenue base.

But while the headline growth looks very attractive to investors, the devil is in the details.

  • Marketing Costs – Groupon must employ an aggressive sales force for each market to make inroads with merchants. This sales staff is NOT a scaleable expense. Groupon needs to add marketing positions each time it expands into a new city.
  • Local Knockoffs – As the “groupon coupon” model becomes more popular, local (and regional – and even national) knockoff companies are entering the fray. Many of these companies are eroding GRPN’s market share by offering merchants better terms and quicker payouts.
  • Almighty Google – As Google continues to expand its product offering, new locally focused coupon offerings are popping up. If Google continues to infringe on Groupon’s turf, it could require GRPN to spend more in marketing, cut pricing (and by extension margins) or even exit particular cities that are no longer attractive.

One particular way that Google and other competitors could undercut Groupon is by offering merchants payouts that are distributed quickly. According to a recent Bloomberg article, Groupon “owed almost twice as much to merchants at the end of September as it held in cash.”

Of course Groupon’s cash balance is now much higher after the IPO offering, but if GRPN decides to become more attractive to vendors by offering more prompt payouts, it could have a material effect on the company’s working capital.

2) Share Dilution

One of the ways that Groupon engineered a successful IPO offering is by offering only a tiny portion of the company to investors. We’re still waiting on the final tally (after accounting for underwriters over-allotments etc.) but it appears that GRPN only offered 6.3% of the company in this first transaction.

The relative scarcity of shares makes this a highly sought after issue. If you are a mutual fund manager and want to take part in this growth opportunity, you will be competing with dozens of other managers to get exposure right now. The high demand and low supply has naturally pushed the stock price higher.

But this “artificial scarcity” isn’t likely to last. As GRPN continues to enter more markets and beefs up its marketing staff, it will likely continue to need to tap equity markets. (Remember, the company is still operating at a loss – so they are burning through cash on a monthly basis).

Perhaps more importantly, we have the issue of stock held by executives and employees. These shares will be “locked up” until sometime in May – so they don’t represent an immediate danger to current investors. But if GRPN continues to sport a hefty valuation when these shares become available for sale, there will be a major temptation for employees to cash in on their new-found wealth.

As more shares flood the market (either directly or through secondary offerings) the relative scarcity of shares available will dissipate – and GRPN will begin to trade more in-line with fundamental valuations… By the way, it’s extremely difficult to “fundamentally value” a company that generates negative earnings for the foreseeable future.

Bottom line: Groupon’s share price is currently influenced by a relatively low number of available shares. As this changes, its easy to make an argument for a significantly lower stock price

3) New options for “Social Media” Investing

One of the reasons demand for GRPN stock has been so high, is because GRPN is one of the few available options for investing in the new generation of “social media” companies. The other major publicly traded companies in this area are LinkedIn Corp. (NYSE:LNKD) and Pandora Media Inc. (NYSE:P).

One possible addition couldbe Renren Inc. (NYSE:RENN), but so far investors have been extremely disappointed in the “Chinese version of Facebook.” Investors have a number of reasons to be wary of Chinese investments traded on US exchanges – from economic uncertainty in China, to regulatory risks, to censorship issues facing all social media sites in China.

With relatively few “social media” companies available for trading, there is an imbalance between supply and demand. Investors want to be participating in this hot area of the economy, but they are limited in the number of “investment quality” companies they can trade.

In the next few months, we are likely to see shares of Zynga become available for traders – and the mother of all social media companies – Facebook Inc. - will likely offer shares early next year. As new offerings increase the number of choices for “social media” investing, mutual fund managers, as well as individual investors will likely migrate towards the participants that are actually generating profits.

Patiently Stalking a Trade

The key to profitable trading is to have patience while a situation develops. At this point, we don’t have any short exposure to social media stocks. Groupon’s successful IPO just goes to underscore the currently willingness of investors to buy into growth opportunities.

But as we track overall market sentiment – the willingness of investors to accept risk and pursue growth – as well as the technical patterns for individual sectors, we will be identifying support and resistance areas for social media stocks.

The current market has plenty of uncertainty – and social media companies offer more questions than answers right now. But in time, there should be a number of very attractive trade setups for patient bulls in waiting.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.