Groupon Sells Investors Bad Accounting, Working Capital Deficits, And Rising Losses

Nov.15.11 | About: Groupon, Inc. (GRPN)

Groupon (NASDAQ:GRPN) is the worldwide leader in so-called 'daily deals'. The company offers consumers the opportunity to purchase daily coupons that entitle them to discounts at participating merchants. Groupon collects money from customers for the coupons, keeps around half of the total, and disperses the rest to the merchant. Specifically, Groupon's "revenue is the purchase price paid by the customer for the Groupon less an agreed upon percentage of the purchase price paid to the featured merchant".

The company went public on November 4, placing 35 million shares at $20 each, well above the target range of $16-18 per share. On the first day it was available to the public, the stock traded up better than 50% intraday before closing up 31% to $26.11. Since then, the stock has cooled off a bit and now trades around $24 per share.

In a previous article, I recommended buying Groupon's shares as close to the IPO price as possible and selling immediately into the rally. If you were lucky enough to get in early and you haven't sold your shares yet, it might be time to start unloading them. While many investors were skeptical of Groupon's business model early-on, reasons for not liking the company (as an investment that is) just keep piling up.

Before going into some of the reasons why you should not buy Groupon's stock, it is worth mentioning that the 'demand' for Groupon's shares on the first day was artificial. Groupon's 5.5% share float is the second smallest of any IPO in the past ten years. This is a clear example of creating demand for something by artificially constraining supply.

Having said that, it should be noted that despite the company's awe-inspiring growth record, Groupon has never actually made a dime of profit. The company has lost $633 million this year as of September 30. In its prospectus, the company says the following: "...we have incurred net losses since inception and we expect our operating expenses to increase significantly into the near future." In other words, "our business model is clearly not conducive to profit generation and we expect rising costs to make it even more difficult for us to climb out of the hole."

Make no mistake, the company is burning through cash in an effort to recruit new customers. Groupon has spent $466 million this year on marketing in an attempt to lure in new subscribers. In a rather alarming passage from the prospectus, the company notes that it "cannot assure [investors] that the revenue from subscribers we acquire will ultimately exceed the cost of acquiring new subscribers". This means the company is slowly drowning. This is especially scary given that only about 25% of Groupon's subscribers have actually purchased a coupon from the site.

In its prospectus, the company also notes that "if we fail to retain existing merchants or add new merchants, our revenue and business will be harmed". This statement could be written-off as simply a cautionary reminder to prospective investors were it not for the fact that Groupon is already losing business due to the company's reluctance (or inability) to pay participating merchants their part of the deal price.

As it turns out, Groupon pays merchants in three installments over 60 days. Compare this to the payment policies of the company's competitors and it is difficult to imagine why any merchant would choose Groupon. Amazon Local (NASDAQ:AMZN) and Living Social pay merchants 100% of what they are owed within two weeks while Google Offers (NASDAQ:GOOG) pays participating businesses 80% within four days and the remaining 20% within three months.

A recent Wall Street Journal article entitled "Groupon Holds Cash Tight" provides numerous first hand accounts from merchants who are dissatisfied with the way Groupon disperses payments. As the article notes, keeping cash on its books instead of turning it over immediately to merchants makes Groupon's cash position look better than it actually is. Apparently, this is typical behavior for the company. Groupon is notorious for reporting the full amount of coupons purchased by subscribers as 'revenue' as though it did not have to turn over a percentage of the profit to merchants at all. Even more disturbing is the fact that the percentage of each deal that Groupon does get to keep is falling fast.

Additionally, it should be noted that Groupon owes merchants more than it has in cash - that is, if asked to pay merchants what it owes them in one lump payment, the company could not do so. The whole thing looks eerily similar to a ponzi scheme. Red flags also abound regarding the company's accounting practices, most notably:

Groupon significantly changed the definition of key expense metrics such as marketing expenses, cost of revenue and selling, and general and administrative costs...just two weeks before its IPO...[without restating] the numbers for the previous two quarters.

The good news for traders is that Groupon options began trading on Monday. Apparently, more investors are betting on Groupon to fall than rise as 7,000 puts traded hands against only 5,500 calls. I believe Groupon's stock will eventually fall below $5 per share. The company will likely lose in excess of $700 million (ironically the total it raised in its IPO) this year and it does not even have enough cash on its books to pay merchants their half of the deals it sells.

All this at a company where the CEO is now worth $1.2 billion - there's something wrong with that. Now is the time to either short these shares or buy some put options on the stock.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GRPN over the next 72 hours.