When To Short Groupon

| About: Groupon, Inc. (GRPN)

Groupon (NASDAQ:GRPN) has been up rather dramatically the past few days. It opened for trading on Tuesday at $18.80 ($1.20 less than its IPO price) to as high as $22.90 today. The near 22% return is notable even for this highly volatile stock. There have been numerous “reasons” for this explosion from short sellers taking profits after the stock’s steep decline late last month to the debut of Groupon’s new application “Groupon Scheduler.” However, the most likely catalyst was the recent news of rival Living Social’s new round of funding.

According to a Bloomberg report yesterday, competitor LivingSocial recently initiated a second $400 million funding campaign in which $176 million has already been sold. Among the investors was Amazon (NASDAQ:AMZN), which had previously invested $175 million in the initial private offering a year earlier. The most recent round of funding gives the online daily discounter a valuation of approximately $6 billion dollars, nearly double what it was worth just eight months ago. Expected 2011 revenues have been estimated from $1 billion to as much as $2 billion according to varying research firms. Since the financial information is not public, perhaps a better tool to compare LivingSocial to Groupon would be the number of subscribers. As of November 30, 2011, LivingSocial had approximately 46 million subscribers. That number pales in comparison to Groupon.

As of the end of third quarter 2011, Groupon reported an estimated 143 million subscribers worldwide, more than three times that of LivingSocial. Since subscriber total is integral to the valuation of these Internet IPOs, Groupon should seemingly have a larger market capitalization. Groupon sold about 5.5% of its stock on November 4, 2011. With 637.2 million shares outstanding, its market cap is currently around $14 billion. A case can be made that if LivingSocial is receiving funding at a $6 billion valuation, Groupon’s shares should be trading much higher than current levels upwards of $28 a share for a market cap of $18 billion. The recent news of LivingSocial’s funding likely caused a scare among the shorts and triggered a short squeeze.

I recently wrote an article on why investors should be bearish long term on Groupon. Groupon does not make money. It hasn’t since its founding in and won’t anytime soon. But that’s not what worries me the most. It’s lack of growth, rather its retracting growth, is what’s most troublesome. Yes, Groupon is in reality shrinking, not growing. While Groupon has had a rapid incline in its subscriber numbers, the actual number of groupons actually sold as a percentage has been on a decline year after year, quarter after quarter. Look at the chart I created below with data collected from Groupon’s S-1 filing earlier this year.

As you can see, the number of groupons actually purchased declined from 69% in 2009 to 60% in 2010. Each quarter's sales this year was lesser than the same quarter the year before: Quarter one declined 17%; Quarter two declined 11%; Quarter three declined 15%. What’s even worse is that just this year, the number of groupons sold (again as a percentage) has declined sequentially quarter after quarter. From 34% in quarter one to 28% in quarter two, to 23% in quarter three! Now this wouldn't necessarily be a problem if the company was making money, but it doesn't. The losses have only gotten greater with every passing quarter. Which means only one thing: the cost of subscriber acquisition is greater than the revenues received from those new subscribers, much greater. The only logical explanation I can think of for this is that either the old subscribers aren't buying as much or the new ones aren't buying as much as the older subscribers, if at all. Either scenario doesn't bode well for neither the top nor bottom line. Groupon is quick to boast about how many subscribers they are adding, but if those subscribers don't buy, it just doesn't make dollars and sense.

Most importantly, what we really need to know is how many subscribers are actually purchasing groupons. Groupon can easily disclose this information but they do not. Their failure to do so is definitely a red flag and a negative sign to say the least. Competition from companies like LivingSocial, Amazon, and Google (NASDAQ:GOOG) is the most likely culprit for Groupon's downward trend. Groupon's illusory perception of growth is the perfect kind of stock for an investor to start a short position because when the cat is let out the bag, everyone runs for the door. The only question is WHEN?

It is definitely wise to wait and see what Groupon reports in its fourth quarter earnings. If the percentage of groupons sold relative to the number of subscribers has again declined and the losses have also increased substantially, then the case against Groupon is solidified. However, because of the usual rise in the broad market at the beginning of each year, colloquially termed the "January Effect," an immediate short position may not be wise. The end of March to early April 2012 is probably the most ideal time to take advantage of an approaching decline in Groupon’s stock for two reasons. First, May 4, 2012 is the first opportunity for Groupon insiders to sell stock. According to the lock-up agreement that the company filed with the SEC, directors, officers, and anyone holding 5% or greater of outstanding capital stock are restricted from selling shares until after the 180 day period has expired (See page 130 of S-1 under Shares Eligible for Future Sale section). Shares of LinkedIn (NYSE:LNKD) plummeted more than 15% to the lows of the year immediately after insiders capitalized on their newly found freedom to sell stock on November 18, 2011 (see chart).

(Click to enlarge)

Groupon insiders will no doubt follow the same trend. They are an over-valued internet IPO darling much like LinkedIn (and for that matter Pandora (NYSE:P) and Zillow (NASDAQ:Z)), and their history tells us they will definitely do what’s best for their individual pockets as opposed to company expansion and re-investment. In the early days of their venture capital funding, $942 million of the $1.1 billion raised were paid to insiders (Insider Greed). In the latest round of private offerings, Groupon raised $946 million, of which $810 million were used to pay off insiders (Insider Greed 2)! Of course, insiders should reward themselves, but to the tune of 85% of the total venture capital funding??? The whole point of raising funds is to invest in the company’s expansion and growth. Groupon insiders clearly have a hit and run mentality and you shouldn't expect anything different come the beginning of May 2012.

The second reason to take the bearish approach during the above mentioned time-frame is to capitalize in advance on one of the worst trading months traditionally for the stock market – May. The old adage “Sell in May and Go Away” rings true year after year as the Dow Jones, S&P, and Nasdaq have suffered notably poor performances in this particular month. Don't forget, Groupon should report its first quarter earnings sometime in April. So if the numbers go as I predict, it would create the perfect storm for a steep decline in share price. To take full advantage of these events, incrementally buying at the money or out of the money puts (no more than 5% out of the money) in end of March/April with three months expiration out should net significant gains if the stock should plummet as predicted. Shorting the stock outright has unlimited exposure, but with puts, at least losses can be capped if the tide turns the opposite direction.

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