Internet Stocks Should Be Analyzed Like Retailers

Includes: GRPN, ZNGA
by: New Century

Some of the most relevant and interesting internet companies went public in 2011, allowing the general public to buy or short shares, or at least follow the financial success of the companies with much more information than before. Two of the more remarkable internet growth darlings turned public companies are Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA). Groupon enables brick-and-mortar merchants to reach customers by offering heavily discounted offers through the Groupon platform. Zynga is a social-gaming powerhouse that offers games that are played by 50 million people daily through Facebook or smartphones.

Both of these companies are clearly revolutionary entities that are best understood by whatever non-GAAP metrics that its founders and/or management believe best represents their business, right? Wrong!

In fact, I think that it makes sense to analyze both companies (and other internet companies) like traditional retailers. Obviously there are some caveats, but I believe that the parallels are significant enough that it makes sense. Essentially, businesses have two ways to grow revenue and profit - get new customers, or sell more to existing customers. Traditional retailers provide a lot of information regarding these metrics, though selling more to existing customers (or as they call it, "same store sales" growth) is often given more weight because it represents growth that is more organic and representative of overall business health.

Groupon actually does an excellent job reporting a comparable statistic. In its Q4 report, Groupon reported that "trailing twelve month gross billings per active customer, which is a proxy for total annualized spend per average customer [same customer/"store" sales], increased to $188 in fourth-quarter 2011 from $160 in fourth-quarter 2010." That increase, almost 20%, is a very positive indicator for Groupon. As Groupon filed its S-1 and prepared to go public, many investors were concerned about the huge customer acquisition costs that Groupon was (and still is) incurring - but it appears that customers are actually relatively sticky, and Groupon has been able to get the customers that it wins to spend more money on its deals. Growing same-store sales is the mark of a booming retail business; Chipotle (NYSE:CMG) and McDonald's (NYSE:MCD) come to mind as two businesses that have performed well in this regard, and shareholders have been rewarded.

However, as I previously wrote, Zynga did not provide such a metric, at least in its Q4/FY2011 press release, though it was possible to manufacture a similar statistic. In that article, I calculated a metric called "Online Game Revenue per Monthly Unique Payer," which I believe is what you can think of as Zynga's same store sales statistic. ("Online Game Revenue" is the in-game purchases from which Zynga gets 90% of its total revenue, and "Monthly Unique Payer" is a somewhat complicated statistic that appears to mean the number of unique people who paid Zynga for an in-game purchase, in a month, averaged over the quarter). Unlike Groupon, Zynga's same-store sales-equivalent number seems to be decreasing; based on my calculation, it may have fallen from about $110 to $98 between Q3 and Q4 2011, a decline of about 10% quarter-over-quarter. (As noted in that article, since I had to create that calculation myself from numbers that Zynga did not report directly, there's a chance that it may not be perfectly accurate, and I will adjust if necessary when Zynga publishes its 10K).

Does this mean that it's time to buy Groupon and short Zynga? Not necessarily. Both companies have the ability to grow their business by acquiring new customers. In the case of Zynga, which appears to be the weaker of the two, it has many options available. It can actually acquire more customers, which it seems poised to do as more people join Facebook and start using smartphones. It can create more products, by publishing more games and by creating more virtual products within those games. It can also ramp up advertising sales, which exhibited significant growth during 2011. Groupon, too, has the ability to reach new customers and expand product offerings, as it has done with vacations and goods.

At the end of the day, an investor should weigh his own growth expectations versus those baked in by the current share price. Right now, I don't think that Zynga or Groupon is an attractive value, though others may come to a different conclusion. I'll be watching these "same store sales" metrics going forward, and healthy numbers may warrant a change of opinion.

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