I bought Rocky Agrawal brunch on Saturday, at a cost to myself somewhat smaller than the amount I’m going to have to shell out if I lose my bet with him. Which is looking increasingly likely. I lose the bet if Groupon’s (GRPN) market capitalization on October 31 is less than 30% of the market capitalization of Priceline (PCLN). When Groupon went public, the ratio was 72%, which gave me a very healthy cushion. But as of today, I’m underwater: the ratio is now just 24%, thanks in large part to an astonishing and quite unexpected run-up in Priceline’s stock, which is now comfortably over $700 per share.
Still, the proximate cause of the ratio dropping below 30% came from Groupon, not Priceline: it revised its 2011 results downwards, in a pretty opaque manner. “The revisions are primarily related to an increase to the Company’s refund reserve accrual to reflect a shift in the Company’s fourth quarter deal mix and higher price point offers, which have higher refund rates,” says the press release, in a marked departure from Groupon’s normal habit of communicating in plain English.
The official SEC filing is a tiny bit clearer:
At the time revenue is recorded, we record an allowance for estimated customer refunds. We accrue costs associated with refunds in accrued expenses on the consolidated balance sheets. The cost of refunds where the amount payable to the merchant is recoverable is recorded in the consolidated statements of operations as a reduction to revenue. The cost of refunds when there is no amount recoverable from the merchant are presented as a cost of revenue.
To determine the amount of our refund reserve, we track refund patterns of prior deals, use that data to build a model and apply that model to current deals. Further analysis of our refund activity into 2012 indicated deviations from modeled refund behavior for deals featured in late 2011, particularly due to a shift in our fourth quarter deal mix and higher price point offers. Accordingly, we updated our refund model to reflect changes in the deal mix and price point of our deals over time and we believe this updated model will enable us to more accurately track and anticipate refund behavior.
Groupon is explaining how it accounts for the money it sets aside to cover customer refunds.
Groupon basically has two business models: the US model, and the European model. In the US, Groupon sells a bunch of deals for a given merchant, gets lots of revenue as a result, keeps roughly half that revenue for itself, and then passes on the other half to the merchant in question. In Europe, by contrast, Groupon keeps the merchant’s share of the revenue until such time as the buyer redeems the Groupon.
Obviously, the US model is much more attractive to merchants than the European model is. But it also creates much bigger dangers for Groupon, thanks to Groupon’s refund policy. “If the experience using your Groupon ever lets you down, we’ll make it right or return your purchase. Simple as that.”
That policy is good business for Groupon: it gives people a lot of confidence to buy a Groupon for merchants who might otherwise seem a bit sketchy. But it also creates dangers, because if Groupon does a deal with a sketchy merchant, then Groupon can be on the hook for a lot of refunds. And even if the merchant is entirely legitimate, if for good reason a lot of people end up being disappointed with their deal, Groupon can still end up massively out of pocket.
What happened in 2011 is that the price of Groupons started going up — and it turns out that Groupon ends up issuing refunds on a significantly higher percentage of high-ticket Groupons than it has historically done on low-ticket Groupons. I’ll let Rocky explain why:
Groupon is selling bigger and bigger deals and many of these have requirements for use. Some deals have medical qualifications. The former salesperson told me about Groupons for a procedure called “cool sculpting”. In this procedure, fat is frozen off the body. In order to get the treatment, patients must be medically qualified. But Groupon has no way of medically qualifying purchasers and will sell it to anyone. When they go to the doctor and find out that they aren’t eligible, they call Groupon for a refund. If this is several months later, after Groupon has paid out the entirety of what it owes the provider, this can mean a refund loss for Groupon.
Travel is another risky category for Groupon. Unlike Expedia, Travelocity, Priceline, Jetsetter and nearly every other major travel provider, Groupon does not require consumers to pick their dates and confirm availability at the time of purchase. When a consumer finds he can’t use his Groupon months later, he calls for a refund. Groupon also hides material restrictions on travel deals, something I pointed out in September and Groupon still hasn’t rectified.
Because these are higher ticket items that cost hundreds or thousands of dollars, consumers are more likely to ask for a refund than on lower ticket items. In the short term, it means a revenue boost to Groupon, which the company needs as its once torrid growth cools. In the long term, it means refund losses.
Pretty much all of these problems could be addressed quite simply if Groupon simply moved its high-ticket US sales to a European-style system where it paid the merchant only after the deal was successfully redeemed. If Groupon hasn’t done that, then that implies that there might be less merchant demand to run Groupon deals than Groupon likes to imply — and that Groupon needs to be able to promise a large amount of cash up front in order to be able to sign up the merchants it needs.
Groupon, as an intermediary, is in the business of balancing the interests of merchants and consumers. The problem with the high-value tickets is that it’s trying to have it both ways: giving merchants a lot of money up front, while also giving very strong consumer protections to the people buying the deals. The result is enormous contingent liabilities for the middleman — Agrawal estimates that Groupon has more than half a billion dollars in liabilities which aren’t showing up on its balance sheet.
I suspect that what’s going to happen is that Groupon will start tightening up its standard contract with high-ticket-price merchants, to make it easier for Groupon to have recourse to the merchant when it needs to issue a refund. Will that scare away the merchants Groupon wants? If it does, then there are much deeper problems at Groupon than simply refund issues. Because a Groupon without a steady supply of merchants wanting to do deals would surely be a company in very big trouble.
Update: Groupon’s Mike Buckley calls to say that only about a third of the money payable to the merchant is paid up front, and that “a significant portion” is held back until the customer actually redeems. And that as a result, Groupon never loses money on a deal, it just ends up selling fewer than it originally thought. But there are still some question marks over when exactly the merchant gets the last payment, and whether it’s before the Groupon expires — I’m hoping to nail those down shortly.