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About a month ago, we had pointed out that Groupon (NASDAQ:GRPN) shares were significantly undervalued and there was profit to be made from investor fears. We had suggested that:

Groupon has gone down far too quickly, based mainly on fear. A positive surprise in the next earnings report on May 15, 2012 could easily return it back to where it was trading just two weeks ago at $18+.

Since then, the market provided significant opportunities to profit from the fear around Groupon while the business has been firing on all cylinders. The stock remains significantly undervalued and there is little reason why it shouldn't go back to the $20 in the next few days after this earnings release.

Fear creates opportunity

Significant concerns have been expressed about Groupon:

  1. It is a bad deal for merchants so it won't last. In reality: The customer is king. As we pointed out in the earlier article, "As long as Groupon continues to delight its users, the merchants are sure to follow." This business is customer driven rather than merchant driven. Merchants will be bound to come where the maximum customers are and Groupon has a significant head-start. Groupon's customer satisfaction rating remains outstanding, positioning it among the top online retailers based on customer satisfaction.

  2. The Groupon Promise is a big problem. Refer to point 1- the customer is king, and the Groupon Promise increases customer loyalty and satisfaction.

  3. The refund rates from Groupon Promise will sink Groupon. Most of the catastrophic scenarios around Groupon appear to model an assumption that refund rates will be huge and this is a big unknown since Groupon does not really know how many Groupons are outstanding. Again, this is not as bad as it is made out. Firstly, as there are more mobile users, typically more Groupons are being marked as redeemed directly by the merchant. Redemption tracking will continue to improve and, even without complete data, the return rate can be reliably modeled over time by statistical methods. Groupon is accumulating vast amounts of data on this, which will make this estimate increasingly more accurate. Practically speaking, most refunds would occur soon after the offer expiry date and the outliers are unlikely to be significant. Anecdotally, I have yet to ask for a refund on a Groupon, though the fact I can get one makes it easier for me to purchase the deal in the first place. The customer is king.

  4. Groupon remains liable for refunds even after it has paid the merchant. Again, there is more FUD [fear, uncertainty and doubt] here than reality. First, for the majority of its business (the international segment) Groupon pays the merchant only after the offer is redeemed. International business increased from 60.6% in FY 2011 to 63.5% in the recent quarter so this liability is applicable to an increasingly smaller portion of its business. Secondly, even in North America, this liability is only theoretically unlimited. As we point out above, most outstanding refunds would occur soon after the offer expiry date. The liability can also be modeled using historical return rates and actuarial methods, where part of the 35% that Groupon charges can be considered an insurance premium paid by the merchant to insure against future returns.

  5. The accounting is unreliable. Groupon has grown rapidly and self-disclosed that it needs better accounting controls. The main criticism of the accounting has been around the issue of revenue recognition and returns that we covered earlier. Usually cash flows are harder to fudge than net income and Groupon generates unbelievable amounts of cash. It also made two significant additions to its board that will boost financial oversight.

  6. The expiry of the lock-in period will sink the stock. Major insiders already sold shares at a better price during the IPO (a fact we don't like so much) and as Kena Sen of Evercore points out, "we believe the top five holders, which constitute about 50% of ownership, will demonstrate restraint when these lockups expire June 1st to await a better exit opportunity, we view lockup concerns as overstated."

  7. The competition will kill Groupon. Groupon, by its very nature, has significant scale effects. Merchants want to be where the maximum customers are. Groupon is the top-dog in this. I signed up for both Google Offers and Amazon Local. However, I did not really want to receive so much offer email, so I unsubscribed since Groupons were the most interesting. Groupon has the best brand recognition in this space and has defined the category. It is harder than it looks to displace a market leader. We do see that the Groupon Now business will be impacted through Google Offers in Google Maps, but do not see it as a Groupon killer. The real question here is whether active members will unsubscribe from Groupon when they also see offers when searching through Google Maps. We do not see this as mutually exclusive.

As long as Groupon continues to delight its customers and keeps growing its active customer base, we see it doing well.

Gobs of cash

We see free cash flow of at least $500 million in FY 2012, given this is the first quarter and revenue is increasing sequentially even after the Q4 2011 holiday season quarter and 89% yr/yr. Q4 2011 generated FCF of $155 million. What multiple would you assign to a company growing at 89% yr/yr? A back of the envelope calculation with a multiple of 40, less than half the growth rate, gives a valuation of $20 billion. Adding cash in hand of $1.2 billion and assuming a diluted share count of 700 million (current is 648 million) we get a valuation of about $30 a share. The Facebook (NASDAQ:FB) IPO will provide another catalyst to realize the valuation. At a price under $15, shares are over 50% off and it remains as good a deal now as any Groupon.

Disclosure: I have long calls on GRPN.

Source: Great Deal: Groupon Shares Offer 50% Upside