Groupon (GRPN) is one of the most controversial stocks in the market, and one of the most emotionally charged. Its supporters, most of whom are overwhelmed here on Seeking Alpha, argue that the company is a leader in a huge new market, and will become a large and profitable e-commerce company. And its detractors, many of whom are here on Seeking Alpha, argue that the company is nothing more than an unsustainable Ponzi scheme. Emotions are running high on both sides, something that we think is unwise. Emotion has no place in investing, and the hysteria surrounding Groupon has drowned out almost all reason and logic.
In this article, we will attempt to address two issues central to the Groupon debate: its merchant satisfaction and the way Groupon accounts for its payments to merchants. We will also touch on Groupon's competitive positioning, as well as its overall restructuring of its accounting department.
Since Groupon made its public debut back in 2011, the stock has steadily fallen, due to lock-up expiration, competitive fears, and a general climate of distrust surrounding Groupon.
For purposes of disclosure, we initiated a position in Groupon this week, albeit indirectly, based on our belief that the stock has fallen too far. We own shares of GSV Capital (GSVC), an investment fund that owns shares of Groupon, and hold cash-secured puts (July 2012 puts at $9 strike) in Groupon. Before we delve into our examination of Groupon, a quick financial overview is in order.
|Q1 2012||Q1 2011||2012E||2013E|
|Revenue||$559.283 Million||$295.523 Million||$2.4 Billion||$3.1 Billion|
|Operating Income||$39.639 Million||-$117.148 Million||N/A||N/A|
|Operating Cash Flow||$83.714 Million||$17.94 Million||N/A||N/A|
|Net Current Assets||$318.531 Million||$328.165 Million*||N/A||N/A|
*Data is for Q4 2011, not Q1 2011
Groupon is set to reach sustained profitability in 2012, based on consensus Reuters estimates, and as of this writing, trades at a P/E ratio of 49.75x 2012 EPS, and 14.21x 2013 EPS. We now turn to Groupon's merchant satisfaction and what the company is doing to increase it.
Merchants: The True Customer
Subscribers who buy Groupons are essential to Groupon. And yet, they are not the company's true customer. Merchants are who Groupon is truly seeking. Without merchants, there would be no subscribers to buy Groupons. Therefore, Groupon must do all it can to attract, and above all, retain merchants to ensure the company's sustainability.
Much has been made over whether or not Groupon provides value to merchants. Groupon would like to see itself as a company that enables each and every merchant to prosper with a Groupon deal. And Groupon's critics see it as a Ponzi scheme that throws merchants under the bus. As with many things, the truth lies in the middle. For some merchants, Groupon is in fact a flawed promotional tool. And for others, Groupon is a great way to enhance exposure and generate traffic.
In general, merchants have one of two goals when they strike a Groupon deal: to either generate traffic or reduce inventory (such as off season inventory). There have been plenty of "horror stories" about how Groupons have proved disastrous for businesses. But there are also many success stories as well, and it is important to not let one side dominate the discussions. No product, including Groupons, can provide exactly what a customer wants every single time. As long as the majority of Groupon merchants are happy, then Groupon has done its job.
So just what is Groupon doing to attract and retain merchants. The company's first quarter conference call yielded many insights into the company's strategy. Groupon served 100,000 unique merchants for the first time in its most recent quarter, a testament to the company's growing reach. So what is the company doing to retain those merchants? Several initiatives are being rolled out to address these issues.
- Groupon Rewards: This loyalty program for Groupon customers allows merchants to create offers that attract and retain customers. Central to the debate surrounding Groupon has been the discussion of whether or not Groupon customers come back to that business. Groupon Rewards is designed to keep them coming back to the business in question. As of mid-May, 30% of eligible merchants in Groupon's pilot cities had signed up for this program. Groupon's data indicates that the program is working as intended. Users of the Rewards program are more loyal to each merchant than non-Groupon Rewards users.
- Groupon Scheduler: This program, which has seen 2,500 merchants sign up so far during the ongoing beta phase. Scheduler allows merchants to streamline the flow of customers and Groupon redemptions. There have been instances where the intent of a Groupon has been overwhelmed by the traffic they generate, thus negating their effects for a merchant. Scheduler is designed to reduce, and hopefully eliminate that risk. Scheduler allows merchants to manage their entire business, not just the segments that do business with Groupon. That creates goodwill with merchants (an essential for Groupon), and increases the chances that they will be repeat customers of Groupon.
Groupon is moving aggressively to prove (to both merchants and critics) that it is an asset for merchants. In the coming quarters, these 2 initiatives will need to be watched closely for signs of increasing traction. Groupon's model is based in part on a cycle. More merchants mean a bigger subscriber pool. And more subscribers mean more merchants. Whatever Groupon has been doing to retain merchants, it seems to be working. According to studies commissioned by Groupon and conducted by ForSee (as well as independent ForSee studies), Groupon scored a 79 on ForSee's benchmark merchant satisfaction test, while the average score was a 64. Groupon also exceeds the Fortune 500 B2B (business to business) benchmark score by 10 points. In addition, 74% of merchants say that the main reason they work with Groupon is that the company helps them bring customers in the door.
Merchants: A Dynamic Accounting Process
The way that Groupon accounts for its operations has been the subject of much debate and arguments. We will focus here specifically on merchant accounting, and touch on overall accounting later in the article.
When a subscriber purchases a Groupon, Groupon splits that amount between itself and the merchant. Groupon's 10-Q filing for the first quarter of 2012 addresses the way it accounts for its payments to merchants. Groupon currently has 2 ways of paying the merchants it deals with: a redemption payment model and a fixed payment model. Below are direct excerpts from Groupon's latest 10-Q filing explaining the 2 models.
- Redemption payment model: "Under our redemption merchant partner payment model, we collect payments at the time our customers purchase Groupons and make payments to most of our merchant partners at a subsequent date. We utilize this model in most of our international operations as it conforms with the local market practice. Using this payment model, merchant partners are not paid until the customer redeems the Groupon that has been purchased. If a customer does not redeem the Groupon under this payment model, we retain all of the gross billings for the Groupon purchase. The redemption model generally improves our overall cash flow because we do not pay our merchant partners until the customer redeems the Groupon"
- Fixed payment model: "Under our fixed merchant partner payment model, we pay our merchant partners in installments over a period of generally sixty days for all Groupons purchased. Under this payment model, merchant partners are paid regardless of whether the Groupon is redeemed."
Groupon's cash flows benefit from a redemption model because it sends cash out the door on an "as needed" basis. When a Groupon is redeemed, cash is sent, and it stays with Groupon until that time. Given that 57.34% of Groupon's revenue is derived outside of North America, the company's merchant payables increase quarter to quarter because international operations have so far been based on a redemption model. In the most recent quarter, the company's accrued merchant payables increased to over $576 million. There are several reasons for this. The first is due to international operations. Given that they are based on the redemption model, this figure serves as a sort of proxy for unredeemed Groupon liabilities, at least in the international business. The second is Groupon's scale, and the time lag of the fixed payment model. Under that model, used in the United States and likely the rest of North America, merchants are paid within 60 days of the Groupon purchase. Therefore, as Groupon pays merchants each quarter and accrues new liabilities, the accrued merchant payable account sees significant turnover, which many investors forget. It is not as if Groupon is simply not paying its merchants at all. Rather, that specific liability is growing because Groupon itself is growing. More Groupon deals mean more merchant payables to pay, and the company is accumulating them faster than it is paying down old ones. Given that Groupon is still in "growth mode," this is to be expected. More merchants mean more revenue, and so long as Groupon can continue to achieve leverage in its business, that liability should not be seen as a major concern, in our opinion. The risk to this is that Groupon's cash flows are being propped up. However, this specific change in working capital would not drag Groupon to negative operating cash flow if it were absent. In the most recent quarter, Groupon had operating cash flow of $83.714 million. Changes in accrued merchant payables contributed $46 million of that, and that figure represents a sharp drop from the $121.173 million it contributed in the year-ago period. A shift to a fixed payment model would, on balance, depress Groupon's cash flows because cash would be sent out the door faster, but with operating leverage, sustained profitability would allow for more cash to be brought in the door.
Groupon's accounting also ties into the satisfaction of its customers, meaning merchants. To increase their satisfaction, Groupon is speeding up the time it takes to pay merchants. According to CFO Jason Child, Groupon is accelerating payments to merchants in Europe, a trend that has been happening for a few quarters now. Groupon is moving some of its mature international operations (meaning Europe) to the fixed U.S. payment model. A year ago, Groupon took 75 days, on average, to pay its merchant customers. In the most recent quarter, that figure has fallen to 66 days.
According to the usual "people familiar with the matter", there is another reason why Groupon slows its payments besides cash flow benefits: it has seen merchants use Groupons to provide a quick infusion of cash before going out of business, which would leave both subscribers and Groupon itself holding the bag. Merchants themselves are mixed on Groupon's payment terms, which lag those of competitors such as LivingSocial and Amazon (AMZN). Both promise full payment in 15 days, as opposed to Groupon's process of paying in installments of 1/3 of 60 days. Google (GOOG) promises 80% payment in 4 days and the remainder to be paid within 90 days. Some small businesses need cash flows to be prompt, while others say that there are no issues with stretching out payment, particularly if it means being able to do a deal with Groupon, which does have more scale than any of its competitors.
Too many investors and followers of Grouopn ignore the nuances of the company's accounting, both on the bullish and bearish side. It is important to understand how Groupon's accounting for its deals with merchants works before making a judgment call on the stock.
Overall Accounting & Control Processes
Ever since Groupon entered the public eye, its overall accounting practices have been the subject of much scrutiny. The latest accounting controversy at Groupon had to do with its restatement of 2011 results due to a need to increase refund reserve accrual. Groupon has pledged to tighten its accounting and internal controls, and so far we think the company is delivering on that pledge. Groupon has added 2 directors to its board with extensive accounting experience: American Express (AXP) CFO Daniel Henry and Robert Bass, who retired as a vice chairman at Deloitte this month. The 2 will add accounting oversight to Groupon's board. Analysts brought up this issue of accounting and internal controls to CFO Jason Child on the company's latest earnings call. Child responded that Groupon is working to tighten its internal controls. He stated that the company has changed its refund methodology to get a much more granular look into the business. The company is now able to see weekly what is going on and plan for refunds accordingly. That process is being rolled out to the 48 countries in which Groupon does business, he said. Child expects for these fixes to be completed within one or two quarters. The statement of material weakness present in Groupon's annual report, however, will stay there until the company files its annual report for 2012.
Competition: What is to be Done?
In addition to accounting, competition has also been central to the bearish thesis on Groupon. And the truth is that there will always be at least one competitor for Groupon (LivingSocial). The daily deals market is such that it is easy to set up shop. But building a profitable business is what matters in the long run, and we believe that only Groupon, and possibly LivingSocial, have the necessary scale and reach to build a sustainable and profitable daily deals business.
Groupon is the current leader in this sector, and it is working to maintain that lead. Initiatives such as Groupon Now! and Groupon Goods show that the company can innovate rapidly to stay ahead of its competition. Furthermore, Groupon's mobile presence is proving to be an increasingly profitable part of its business. In April, 30% of Groupon's transactions in North America were performed on mobile devices, as opposed to 25% just 4 months before that. Thanks to Groupon Now! and an emphasis on mobile features, subscribers who use the company's mobile applications generate about 50% more revenue than Groupon's web-only customers. As mobile becomes an increasingly bigger part of Groupon's business, revenue growth should be set to continue.
It is important to understand that Groupon will never have the best deal for each and every subscriber. It is impossible for Groupon, or any daily deal company for that matter, to attract and retain every merchant. And on any given day in any given city, it is possible that Groupon will not be offering the "best" daily deal out of every single deal offered by every single daily deal company that operates in that city. But it is also possible for Amazon, Google, or LivingSocial to not offer the best deal as well. It is important for investors to not extrapolate their own experiences (or lack of experience) with a particular company's product from clouding their opinions about that company. The way that Groupon operates in your particular city on a given day, week, or month is unlikely to be indicative of how the company functions across all of its markets.
Groupon is likely to emerge the victor in the daily deal battle because it has built a large business that despite popular opinion, has a decent economic moat. Groupon's merchant tools are at the forefront of the industry, and the company's subscriber base provides an added incentive to work with Groupon. It is a cycle that reinforces itself, and we expect that 2012 will prove that it is sustainable. Furthermore, Groupon is rapidly building its international business, and it now contributes a majority of Groupon's revenue. Groupon has worked hard to cement its status as the international leader, and we believe that too many people overlook the potential that Groupon has abroad. Groupon has a strategy of either entering localized international markets itself or buying the strongest daily deals company in those markets, using it to cement relationships with merchants, which is even more essential internationally than here in the United States.
Emotion has no place in investing, and emotions have clouded the judgment of many Groupon investors on both sides of the debate. Groupon is not yet a company that is worth $20 per share. Will it someday be worth that amount? Possible. Is Groupon worth less than $10 per share? We do not think so, and that is why we now hold cash-secured puts against the stock. Now that the lockup has expired and so called "weak longs" have been flushed out, we think that it is likely that Groupon has found a bottom. Once emotion is removed, an investor can find that Groupon is a company that is on the way to sustained profitability, albeit not the kind of profitability that inflated expectations when the company first launched. A rational look at Groupon reveals that the stock has fallen too far, and that over time, long-term investors should see a good return on their investment as Groupon cements its leadership position here in the United States and internationally.
Additional disclosure: We are long GRPN via cash secured puts and via our holdings of GSV Capital. We are long GOOG and AMZN via a mutual fund that gives the company respective weightings of 2.1% and 0.94%.