Every public (as well as private) company operates in a slightly different way. There are nuances in each business model and strategy, nuances that take time to understand and evaluate. And in this article, we would like to discuss one of the most misunderstood companies on the market today: Groupon (NASDAQ:GRPN). Groupon has had a tumultuous history since its founding in 2008. It has gone from a small startup to a Google (NASDAQ:GOOG) acquisition target, to a public company accused by many of being nothing more than a Ponzi scheme. Since its November 2011 IPO, Groupon has lost over 81% (as of this writing) of its value, as the reality of the company's business failed to match the hype. But Groupon near $5 is a far different stock than Groupon at $20. And for long-term, patient investors, we believe that shares of Groupon are a buy. For the record, unless otherwise noted, financial figures and management commentary will be derived from 3 sources: Groupon's Q2 2012 earnings release, its latest 10-Q, or its earnings conference call.
Q2 2012 Overview: Looking at Headlines is Not Enough
Groupon's latest round of stock malaise was sparked by its Q2 2012 earnings release. Buried within it was the fact that in Q2, Groupon's gross billings (the total $ value of its deals sold) shrank sequentially from Q1. While Q2 2012 gross billings of $1.29 billion were up 38.829% from Q2 2011, they were down 4.797% from Q1 2011 (in fairness to Groupon, currency volatility reduced Q2 2012 gross billings by $75 million). The sequential rise in Groupon's revenue was due to continued growth in the company's new Groupon Goods business. Groupon lost over a fifth of its value after posting its Q2 earnings, as investors fretted about growth and the company's continued direction, even if revenues grew by 44.8% year-over-year, and the company posted a GAAP profit of 4 cents per share. Groupon's Q3 outlook calls for revenues of $580-$620 million (representing growth of 35-44% year-over-year) and operating income of $15-$35 million (compared to a loss of $0.2 million a year ago). Based on the midpoints of Groupon's guidance, revenues will grow 5.572% sequentially, and operating income will drop 46.219%, reflecting planned investments Groupon will make in its international business, which we discuss below.
Groupon's earnings call yielded a great deal of insight into the reasons why gross billings declined, as well as what the company plans to do about this issue. Groupon's decline in sequential billings and billings growth were caused by weakness in Europe, which forms the core of Groupon's international business (international revenues comprise 54.22% of Groupon's total revenues). On the call, CEO Andrew Mason explained that the company's European deals have, on average, higher price points than its North American deals, stating that, "these more discretionary offers are more susceptible to negative demand elasticity over the past few quarters as macroeconomic conditions have deteriorated." While macro issues did indeed play a part in Groupon's European weakness, the company does have levers to pull when it comes to defending against such weakness. Over the past several quarters, Groupon has rolled out various technological improvements within its North American operations, improvements that enable better deal personalization and better merchant campaign tools, which are crucial in retaining merchants. We believe that while Groupon is somewhat exposed to macroeconomic stress in Europe, the stock's steep post-earnings selloff has priced in most of that weakness. Furthermore, Groupon sees mobile, a sector that has plagued many social companies, as a way to strengthen its European (as well as overall international) position. Groupon's mobile application is the #3 shopping app in the United States, and CEO Andrew Mason stated on the company's conference call that mobile users spend 50% more on Groupon's than traditional desktop users. Mason declined to state how long the company would be in investment mode related to its international business. But, he did say that Q3 guidance takes this into account, and that Groupon is looking to integrate its 6 various technology platforms so that improvements can be deployed much quicker than they are today. There is risk that margins may be pressured in the short-term (the company's GAAP operating margin was 8.179% in Q2 2012), but we believe that integrating Groupon's technology platforms is the right long-term move.
It is true that on a GAAP basis, Groupon's gross billings declined sequentially this quarter. And it is also true that Groupon's year-over-year billings growth has slowed. But it has slowed from 108% in Q1 2012 to 47% in Q2 2012, which is still an impressive growth rate. And in our view, billings growth alone cannot be used to paint a bullish or bearish picture of Groupon. It would be as if Intel's success were measured solely on the number of chips it sells. Without taking into account things such as margins, or the percentage of each deal that Groupon takes, this metric means little. On a year-over year basis, Groupon posted a non-GAAP operating margin of 12.7%, compared to a non-GAAP operating margin of -15.9% a year ago. While growth has slowed year-over-year, profits have arrived. We believe that in the long run, investors will come to realize that in this case, extracting higher profits from a slower-growing company is better than chasing every penny of revenue growth while ignoring the bottom line.
Taxes: Another Lever for Groupon to Pull
In the prior segment, we discussed the "levers" that Groupon has to strengthen its European and international business, which can serve as a defense against macroeconomic stress in those markets. In the long run, those technology investments should lead to increased profits. But, there is another lever that Groupon can pull, one that many investors have overlooked: taxes. In Q2 2012, Groupon's tax rate was a stunning 66.593%. Of Groupon's $100.424 million in pre-tax income, $66.875 million was set aside for income taxes. Had Groupon paid even the statutory rate of 35%, GAAP profit would have come in at 9 cents per share, more than double the reported 4 cents in profit. We can think of few companies that pay such a high tax rate. On the call, CFO Jason Child said that at this point in time, the company is unable to use net operating losses to offset tax payments in profitable countries. However, Child did say that the company expects its tax rate to decline "meaningfully" over time, as it implements its international tax strategies. We do not think that Groupon will be paying taxes at a rate of over 66% in perpetuity. In the quarters to come, this rate should come down, and those savings will flow straight through to Groupon's bottom line.
Merchant Satisfaction and Accounting Practices: Decoding the Truth and Evaluating the Upside
Ever since Groupon was founded, there has been one overarching question in every debate regarding the company: does it help merchants? We believe that the answer is that on average, Groupon does indeed help merchants. Is it true that for some merchants Groupons are a failure? Yes. And it is also true that for some, they are a wild success. The reports regarding merchant satisfaction tend to focus on both extremes, and the reality, as always, lies somewhere in the middle. It is impossible for Groupon, or any other company for that matter, to satisfy 100% of its customers 100% of the time. Such expectations are unrealistic. As long as Groupon satisfies a majority of its merchant partners the majority of the time, things will be fine. Studies commissioned by Groupon and conducted by ForSee (alongside independent studies the firm did) show that Groupon has a score of 79 on ForSee's merchant satisfaction index. The average for all B2B companies included in the study was 64. Groupon beat the Fortune 500 by 10 points.
Groupon's Q2 conference call, however, showed that in Europe, Groupon's merchant satisfaction score was 25 points lower than here in the United States. Raising that score, by striking the proper balance between merchant and consumer value, will lead directly to increases in Groupon's revenues. We expect more color on this issue in Groupon's Q3 report, and believe that improving merchant satisfaction is another way to strengthen the company's international business. On Monday, September 17, Groupon fell nearly 10%, with the losses driven by a merchant survey released by Raymond James. The firm conducted a survey of more than 100 merchants, and its results showed that while 53% of merchants were either satisfied or very satisfied, a third were unsatisfied, and that 39% are "unlikely" to run a Groupon deal within the next few years. Frankly, we do not see this survey as being representative of the overall Groupon merchant experience. Groupon had more than 100,000 merchant partners at the end of Q2, and we do not think that surveying 0.1% of the company's merchant base can give a wholly accurate picture of the sentiment that Groupon's merchant partners have toward the company. Still, we believe that Groupon needs to communicate the value it brings to merchants more clearly. The company is not being given the benefit of the doubt by the markets, and Groupon needs to do all it can to dispel the rumors that surround it.
We would like to turn now to Groupon's merchant accounting practices, an issue we discussed in detail in our last article on the company. In this article, we will focus on Groupon's accounting practices this quarter, as well as in the quarters beyond (readers who would like a more detailed overview of the company's accounting may turn to our previous article, which is linked to above). As a reminder, Groupon has 2 merchant payment models, which are outlined in its 10-Q filings with the SEC.
- Redemption payment model: "Under our redemption merchant partner payment model, we collect payments at the time our customers purchase Groupons and make payments to our merchant partners at a subsequent date. 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 from the unredeemed Groupon. 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."
A cursory reading of these 2 models makes it clear which model is better for Groupon. Under the redemption model, Groupon sends cash out the door only when Groupon's are actually used. Under the fixed payment model, merchants are paid within 60 days, redemption or no redemption. Groupon is slowly rolling out its fixed payment model to its international markets, but CFO Jason Child made it clear that the company will not make the transition overnight. He stated on the earnings call that, "While rolling out changes to payment terms of merchants in our international business is something that we believe can further enhance the merchant value proposition, the transition will occur on a deal-by-deal basis and with appropriate level of consideration to customer experience and credit risk management. Over time, we do expect working capital to continue to be a meaningful driver of our cash flow." Groupon posted operating cash flow of $75.315 million in Q2 2012, up 93.012% from Q2 2011, driven by changes in working capital as well as depreciation and amortization. Interestingly, stock-based compensation (which is added back into operating cash flow) declined by 30.048% to $27.084 million. Analysts pressed CFO Jason Child as to how the company's changing merchant payment practices would affect the company's cash flow. Child responded that in Q3, working capital's contribution to operating cash flow should remain at about the same ratio as it does today. Child reminded analysts that this process will not happen over the course of a single quarter, but rather many quarters. Child stated on the call that the company will keep analysts and investors updated on the company's merchant payment models and practices. We believe that worries regarding cash flows were much more material in the company's early days. But now that Groupon has $1.185798 billion in cash & equivalents on its balance sheet (and that excludes $131.177 million in equity investments), the company is in much better shape to weather a change in cash flows. And in our view, the transition to a fixed payment model across all of the company's international markets will help increase overall merchant satisfaction, which will, in the end, lead to higher cash flows. Groupon is continuing to strengthen its accounting team, and hired Brian Stevens as its Chief Accounting Officer earlier this month. Stevens joins the company from KPMG, where he worked for 16 years, most recently as an audit partner.
Competition: Not as Easy as it Seems
A central tenet of the thesis against Groupon has been that there are no barriers to entry in this industry. The conventional wisdom seems to be that anyone can set up a website and begin selling daily deals. But the truth is that it is not that easy. Groupon ended Q2 2012 with 12,820 employees, and that number grew 33.195% from Q2 2011 and 2.168% sequentially. It takes thousands of employees to do what Groupon does, and to succeed in the daily deals industry, it will take much more than just a website. It is true that Groupon's competitors include companies such as Google and Amazon (NASDAQ:AMZN). But simply because Groupon competes against such companies does not mean that it will fail. Groupon is working hard to strengthen its relationships with both merchants and consumers. On the company's conference call, CEO Andrew Mason stated that Groupon Rewards, the company's customer loyalty program, now has 6,000 merchant partners and over 1.5 million subscribers enrolled. And 20% of merchants are suing at least one of the company's merchant tools, such as Groupon Scheduler, Groupon Now!, or Groupon Rewards. As we stated in our last article on Groupon, it is impossible for Groupon, or any daily deals company, to have the perfect deal for each subscriber each and every day. As long as Groupon has, on average, the best deals in the industry, we believe the company can come out ahead. And according to industry reports, that is in fact a distinct possibility. Sources close to Google indicate that the company has laid off a large portion of its staff at its German subsidiary DailyDeal, due to an inability to gain traction in that market.
Analyst Estimates, Valuations, and a Word Regarding Their Role
Stocks prices often become unhinged from the fundamentals of the underlying company, and can deviate from them, both to the upside and the downside. At $20 per share (the price at which Groupon priced its IPO), the price was unhinged to the upside (whether or not Groupon should have priced its IPO at that level is beyond the scope of this article; a higher stock price would bring in more cash for the company, but also makes it harder to sustain the share price). And at around $5, we believe that the price is unhinged to the downside.
As of this writing, analysts expect Groupon to post EPS of 37 cents per share, which would give Groupon a P/E ratio of 12.838x 2013 earnings, hardly overvalued for a company projected to grow earnings at a rate of 117.647% in 2013.
Click to enlargeAnd yet, analysts had forecast 2013 EPS of 70 cents per share back in June when our last article on Groupon was published. While we admit that Groupon's Q2 results could have been better, were they really so terrible as to warrant a 47.143% cut in 2013 earnings estimates? Has Groupon's business really worsened by nearly half in the span of a few months? We do not think that it has. And such seemingly dire cuts in earnings forecasts stand in stark contrast to analyst price targets. After Groupon posted its Q2 results, Citi slashed its price target from $19 to $9. And JPMorgan cut its target to $8. Both firms cited Groupon's quarterly results as reasons that their old price targets were unwarranted. And yet, these price targets imply that under $5, Groupon shares have tremendous upside. Based on the company's stock price of $4.75 as of the close of trading on September 17, Citi's price target implies upside of 89.474%, and JPMorgan's implies upside of 68.421%. The exception to this is Ken Sena of Evercore Partner. Frankly, his ratings revisions regarding Groupon are a bit puzzling. After the company posted its Q2 earnings, he cut his price target to $6.50. As of today, that target stands at $3. What exactly has changed over the course of the past month? Has Groupon's business really deteriorated that badly?
Investors need to remember that at the end of the day, analysts do not provide facts. They provide opinion. While we do not buy into the idea that analysts exist solely to defraud retail investors, we do believe that their reports need to be taken with a grain of salt. When Groupon first went public, analysts may have been too optimistic. Even we will admit that it is tough to see how Groupon is worth $20 per share based on current fundamentals. But, those same fundamentals imply a share price higher than $4.75. Groupon's Q2 report may not have been ideal, but did it really warrant a nearly 50% cut in estimates? We do not think so, and think that analysts are switching from excess optimism to excess pessimism, a situation that may set the stage for an upside surprise in the quarters to come.
Microsoft and Groupon: A History Lesson
Critics of Groupon will no doubt view any comparison between that company and a blue-chip company such as Microsoft (NASDAQ:MSFT) as deeply offensive and insulting to Microsoft. How can a worthless company such as Groupon be compared to the enormously profitable Microsoft? We are not making an argument that the 2 companies have similar profit potential or should be seen as equals when it comes to financial condition. Rather, we are comparing how the two companies were perceived in their early years. In this instance, there are some similarities.
Both Microsoft and Groupon ushered in new industries. Groupon was crucial in launching the daily deals industry, and Microsoft was instrumental in launching the personal computing revolution, and helped lay the foundations of a good deal of the technology that we use today. In hindsight, it seems foolish that anyone could question the business potential of Microsoft. Yet in the company's early years, it was met with skepticism. Steve Ballmer, Microsoft's current CEO and the company's 30th employee, recounted in an interview with Forbes that his parents were deeply skeptical of this new software company, one that he dropped out of the Stanford Graduate School of Business to join. Steve Ballmer stated that when he told his parents that he was leaving Stanford for Microsoft, his father asked him what software was. And his mother didn't understand why anyone would actually want a computer. In hindsight, those questions may seem foolish. But at the time, people did not grasp the potential that Microsoft had. It takes time to understand, evaluate, and value a new industry. It took time for Microsoft, and it will take time for Groupon. The daily deals industry is still relatively new, and investors need to examine it without prejudice or emotion. We believe that in time, people will come to accept the long-term potential of daily deals and local commerce. And we believe that as the leading daily deals and local commerce company, Groupon stands to benefit from the growth of these industries more than any other company.
We continue to believe that Groupon's best days are ahead of it. Groupon is a misunderstood company, and there are a number of issues that investors need to understand when it comes to this company. But, we believe that the markets are unduly punishing Groupon. While the company may not be worth $20 per share, we believe it is worth a good deal more than $5. And at under 13x estimated 2013 earnings, we find it hard to see Groupon's shares as overvalued, and think that there is far too much pessimism surrounding this company. The market is offering investors an excellent deal on shares of Groupon. We have taken the deal, and believe that in the long run, other investors that do the same will be rewarded for their convictions.
Disclosure: I am long GRPN, GOOG, AMZN, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are long shares of GOOG, AMZN, and MSFT via the Fidelity Growth Company Fund.