To say that I have not been a fan of Groupon (GRPN) shares since the IPO is an understatement. I even made a small profit from a short position that, regrettably, I held only for a few days. The main issues for me were stock's high valuation and, more importantly, the lack of barriers to entry for the business. Every day, new daily deal sites were popping up all over the world. Even though imitation is the sincerest form of flattery, this worrying trend showed how easily everybody could clone Groupon's ingenious business idea and become a competitor.
Even the constant drop in the share price did not entice me to go long Groupon. After all, in my mind the business model was fundamentally flawed.
When the announcement of Groupon Payments came out, I realized the company is both diversifying its business and adding to its competitive advantages. After doing some research, it became apparent to me that Groupon is striving to be much more than just a daily deals site.
Let's take a look at what has changed for Groupon in the past few months.
In the past few months, Groupon has extended its offerings for the local merchants meaningfully and will likely continue to do so. The company is transforming itself from a daily deals business to what Andrew Mason, Groupon's CEO, calls "an operating system for local commerce." The goal is for Groupon to become a major commerce platform and an end-to-end solution provider to local merchants. Today, Groupon's businesses include:
- Daily Deals: The original daily deals business is still at the core of Groupon's identity.
- Goods and Getaways: Deals on physical goods and vacations.
- Groupon Now!: A yield management service that allows businesses to market their unused capacity and/or inventory at a discount to maximize profits.
- Groupon Rewards: An easy to use customer retention loyalty program. Groupon rewards was launched nationwide in May 2012.
- Groupon Payments: A payment processing service that can turn any iPhone or iPod touch into a POS system. Groupon Payments was announced in September 2012.
- BreadCrumb: A restaurant management system built for the iPad. Groupon acquired BreadCrumb in May 2012.
- Savored: A restaurant reservation and yield management software through which restaurants can take online reservations and offer time-sensitive discounts. Groupon acquired Savored in September 2012.
Most of the businesses that Groupon operates in are very competitive. While the company lacks any discernible moats, it does possess some important competitive advantages. These include:
Brand Name Recognition: Groupon is by far the best known company in the daily deals business. In fact, many people call daily deals "Groupons" even when referring to deals from competitors. This is akin to people calling tissue paper "Kleenex" or MP3 players "iPods." It demonstrates a powerful and valuable brand.
Scale: Scale is important in more than one way in this business. As the largest daily deals company in the world, Groupon can leverage its sales organization and database of businesses to scale its recent and future small acquisitions into globally relevant brands and services.
Groupon can also leverage its financial and engineering resources to develop and distribute tools for local commerce to try and lock merchants into its platform. The free Groupon Scheduler is a first step. I would not be surprised if Groupon makes a move into POS, analytics, accounting, and inventory management software-as-a-service area for small, local merchants.
Of course, Groupon does not have the upper hand on its larger competitors such as Google and Amazon as far as scale goes. However, it can easily out-compete the smaller players with less resources. I suspect in a few years many of the smaller competitors will be either forced out or acquired. The race to the top will be between a few, large companies.
Sales and Analytics Expertise
Designing an effective deal is not as straightforward as it seems. A good deal brings in as many clients as possible without going over budget or overwhelming the business with a flood of customers. From the merchant's perspective, a good deal also encourages customers to spend beyond the value of their voucher. Deal frequency can also be a factor in what percentage of users become regular paying customers as opposed to just deal hunters.
With its vast database of past deals and analytical data across many businesses and geographies, Groupon is strongly positioned in the industry to design the best deals for its merchants and its end users. Groupon can also apply its knowledge database to its new offerings, such as Groupon Rewards and Groupon Now.
There are significant synergies to be had from becoming an end-to-end commerce platform for local merchants. Groupon Payments can significantly simplify the process of redeeming a Groupon both for the merchant and the customer. I imagine in the near future when a customer uses a credit card associated with his or her Groupon account to pay at a Groupon Payments terminal, the system will automatically deduct the amount of Groupon from the bill, charge the rest to the card, and mark the Groupon as used. There will be no need to even present a voucher.
Groupon Payments can also offer valuable data on customer purchasing habits that can be leveraged in designing Rewards programs and Daily Deals. Other opportunities include integrating Groupon Deals, Groupon Now, Savored, and BreadCrumb for a complete restaurant management, reservation, and yield enhancement solution.
Groupon is hard to value. It is a young company with an evolving business model in a fast changing competitive landscape. Any assumption about its future financial performance can be grossly inaccurate. As such, I will not go into much detail in terms of valuation, but will discuss a few points worth mentioning.
Balance Sheet: Groupon has $1.2 billion in cash and equivalents, no long-term debt, and a current ratio of 1.3. This gives the company flexibility to invest in new technologies and acquire complimentary businesses.
Operating Cash Flow: Groupon generated $159 million of cash from operation in the first half of 2012. However, most of this came from increasing accrued expenses ($63 million), merchant payable ($32 million), and accounts payable ($18 million).
While working capital management is important, withholding payments from merchants for longer and increasing payables is not a sustainable source of cash flow. I would keep an eye on Groupon's cash flow and, more importantly, its sources in the coming quarters.
Reasonable Forward P/E: Twenty-three analysts who cover Groupon on average expect the company to earn $0.36/share in FY 2013. At $4.70/share, the stock is trading at a reasonable forward P/E of 13. Of course, because of the dynamic nature of the business and the competitive landscape, any forward estimates should be taken with a grain of salt.
Unusually High Tax Rate: In 2011, Groupon paid $44 million in income taxes even though the company had a before-tax loss of $254 million. Last quarter, the company's tax rate was 67%. The reason for this unusual tax situation is that Groupon has been unable to deduct its losses in unprofitable jurisdictions from profits in other countries. The situation should correct itself if Groupon becomes profitable in all jurisdictions. There may also be opportunities for Groupon to reduce its tax bill by optimizing corporate structure, and moving some expenses to highest tax jurisdictions.
I view Groupon's move to diversify its business and move toward becoming a platform for the multitrillion-dollar local commerce market as a positive for the company. Groupon possesses unique competitive advantages -- even against its larger rivals such as Google and Amazon -- that give it a fair shot at achieving this goal. I believe below $5/share the stock is a good speculative purchase. I would wait for proof of progress in executing its business plan and improvements in cash flow quality and earnings before taking a large position in the stock.