Is Groupon Fairly Valued?

| About: Groupon, Inc. (GRPN)

Recently, the US retail sector has witnessed a shift in the consumer spending pattern where coupon and bargain purchases are now becoming the new trend. The uncertain economic environment coupled with declining disposable income has been the main cause of this shift towards making more bargain purchases. Companies offering discounted prices and coupons to their customers have been able to thrive even in these difficult times, while companies cutting back on these discounts and coupons were headed towards a dead end. Those in doubt can take a look at where J.C. Penney (NYSE:JCP) stands right now. After ending its coupon policy, the company began to lose customers to other retailers that continued to offer such schemes to their customers, such as Macy's (NYSE:M).

This trend applies equally to large companies and small local businesses. Due to the lack of resources and a proper platform, the smaller companies were unable to reach a wider audience that would have made offering these coupons and discounts financially feasible.

Daily deals/local commerce websites emerged as a solution to this problem. It served as an active platform for smaller companies to promote their business and provide special offers. These companies aimed to attract higher traffic and build a loyal customer base, in return for a cut in profits on the coupons sold. This business idea quickly exploded in the US and many companies began to offer such discounts. According to the BIA/Kelsey, the industry reached $1.8 billion in 2011 from minimal existence a few years ago. Specifically in 2011, the total spending on such deals experienced a more than twofold increase as compared to the previous year.

Source: Yipit Data

Despite the increased competition from the new entrants, Groupon (NASDAQ:GRPN) remains to be the dominant player in the US daily deals industry. Although Groupon offers daily deals to local businesses in 47 countries, the North American market continues to be the major sale point for the company. The company's shares began trading in November, 2011 but soon afterwards its stock price plummeted sharply, dropping below $3 per share in slightly more than a year from the initial value of $26 per share. Although the company's share price has somewhat recovered since then, it still trades at a discount of more than a 50 percent to its initial value.

Source: Ycharts

Historic Performance

Source: GRPN Financial Statements

Gross billings represent the total dollar amount received from customers' purchases of goods and services, excluding applicable taxes and net estimated refunds. Although Groupon only retains a certain portion of these revenues, this measure gives an insight into the customer traffic and the purchasing power of the visitors visiting the company's websites.

After experiencing an initial phase of high growth, the growth in gross billing has significantly slowed down over the periods as the level of competition increased. Gross billings over the periods shown above have grown at a CAGR of 8.7 percent.

Although the company has launched its own retail website in the second half of 2011, by the name of Groupon Goods, third party revenues still contribute approximately 69 percent of the company's total revenues. Thus, gross billings have a significant impact on the company's revenue base.

The company's revenues have exhibited a similar trend as gross billings, registering a CAGR of 8.4 percent. Initially, third party revenues increased and then experienced a decline in the last 5 quarters. Third party revenues had increased at a CAGR of 16.3 percent and then declined at a CAGR of 5 percent. The decline in third party revenues seems even more surprising when considering the fact that these revenues had grown at a CAGR of more than 50 percent since Q1 2010. The reason being that the increased competition has led to a slowdown in the number of active customers and the proportion of gross billings retained by the company from third party revenues had also fallen by almost 10 percent.

Source: GRPN Financial Statements

Direct revenues are generated from the sale of merchandise directly to the end customers. These revenues have increased sharply since the launch of this service in the second half of 2011. Direct revenues increased from around $7 million in Q3 2011 to approximately $190 million in Q2 2013, a CAGR of 60 percent since the introduction of this program. Despite this amazing growth, direct revenues have also fallen in the last two quarters from $225 million in Q4 2012.

Source: GRPN Financial Statements

The graph highlights the reasons for the decline in the performance of the company in the latter periods. The company's gross billings per active user have dropped significantly in the last 6 quarters and the growth rate in the number of active users over the same period has also slowed down sharply. The growth in active users fell from a high double digit quarter-on-quarter growth to lower single digit figures. Gross billing per active user has fallen at a CAGR of 2.2 percent over the last 9 quarters. Thus, a slowdown in the customer traffic combined with lower average spending by the users of Groupon's website resulted in a sharp decline in the company's financial performance.

Margins and Costs

Source: GRPN Financial Statements

On the face of it, the company's profitability has improved significantly. The operating margin improved from -39.6 percent in Q1 2011 to 4.5 percent in Q2 2013. It seems that the company will continue to follow this trend in the future. However, I believe it is more important to analyze the driving factors for this improvement in the company's performance in order to decide whether the company will be able to sustain such performance.

Despite achieving high growth in its revenues over the years, the company's selling, general and administrative expenses have generally remained under control. These expenses as a percentage of revenues have remained somewhat stationary over the period, increasing to 49.7 percent of revenues from 48.3 percent in Q1 2011. The company's management has been working on building its global sales force and investing in technology and infrastructure in anticipation of growth in the coming periods. Although the costs have slightly increased, these expenses are being incurred to prepare the company for future growth. If the revenue growth continues in similar fashion as in the previous quarters, this ratio will fall considerably in the coming years.

Improvements in the returns of the company's equity investments also contributed positively to the reversing trend. Previously, the significant losses coming from these investments were putting additional downward pressure on the company's bottom line. In the last two years, these investments have started turning fruitful for the company as the losses continue to decline sharply.

The decline in the company's marketing cost has helped the company in improving its profitability. However, the cost control measures exercised by the management in this area may prove to be detrimental for the company's future growth.

Source: GRPN Financial Statements

The marketing expense as a percentage of revenues has fallen sharply as the company shifts its focus towards spending more on subscriber activation rather than subscriber acquisition. This has led to a drop in the growth of active users of the company's website and platform. In my opinion, this has led to a drastic decline in the company's revenues. I believe that the company needs to equally focus on subscriber acquisition in order to spur growth in revenues in the future.

The shift towards direct revenues may lead to a decline in the company's margins in the future. The company generates direct revenues at considerably discounted gross margins and the increasing proportion of these revenues will significantly reduce the company's profitability in the future. This clearly explains the fact that why Groupon should continue to invest in order to increase the user traffic on its website. Thus, the changing revenue mix coupled with the declining growth in user traffic will continue to harm the company's performance in the future unless the company redirects its focus on investing to increase its customer traffic.


Source: BIA/Kelsey

According to a revised estimate released by the BIA/Kelsey, it is expected that the consumer spending on daily deals is expected to grow at a CAGR of 19.8 percent till 2016. As per the research, a large proportion of local business operators are likely to use such services in the future. The increased competition has led to a cut in the percentage of gross sales revenue retained by the daily deals companies. This has made such services more affordable for many local businesses.

Despite the positive outlook for the overall industry in the US, the increased competition within the industry, especially the entry of big players, will make it difficult for Groupon to cash on this growth opportunity. Recent results have shown that Groupon, although still a market leader, has experienced declining market share in the industry. Even in the realm of online merchandise, the company will face huge competition from larger and well established businesses. Thus, I believe that the company will either perform at par or below the industry.

The competition faced by the company in other regions has also increased over the periods and will hamper its performance in those markets as well. After deeply analyzing the company's performance, I have come to a conclusion that the company is at best fairly priced with a significant downside potential. Hence, I will give a sell recommendation for this company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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