Why I Will Stay Away From Groupon's Stock

| About: Groupon, Inc. (GRPN)
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In its first earnings release since became public, Groupon (GRPN) missed analyst estimates on the bottom line, but beat on the top line. Specifically, the company reported a loss of 2 cents, missing the 3 cents profits analysts expected. Revenues came at $506 million, exceeding the $475 million estimate. Obviously, markets didn't like the results, as the stock was sharply lower in after-hours trading. What should investors do?

Stay away from the stock, as the company doesn't have a sustainable competitive advantage. Groupon's business model is based on three economic concepts that allow the company to enjoy an advantage over its competitors: "economies of networking", "economies of scale," and the "power of WOM and Buzz."

Economies of networking arise on the demand side of the market, when consumers buy a product in groups rather as individual units, the larger the number of consumers joining the group, the greater the benefit for each consumer. Economies of network in Groupon's model arise, as soon as a certain threshold is reached, in the form of discounts (coupons) to consumers who participate in the network - the larger the threshold, the larger the discount. As explained in Groupon's site: "Each day, Groupon emails its members one unbeatable offer on something great to do in your city. We offer consumers great values by guaranteeing businesses a minimum number of customers. If a certain number of people sign up, then everyone gets the Groupon offer. If that minimum isn't reached, then no one gets it."

Economies of scale are the cost savings associated with a larger production size of certain product, the larger the production scale, the lower the per unit product cost. Manufacturing 100,000 laptops is cheaper than manufacturing 10,000 laptops. This means that economies of scale arise on the supply side of the market, on the savings from a larger production batch with the same fixed resources, and with the improved bargaining power with suppliers that eventually is passed on to consumers.

Groupon's offerings create Word-of-Mouth and buzz for new products and services, helping them reach the "tipping point-" a very important factor for marketing new products and services. In essence, Groupon is turning consumers into "product evangelists," which is nothing new. Amway and Avon (AVP) products have been exploiting this idea for many years - though in a different format, turning consumers into entrepreneurs and independent business owners, rather than product evangelists.

While Groupon's model is simple, it isn't sustainable; for two reasons. First, as has been the case with other web-based companies like Netflix (NFLX) and Open Table (OPEN), and LinkedIn (LNKD), Groupon is selling other companies' products that have the upper hand in any deal negotiations. Second, they have plenty of competition from direct offerings from other web-based companies with a broad user base like Google (GOOG), Amazon.com (AMZN), and Yahoo (YHOO), Expedia (EXPE), Priceline.com (PCLN) and Travelzoo (TZOO).

Compounding the problem is the product nature of Groupon deals. Most offers are in the discretionary category and services that are at the low end of the consumer list that are economically sensitive - like club memberships and cruises rather than everyday items like dental paste and laundry detergents. This means that Groupon must spend heavily on advertising to push these products and services on the top of their list, which certainly has a negative impact on the company's profitability.

The bottom line: Groupon's most important source of advantage is the power of WOM and Buzz that it creates among customers for new products and services. But this advantage isn't sustainable as the company has little bargaining power with product suppliers, and no barriers of entry to protect its businesses from competition. That's why I will avoid the stock.

Disclosure: I am short NFLX.