I recently wrote an article illustrating why Groupon's (NASDAQ: GRPN) cash position is not as rosy as a lot of people think. In this article I will cover another aspect I considered as part of the short thesis I put forth a few months back. While the concept of credit risk has been brought up from time to time, I feel it is significantly under researched in Groupon's case.
Lender of last resort
Let's consider a hypothetical example. Say you are a small business owner with a burger joint in the US and things are not going so well for you. Business is not that great and cash is running low. You go to your local bank and they reject your loan application. What do you do?
Suddenly a Groupon Sales person comes along and tells you what you really need is a new way of marketing your product. Start a Groupon campaign, he says. So you do and you create a campaign selling your famous $10 "Meat Castle" burger for $6. Groupon keeps half of this and the burger itself costs you $3 to make so there is no profit here, but hey, it is a marketing campaign.
Great news! A 1000 people buy your Groupon deal! Groupon sends you a check for $1000 promising to send another one for the same amount 30 days later followed by a final one within 60 days that take cancellations etc into account (See FAQ note below).
Now what you should really be doing is setting this money aside for the ingredients you need to make the burgers when you customers redeem their coupon. But hey, you have to make rent and money is fungible right? So you use the check to pay the rent and keep the shop open for another month. But unfortunately you cannot make payroll the next month and eventually need to shut down.
"Q: When will I get paid?
A: In advance of your campaign, we send you an email entitled "Getting Ready for your Groupon." This message will confirm the payment method you would like to use. We can pay merchants by check or by ACH. Most of our merchants are paid 33% in each of their first two checks, which are sent immediately and about 30 days post-feature, respectively. A third payment, sent at about 60 days post-feature reconciles refunds and refund escrow funds with additional units sold through our Private Sale. Please allow up to ten business days for checks to be processed and arrive at your place of business. "
Now all this while only 200 people have redeemed their Groupons. The remaining customers come to your storefront and find a closed burger joint. They are not happy and go back to the Groupon Customer Support and ask for a refund. Groupon having been the intermediary and going by the "Groupon Promise" is forced to refund the remaining 800 customers while eating the loss.
Why is this important? To be fair, as long as the economy is expanding, this is unlikely to become a big issue. Yes, there will be fraudulent companies running campaigns on Groupon and some that legitimately fail during a campaign but the numbers should be manageable in a growing economy. The issue becomes more pertinent when we enter a downturn. As more and more small business run into problems in a recession, they are driven to companies like Groupon as a last ditch effort to try to finance their operations and stay alive. Groupon for its part is not a bank. It does not have the means or expertise to properly gauge the credit risk of these small enterprises. The fact, as I showed in my previous article, the company is using the revenue collected from its customers as working capital. This adds a further wrinkle to this equation. The more Groupon needs the new revenue to manage its working capital needs, the more it is susceptible to take on the additional credit risk of marginal merchants.
So how do you value the company? Just as any other cyclical company, it should be valued through the economic cycle. This means we take the performance of the company from peak to trough of the cycle and look at its overall performance during this period. This is the reason why valuation of cyclical stocks such as automobile companies [such as General Motors (NYSE: GM), Ford (NYSE: F)] look more attractive near the peak of the cycle. People are just discounting the fact that the company will be impacted more negatively during a recession. The problem with Groupon however is that it has not been in existence long enough to go through a cycle. We just don't know how bad it is going to get (or even if it will survive) through a recession. The company has failed to make a profit in an expanding economy, so how is it expected to survive a recession?
There are several risks to be considered when investing in a company like Groupon. One often overlooked is the credit risk the company is taking on. While this may not have a material impact when the economy is expanding, it is none the less a risk to consider as we look towards a potential recession in the near future. Recognizing that Groupon is in fact a very cyclical company further challenges its current valuation.
Disclosure: I am/we are short GRPN.
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.