Groupon: More Upside Ahead?

About: Groupon, Inc. (GRPN)
by: Aristofanis Papadatos

Groupon has rallied almost 20% during the last week and 80% during the last five months.

The company is an a transitional model.

It is also facing strong competition while its management is focusing on the wrong metrics.

Groupon (GRPN) has rallied almost 20% during the last week thanks to its positive earnings report. As a result, it has now rallied 80% off the bottom it posted five months ago. Therefore, the big question is whether investors should attempt to jump into this rally or the rally has run its course.

First of all, Groupon has a remarkable record of beating the analysts' estimates in earnings per share. To be sure, the company has exceeded the analysts' expectations in 9 consecutive quarters. In addition, it is in a transitional phase, as it has exited 32 out of the 47 countries it operated in until two years ago while it has also managed to stabilize its SG&A and marketing costs, which were on the rise until last year.

Nevertheless, investors should not miss the fact that the company has failed to make a meaningful profit in every single year since its IPO. The major reason is the fierce competition, which has heated more than ever in the retail sector. Since Groupon decided to direct its business from daily deals to online sales of products, it now has to compete directly with Amazon (AMZN) and Wal-Mart (WMT), which continuously improve the mix of price and delivery speed to their customers. In other words, Groupon has absolutely no moat in its business, as it competes with companies that have much greater financial strength. As a result, after the rapid international expansion that followed its IPO, the company has failed to grow profitably in the last three years.

A major point of concern is the persistence of the management to focus on the gross profit, EBITDA and the number of members instead of focusing on the earnings. I have actually been impressed by the focus of the management on only these three metrics and the absence of any guidance regarding the earnings. Buffett has always advised investors to button their wallet whenever they see managements focusing on gross profit or EBITDA. The value of a company and its stock price are certainly determined by its earnings per share, not its gross profit or EBITDA. In fact, the focus on the wrong metrics clearly confirms that the business model of the company cannot make meaningful profits. That's why the stock has lost 80% since its IPO. If the metrics used by the management of Groupon were the ones that mattered, then the stock would have enjoyed a strong rally instead of plunging. Moreover, the focus of the management on the number of customers is reminiscent of the period of the tech bubble, when loss-making companies were focusing on the number of clicks they were attracting.

It is also critical to note that Groupon recently changed its business model, from a coupon site to an extensive marketplace with numerous products. While that shift was obligatory for the survival of the company, investors should keep in mind that the company essentially changed field, from a niche market it had expertise in to a highly competitive retail market. When a company completely changes its business model after failing in its initial market, it waves an alarming red flag to investors because it no longer has the edge it had in the first place.

It is also remarkable that the management of Groupon has rewarded itself with an excessive amount of shares in the last few years. More specifically, it rewarded itself with shares worth $472 M in the 4-year period 2013-2016 and thus offset about 60% of the share repurchases it executed during that period. As the company has failed to make a meaningful profit and its stock has collapsed since its IPO, it is certainly unacceptable that the management rewards itself in such an extreme way, at the expense of the shareholders.

The share repurchases have also resulted in a markedly weak balance sheet. While the company had no debt until three years ago, its net debt (as per Buffett, net debt = total liabilities - cash - receivables) has now climbed to $524 M. Given that the company hardly makes any profit, this is obviously a negative development. Moreover, the share repurchases have caused the book value to fall towards zero. Therefore, if the company does not manage to turnaround, it will be greatly exposed to its creditors due to its weak balance sheet.

To sum up, while the debt load of Groupon keeps growing and there are no meaningful earnings, its management continues to focus on its own metrics, i.e., the gross profit, EBITDA and the number of customers. At the same time, it is rewarding itself to the extreme via stock options. Therefore, the stock has too many red flags to be viewed as a long-term holding. Of course the stock may continue to rally in the short term or any time it spreads hopes for a turnaround but investors should view it only as a speculative, high-volatility, risky stock, which is not likely to have a happy end.

Disclosure: I/we 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.