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Groupon - A deal if it lasts

I love analyzing companies, constantly trying to find that next investment that is going to be a hit. And Groupon, while not currently public, is a worthy study in how quickly a company can rise, and potentially how it could fall.  It stands in a class all its own. Imagine, a company with humble revenues of just $5,000 in 2008, jumping to $14.5 million in 2009, and then skyrocketing to $200.4 million in 2010. Wow. On the surface, that puts Groupon on an investor's to-do list. But closer inspection reveals a questionable business model that seems unsustainable, as the pillars holding it upright--customers, merchants, and investors--all may demand more from the company, a company that today is grossly unprofitable and draining cash at an accelerating pace.

The essence of my analysis is that Groupon suffers from the lack of "blood"--profits--necessary to keep propelling it forward. It has needed transfusions to keep it going, but eventually, it has got to stand on its own two feet. Yet financials recently released in an amended S-1 filing, paint a frightening outlook for the company that indicates the need for more transfusions.

Concerns over Groupon are seeded from two conditions: 
  • Groupon is losing a lot of money--approximately $0.32 on every dollar of revenues. On average for every coupon sold in the six months ended June 30, the company received $11.35, while its costs were $14.95;
  • Groupon is dependent on outside funding--shareholders and the growth in merchant payables has provided funding so far and more is needed.
 
Groupon is not profitable and there is no evident trend to profitability 

For every coupon sold, Groupon on average lost $3.60 in the first half of 2010. In the same period, revenues did rise to $11.35, which was up from $10.33 in 2010, and costs also declined from $17.50 to $14.95. But this improvement in margins, considering they are still negative, are overwhelmed by concerns of rising competition, and merchant and customer fatigue. And furthermore, there is no indication from their S-1 filing of any attempt to change the direction of the company or its cost structure that indicates forthcoming profitability.

Groupon dependent on outside funding and growth

Groupon has seen tremendous growth, but it has been completely dependent on outside funding. Its free cash flow is negative and is growing at a rapid rate--it was negative $181.7 million in the last six months, up 641% over the same period a year ago (see table Free Cash Flow, below). 

 
I define free cash flow uniquely to Groupon as EBITDA plus equity-based-compensation, less capital expenditures. Equity-based-compensation and capital expenditures are both significant figures, yet the former has no effect on cash and the latter is a reasonably constant necessity in the business.

To meet their ever-increasing negative cash flow, Groupon has raised capital from shareholders, much of which has not been put towards building the capital of the company, but rather to pay out shareholders. A net total of only $154.7 million has been injected into Groupon, yet $1.13 billion was raised!  

 

So what is covering the remaining deficit in free cash flow after accounting for only a small net contribution by shareholders? Incredibly, it lies with the merchants, who are a principal contributor to cash flow, largely due to sharply rising revenues and the commensurate payables balance. And this was enhanced considerably by the generous (to Groupon) practice of withholding payments to merchants for 60 days in the U.S. and until redemption internationally. As of June 30, merchants were owed $391.9 million, up from $162.4 million at the end of 2010, and combined with other account payables, provided $216.9 million in cash flow for the period and $368.5 million in total up to June 30, the largest source of funding for the company. This source of cash flow will dry up eventually as they won't be able to continue expanding merchant payables indefinitely.   
 


Groupon's financial future in question

With no signs of profitability in the near future and the demands for cash to fund its operations increasing, and at a very large scale, it raises the important question of where funding will come from. The company had hoped to raise $750 million through a public offering, which would have covered negative cash flow for probably another year. We really can't accurately estimate how long, because we don't know how much of the $750 million would have been received by the company since some of the proceeds were intended to pay selling shareholders. But now, those plans appear to be on hold.

So the last probable source is further investment by Groupon's shareholders, which could include new private investors. With poor profitability, a highly uncertain outlook, and high and growing cash flow needs, they do have a big gamble to consider.


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