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What Does Groupon and The Matrix Have in Common?

Reggie Middleton's picture




 
Have you ever been in a dream where you thought for sure it was real?What would happen if you couldn't awake from that dream? How would you know if it was real, or not? It's 1999, the Matrix - one of the most creative movies of the century - is released and the stock market has seen companies trading at 3 and 4 digit PEs soar with no business models and even less prospects for the future.

It's 2011, Groupon, LinkedIn, Banks, Brokers & REITs are all partying like its 1999! Social networking stocks are the current obsession for Wall Street bankers. Groupon, LinkedIn and Facebook - a trio of Internet darlings are dabbling the public markets and could even eclipse the market value of internet gaint Google. We have discussed in explicit detail, the valuations and realistic expectations of these companies in the recent past. As a refresher:

  1. A Realistic Forensic Valuation of LinkedIn – There Ain’t No Surprises Here…
  2. The Anatomy Of The Record Bonus Pool As The Foregone Conclusion: We Plug The Numbers From Goldman’s Facebook Fund Marketing Brochure Into Our Models
  3. Did Goldman Just Rip Its HNW and Institutional Clients Once Again? Facebook Growth Slows Pre-IPO, Just As We Warned!

There are also host of other internet startups including Pandora (a music streaming service), HomeAway (online vacation-rentals company) Zynga and PopCap (social gaming sites) that are planning to test their fortunes at Wall Street. After LinkedIn which debuted as one the most expensive IPO (yet one of the most successful) in the American history based on the ratio of its market value to its yearly sales, Groupon has filed its IPO filings to test the market appetite for internet start-ups. If the same frenzied marketers who created the frenzy of buyers who greeted LinkedIn on the first day of trading meet together on Groupon’s listing day, its market value could soon touch $50bn (assuming $25bn IPO). LinkedIn which debuted as the most expensive of IPOs has a current price-to-sales ratio of 28x. Facebook, reportedly to generate $2bn of sales, is commanding a valuation of $70bn in private markets with price-to-sales of 35x. Remember, these are the private markets, with a significant liquidity discount to account for the lack of access to public markets! Groupon with $1.3bn of sales (trailing 12 months) and IPO of $25bn valuation would be 19 times sales and 38 times if it gets as lucky as LinkedIn. These ratios are unmatched in the entire S&P Composite 1500 index of small, midsize and large companies. Indeed, investment bankers (Goldman Sachs and their friends at Morgan Stanley and elsewhere) have to be duly credited in their successful creation of abject euphoria surrounding tech companies. There’s a definitive dearth of commentary in the world of financial pundits regarding traditional metrics such as PE, which is admittedly not applicable to high growth tech start-ups since they fuel rapid growth in the early stages with strong reinvestment of earnings resulting in a dearth of earnings to show off. The caveat is that many observers fail to charge the expenditure of said cash flows with actual value creation. Is value actually being created with the reinvestment of earnings and cash flows or are would be earnings simply being used to purchase additional revenues?

The academic risk-reward trade off, among other things means, has traditionally meant that investors pay less for things that are unproven, ceteris paribus. At the moment, investors are paying premiums for unproven models. After LinkedIn, a similar yet dissimilar strategy is in place for Groupon, aiming for that perfect IPO. After all, you can’t fool someone with same strategy again, even if they may be captured investors that don’t subscribe to BoomBustBlog. If LinkedIn was all about pent up demand and social media with reliable earnings stream, then HYPER-growth is the new mantra at Groupon. Groupon has been credited as one of the fastest growing companies in history. No doubt, Groupon’s revenue grew at astronomical pace growing 2241% in 2010 and 1357% in Q1-2011. However, paying a premium for growth and premium for uncertain things are altogether different things. At the moment, investors are confusing a growth model with an unproven business model. Groupon, LinkedIn and Facebook (to an extent), although all in high growth stages, have yet to demonstrate a lasting and formidable business model and as yet should not command such premium valuation. Perhaps after giving all the discounts-of-the-day to its subscribers, the IPO is just a means to square up things at Groupon.

The Groupon Business Model

Is It Right To look To Groupon’s Sales As A Performance Metric?

Groupon’s revenue consists of the gross amount paid by customers for purchased Groupon whilegross profit is the amount that the company retains after paying its merchants an agreed upon percentage of the purchase price to the featured merchant. So the comparable number for price-to-sales to use for Groupon is gross profit, or the fees it collects from merchants, which the management has correctly stated as the best proxy for the value created by the company. To put things into perspective, if eBay used the same math as Groupon does, it would have report revenues of $61bn instead of $9bn. The company reported gross profit of $530m over last 12 months. At $25bn valuation that would put the valuation at 42x comparable sales. To put things in perspective, Google trades at Price-to-sales of 5.8x, Apple at 4.7x, Microsoft at 3.3x, Amazon at 2.6x and Yahoo at 3.4x.

As excerpted from page 3 of the BoomBustBlog subscription document icon Groupon Forensic Analysis & Valuation (923.04 kB 2011-06-16 10:34:36):

Groupon_Valuation_Page_03Groupon_Valuation_Page_03

Subscribers, feel free to download icon Groupon Forensic Analysis & Valuation (923.04 kB 2011-06-16 10:34:36) 

The following information is excerpted from this BoomBustlog research document. Groupon’s subscribers have increased from 0.15m in 2Q-09 to 83m in 1Q-11 while the total Groupon’s sold have increased from 0.1m to 28.1m in the comparable period. Although the growth rates are still strong, they have declined substantially in the last two years (see chart below). In addition, Groupons sold per subscriber have also declined (see charts below). The decline in Groupon sold per subscriber is a clear indication of the fact that its existing customers are also becoming less engaged and higher marketing (customer acquisition) expenses should be expected to be the norm rather than exception at Groupon (for details refer to “Sustainability of business model”). 

 

 

The Flawed Value Proposition of Groupon’s Primary Customer, the Small and Medium Sized Business

First and foremost, we need to realize that Groupon is a marketing and advertising engine for small and medium sized businesses. With that in mind, it would be inaccurate to view Groupon as a direct revenue generator for said business, but rather a method of building said revenues, akin to Google’s AdSense. It’s all advertising.

Unlike Google’s AdSense, the Groupon model calls for the SME (small to medium sized enterprise) to give a 50% discount, and then they split (50/50) whatever was charged by the merchant. This amounts to an effective 75% discount to the merchant’s products and services. Low margin, or labor/resource intensive products and services can (and apparently do) get slaughtered in such an arrangement. Let’s walk through a Groupon deal with a local massage parlor (a popular item on NYC Groupon).

The parlor promotes a $100 massage that sells for $50. Let’s assume that this massage parlor sports healthy margins of 50%. In the Groupon arrangement, the spa only gets $25 (and so does Groupon), leaving the spa with a 25% net loss on the sale. The measurement of the value proposition for Groupon lies in whether said spa would have been better off dumping 75% of the revenues from a typical sale into a more direct ad campaign such as Google’s AdSense, or better yet a more sophisticated and sticky campaign such as display advertising whose visuals would serve an ad parlors business that much better. 

Now comes the problems that reality delivers: Economies of scale for small businesses – Groupon’s bread and butter customer. In order for Groupon to continue scaling at its historical growth rate it has to convince businesses to sell A LOT of Groupons. Often times it is difficult, if not impossible, for said businesses to handle the amount of coupons Groupon needs to be sold. Using the spa example, a commenter on a tech site article cited a small spa in NY that recently sold over 4,000 massages - that expire in a year – the equivalent of 12 massages a day for a year. With such an arrangement, the spa would have to either dishonour many of the coupons or Groupon would have to significantly lower its commissions split. Of course, Groupon could have marketed this based on a very low redemption rate of 10% or so, as well. If the low redemption rate is the sales mantra, then we still have the material loss on the sale as an advertising fee and the risk that more coupons will be redeemed than previously anticipated.
So, is this superior to direct advertising on a risk adjusted basis?

Restaurant.com had a very similar business model, and over time it failed to scale as anticipated and instead settled as niche ad/marketing tool.

As more competitors enter the space (and they certainly are, as shown below) - these deals look even less appetizing both to the core Groupon customer (small businesses) and the product delivered to said customers (the coupon buyer). Local merchants offering low margin/labor intensive products and services will suffer diminishing returns and even less of an appetite for what is basically the social media spin on the "loss leader" approach to customer acquisition. The primary reason this is particularly so with Groupon is…

The type of customers Groupon attracts are perpetual deal seekers (cheapskates, so to say) that probably value discounts over quality. Even if that is not the case, the mere fact that someone uses Groupon regularly means they have become conditioned to expect deals that retailers cannot actually afford to give (at 25% revenue intake).

Net-net: New customers that the retailer can actually profit from will most likely not appear. Bargain seekers with little to no brand or vendor loyalty or lock-in will jump from opportunity to opportunity, as long as there are enough competitors available, speaking of which…

 

There are plenty of questions about sustainability of the business model. Groupon’s business model has relatively low barriers to entry, which makes marketing even more crucial. In its IPO filing, Groupon says it expects to “increasingly compete against other large internet and technology-based businesses, such as Facebook, Google and Microsoft, each of which has launched initiatives which are directly competitive to our business.” The group’s business model implicitly assumes that the company can absorb customer acquisition costs of an acquired customer as he generates subsequent business which would expand margins at later stages. However, the model fails to understand the “stickiness factor” (or lack thereof) of the customer. Unlike Facebook and LinkedIn which compels users to stick to the portal due to social pressure, there are no such strings attached to Groupon. The customers are free to switch to alternative websites if they find a better deal which would make high marketing expenses (read: losses) a structural more than a cyclical issue. The company had stated in its IP filings that its operating expenses are expected to increase substantially in the foreseeable future as it continues to invest to increase its subscriber base and expand its marketing channels, and business operations. Given the new entrances such as Google, Facebook and Microsoft and lower engagement of existing customers (as evidenced by decline in Groupon’s sold per subscriber and decline in revenue per Groupon sold), it’s hard to present a case where company’s margins would expand.

The point above cannot be emphasized too greatly, for there is even a twitter account that's dedicated towards a grassroots movement of businesses against groupon with over a thousand followers: twitter.com/#!/SayNoToGroupon

Why is this?
Well, the danger of SME discontent can be found in the numbers. As excerpted from our report:

The company generated $1.3bn of revenues for trailing 12 months with gross profit of $530m (gross margin of 40%). The company’s gross margin has been fairly stable at these levels (As noted earlier - Groupon’s gross profit is the actual measure of sales). Groupon has lost a huge sum of money despite all that growth. And furthermore, there are still no signs of profits anytime soon. The company reported operating loss in each of the last three years with an operating loss of $420m and $117m in 2010 and 1Q-11, respectively. Marketing expenses as proportion of gross profit was 94% in 1Q-11 while SG&A as proportion of gross profit was at 84%. In 2010, Groupon reported net loss attributable to common stockholders of $456m (-$146m in 1Q-11). 

You see, Groupon cannot afford unhappy businesses, yet most businesses have no choice but to be unhappy if they are labor intensive or lowmargin and use Groupon.

From an article in Fortune magazine that cites university research which strongly corroborates the findings in our report and analysis:tech.fortune.cnn.com/2011/06/16/study-offers-grim-news-on-daily-deals/

People may love online deals. But a Rice University study finds that bargain-hunters rarely turn into regulars.
FORTUNE -- The growing backlash against daily-deals services got some fresh support this week from an academic study finding that fewer than half of the companies that use such services once are unlikely to do so a second time.
The study, by Utpal Dholakia, professor of management at Rice University, also found that nearly 80% of coupon users are first-timers, and only 20% of them become repeat customers of businesses offering deals through services like Groupon, LivingSocial and OpenTable (OPEN). Other companies like Google (GOOG) are actively eyeing the space.
The whole idea behind these services is that they act as loss leaders, getting customers through the door to take advantage of a bargain. Theoretically, many customers will either spend beyond the deal offer or return for more business. But Dholakia found that just 36% of customers buy goods or services beyond what was offered in the deal. Worse, less than 20% return to the business for full-price purchases.
The findings generally align with the data Groupon released earlier this month when it filed to go public. As competitors pile into the market – some of them huge, like Facebook and Amazon (AMZN) – the business will only get tougher, especially if perception grows among small companies that daily deals don't generate much new business.
"Over the next few years," Dholakia wrote, "it is likely that daily deal sites will have to settle for lower shares of revenues from businesses compared to their current levels, and it will be harder and more expensive for them to find viable candidates to fill their pipelines of daily deals."

As always, may the BoomBust be wth you! Interested parties may feel free to follow me on twitter, emailme directly, or register for/subscribe to BoomBustBlog.

 

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Tue, 06/21/2011 - 18:28 | 1390586 Obaminator
Obaminator's picture

How funny. Im the proud co-owner of a Spa. I looked at GroupOn's scheme last year. (I almost Vomited after 2 minutes of reviewing their pitiful attempt of trying to convince me they would bring new customers to my door) I can unequivocally state that GroupOn and Similar are absolute disasters for any small business who gets lured into offering them. THE ROAD TO HELL. It is indeed a 50/50 split from the selling price of the Groupon, and Groupon demands 50% off the regular price. I can also state that there are no Spa’s operating anywhere close to a 50% profit margin. Between therapists commissons, front desk wages, laundry, product, overhead, license, software, credit card merchant fees, rent a Spa doing Very good can expect 25%, most are 15%.

That being Said Reggie Almost has it right, but I disagree with his simple calculation of the net loss, its much much worse when looked at from a Business Model viewpoint: Lets Say $100 massage Groupon sells for $50, Spa keeps $25. At 25% margin the Spa WOULD have made $25 at reg price, but will now be a net loss of $50 - because the cost of the service is $75 but Spa only took in $25. This is a 200% Loss vs the “income” that the Spa receives – (I will give you a $5 bill for 15 $1’s). I now need to Sell 2 more Massages at full price Just to Break Even. Wow...3X the Volume in customers, wear and tear, just to get to back Zero...WHEN DID BUSINESS OWNERS FORGET the friggin reason for being in business is to EARN a Profit, which is the Owners Salary? Zero = Worse than Unemployed! My God!

Even at 50% profit (virtually impossible) the Spa would still be loosing 100% vs the income, $50 loss vs the $25 income, for a loss of $25 – the entire amount of profit the Spa WOULD have made from a regular priced massage. I now must sell 1 more massage at full price to break even.

GroupOn and similar Schemes are a Death-March on the Road to Hell for any Business that entertain such fool-hearted traps. Unless you already offer cheap products and services and have a business model set up for shear Volume, DO NOT step into the quicksand that GroupOn and Similar schems "offer".

As for “repeat” customers. All I can tell you is: Good Luck…if you think people that use GroupOns will ever wish to regularly pay regular prices, I have a bridge across the Grand Canyon I can sell you. I have many Regular customers that already only come in for the monthly specials, I make 5-10% profit on them. Bargain-Seekers.

Tue, 06/21/2011 - 15:02 | 1389792 wtlf555
wtlf555's picture

I don't know about Groupon but after reading this I'd say there are some serious DEFLATIONARY forces out there if so many retailers are willing to discount so steeply

Tue, 06/21/2011 - 18:31 | 1390607 Obaminator
Obaminator's picture

I think GroupOn is indicative not of Deflationary forces, as more indicative of how many Small business owners fail to do the simple Math of Volume at Any Loss does not equal a profit.

If Business owners would get their heads out of lala land, and look at the end result, they would realize ANY volume GroupOn offers simply makes them work far more hours for the same if not less Pay. Seriously...75% off = working 4X as many services to make the Same amount of money...Why? Work friggin less and earn the same.

VOLUME DOES NOT EQUAL PROFITS...thus the Walmartization of America is well under way...people dont deem to comprehend this 1st-grade level idea.

Tue, 06/21/2011 - 14:46 | 1389743 beanieville
beanieville's picture

Forget Groupon, green energy is gonna take us to Dow 36,000.  I mean, ask TJ Rodgers.

T.J. Rodgers, CEO of Cypress Semi: The Free Market Case for Green http://y.ahoo.it/kkY0WNpv

Tue, 06/21/2011 - 14:18 | 1389645 Buckaroo Banzai
Buckaroo Banzai's picture

Rocky Agrawal's devastating slam of Groupon: http://techcrunch.com/2011/06/13/why-groupon-is-poised-for-collapse/

Tue, 06/21/2011 - 13:57 | 1389583 gatorontheloose
gatorontheloose's picture

why use 100x as many words as are needed to communicate this message?  lol

Tue, 06/21/2011 - 13:39 | 1389518 Westcoastliberal
Westcoastliberal's picture

Great post, Reggie but I think you meant "Adwords" instead of "Adsense".  "Adwords" is a way to expose a listing for your website on keywords and ranking you can control (rather than relying on the search engine fairies). "Adsense" is a way to monetize a website by adding a search function.  Searches from your website can potentially generate backend revenue.

Tue, 06/21/2011 - 13:03 | 1389347 ThisIsBob
ThisIsBob's picture

This sockpuppet's future is dependent upon revenue from businesses which are so desperate for customers that they will sell at 75% off list to anybody with a mouse.

And what happens upon the proliferation of non-profit and co-op coupon sites, coming soon to a smsa near you.

Even John Wanamaker could have figured this one out.

Tue, 06/21/2011 - 12:17 | 1389219 Rastamann
Rastamann's picture

hey Groupon...here's your fate already written for you (not that you care after you've pumped and dumped it)

 

http://www.google.ca//finance?chdnp=0&chdd=1&chds=1&chdv=1&chvs=Linear&c...

Tue, 06/21/2011 - 11:39 | 1389097 Careless Whisper
Careless Whisper's picture

Reggie, from now on I'm just gonna call you, The Red Pill.

 

Tue, 06/21/2011 - 10:53 | 1388955 Fix It Again Timmy
Fix It Again Timmy's picture

It's crap...

Tue, 06/21/2011 - 10:25 | 1388863 johnQpublic
johnQpublic's picture

i grouponed a 2 hour intro flying lesson for 49 bucks

2 hours of touring the area by air...awesome deal, and i saw so much of the area for two hours of flying that i never need to do it again!

 

they didnt really believe i'd get hooked and want another flying lesson did they?

and why would i go back to them in the future when i've already recived two more offers to do it again with other flying companies...for less than 49 bucks?

 

...and that right there is why i told the wife to skip the groupon ipo

i will never be a repeat customer to that flying company, and they will probably never use groupon again

that cessna was using 6 gallons per hour of av-gas

at over four bucks a gallon....net profit zero, just because of fuel alone

intro flights are always cheap anyway to lure people in

paid about a hundred where i used to live just to tour the area by air in the form of an intro flight

its about 100+ an hour for lessons after the first one

 

the whole idea is a fail on so many levels

Tue, 06/21/2011 - 14:26 | 1389654 JuicedGamma
JuicedGamma's picture

So let's see at 8 gallons an hour and conservatively $6 per, they lost about 50 bucks on you.

I suppose if they hook every third or fourth one it will be worth their trouble.

For some companies groupon may actually make sense rather than giving away a free iPod for example.  Although I do agree with most of what Reggie is saying.

Tue, 06/21/2011 - 10:19 | 1388828 css1971
css1971's picture

We've used them both as users and business customers and came to the following conclusions:

Groupon are not going to be able to maintain the 50% split with their business customers or the 50% discount. It simply isn't sustainable particularly as groupon users are not repeat full paying customers and word of mouth is not good enough advertising.

Where they may be useful is niche off season deals when there would otherwise be no revenue.

Tue, 06/21/2011 - 10:01 | 1388757 RagnarDanneskjold
RagnarDanneskjold's picture

In China, GroupOn competes with Dianping, which offers free coupons. (Coupons are limited by users having to register with their mobile phone, there are time and/or number limits to the deals) I haven't noticed Groupon having substantially better offers. What happens if a free competitor shows up in the U.S.

Tue, 06/21/2011 - 09:51 | 1388737 ElvisDog
ElvisDog's picture

Anyone who buys Groupon stock at their IPO deserves what they're going to get. Reggie nails it. They have no sustainable business model. It's all based on 15 minutes of fame. As soon as the next new thing comes along, Groupon will go the way of AOL.

Tue, 06/21/2011 - 11:36 | 1389081 oogs66
oogs66's picture

i think you are wrong.  if you can get shares at the ipo as anything other than as a massive client to the underwriter, then you will regret it.  if it is hyped right, and you are one of these people, you made a good decision, and will likely be able to flip it at a nice profit.

I think you mean that anyone who still owns it after the first day of trading deserves what they get.

Tue, 06/21/2011 - 12:58 | 1389355 ElvisDog
ElvisDog's picture

You are correct. I meant anyone who isn't an insider who gets the stock at a preferential price will deserve what the get.

Tue, 06/21/2011 - 09:01 | 1388523 williambanzai7
williambanzai7's picture

Reggie, google the report about Groupons impact on the British hair salon industry. Apparently the salons all use the same recipt booking service so the data can be tracked.

The conclusion is the Groupon salons lose money but become addicted to Groupon customers because regular full price paying customers get aggravated and leave to get serviced elsewhere.

Groupon is a pyramid scheme in the sense that they need to continuously penetrate markets to sustain their model. If I am selling pizzas why should I do a Groupon if I know the same thing will happen across the street next week?

Tue, 06/21/2011 - 10:50 | 1388925 disabledvet
disabledvet's picture

"eyeballs, eyeballs, eyeballs."

that would be people watching the SITE

http://www.youtube.com/watch?v=Aleyfc8Cg8A&feature=player_detailpage

Do NOT follow this link or you will be banned from the site!