Photo: Business Insider
Six months ago, Groupon was the hottest company on earth.The company had just turned down a $6 billion offer from Google, it was generating more than a billion dollars of revenue in year three, and it was said to be preparing an IPO at a ~$25 billion valuation.
Now, after a backlash against “daily deals,” several quarters of $100+ million of losses, and slowing growth, some people are arguing that Groupon is just a “Ponzi scheme” that will collapse the moment the company cuts back on marketing spending.
So, what’s the truth?
Somewhere in the middle.
Groupon has identified a huge new business opportunity and grown mind-bogglingly fast. It has fought off hundreds of competitors, including Facebook and Google. It has humiliated thousands of critics who have dismissed its business as “easily replicable with no barriers to entry.” And it has done this while consuming very little cash, thanks to its ability to operate with negative working capital.
At the same time, the company has also benefitted from the novelty factor of its primary product, daily deals, and that novelty may be wearing thin. It is hemorrhaging losses (losses, not cash), leading many observers to believe that it will never be profitable. And its investors have already taken more than $900 million off the table, enriching themselves while leaving the company low on cash.
So, what’s the next chapter in the story?
After taking a detailed look at Groupon’s business metrics, here is our take:
- Groupon has a real business and should eventually be profitable—provided management doesn’t screw up and run out of cash
- The transition to profitability will require Groupon to radically cut back marketing spending
- Cutting back marketing spending will sharply slow Groupon’s growth
- Sharply slowing growth will likely clobber Groupon’s valuation
- If Groupon raises a boatload of money in an IPO, several of these concerns will diminish: The company will be able to keep spending aggressively on marketing and not have to worry about running out of money or dealing with slower growth for a while. That said, the transition from growth to profits will not likely be a happy period for Groupon’s shareholders.
- If Groupon cannot get its IPO done, the company will likely have to raise money in the private market
There are several key metrics that support these conclusions. We’ve attached them as charts, and we’ll walk through them below.
Importantly, there’s precedent for a hyper-growth money-losing company like this transitioning to profitability—one that may offer a glimpse of what’s next for Groupon.
That company is Amazon.
In the late 1990s, many analysts argued that the perpetually money-losing Amazon would “never make money.” For a while, these concerns looked silly: Amazon’s stock soared, the company raised and spent huge amounts of capital, and growth blew the doors off.
But then the dotcom bubble burst and the capital markets shut down. And suddenly Amazon had to transition from hyper-growth and losses to slow growth and profits—without running out of cash in the process.
Photo: Google Finance
This transition was seriously challenging. Amazon’s stock tanked (see chart at right), and it nearly went bust. But, eventually, after a couple of rough years, the company emerged as one of the industry’s biggest winners, and it has gone on to build a colossal franchise.This is not meant to suggest that Groupon is the next Amazon. There are some similarities between the companies, but there are also critical differences.
The part of Amazon’s history that Groupon appears headed for is the transition from losses to profits. How rough that transition is will likely depend a lot on whether Groupon can raise another big slug of cash.
The sceptics' specific theory is that, when Groupon scales back marketing spending, the company's growth will tank. But Groupon has already cut back marketing spending (see below). And the company's growth is still impressive!
This is because Groupon's existing customer base now contributes the majority of Groupon's revenue. (See our assumptions below). Because of this, Groupon could radically cut back marketing and still have a huge business—albeit one growing much more slowly.
To estimate Groupon's revenue 'new' vs 'existing' customers, we did the following:
We looked at the number of new customers Groupon added in each quarter (disclosed) and assumed that these new customers each bought one (1) Groupon in the quarter for the average Groupon selling price (disclosed).
This gave us our estimate of revenue from 'new customers.'
We then assumed that the rest of the revenue came from 'existing customers.'
It's possible that many 'new customers' buy more than 1 groupon in their first quarter as a customer, but we doubt the average is as high as, say, 2 groupons per new customer (many of the new customers will have bought their first Groupon in the last month of the quarter, leaving them little time to buy another).
Even if we assume that 'new customers' buy 2 Groupons apiece in their first quarter, the portion of Groupon's revenue from 'new' vs 'existing' customers is still increasingly weighted toward 'existing.'
Groupon sceptics also argue that daily deals are a fad and that Groupon's existing customer base is buying fewer and fewer of them. On a per-customer basis, this is true (see chart below). And this is a valid concern. But don't forget that Groupon's existing customer base is still growing rapidly, so, in aggregate, they're buying more and more Groupons. (Of course, if most of Groupon's existing customers get sick of Groupon, the company will indeed be screwed. So this is something to watch.)
And what about profits? Can Groupon ever be profitable? In our opinion, yes, it can—but it will have to radically cut back marketing spending as a percentage of revenue. As the chart below shows, it has already begun to do this. It has a long way to go. As it cuts back, growth will slow further.
Groupon sceptics also argue that the company's gross margin will plummet as a result of increasing competition. This is certainly a risk, but it hasn't happened yet. Groupon's gross margin has basically been flat for the past year. It seems safe to assume that competitive pressures will eventually drive the gross margin lower, though, so we would plan on that.
Bottom line, thanks to a steady gross margin and reductions in marketing and other operating spending, Groupon's losses as a per cent of revenue are narrowing. This, combined with the fact that the majority of the company's revenue now comes from existing customers, suggests that Groupon has a viable model and can eventually be profitable.
As we described in detail in a prior post, Groupon is running low on cash.
If everything goes according to plan--successful IPO, continued growth--this won't matter. Groupon will be able to gradually reduce marketing spending and take its time getting to profitability.
If the IPO is not successful, however, Groupon will likely have to raise money in the private market to give itself a bigger cushion.
Regardless of which path Groupon takes, at some point the company will have to transition from hyper-growth and losses to much-more-modest growth and profits.
This transition is generally not a happy period for shareholders. Just ask anyone who owned Amazon's stock from 2000-2002 (yours truly, for example).