Groupon management is out on its IPO roadshow, meeting privately with dozens of big institutional investors.In a couple of weeks, at the end of the roadshow, Groupon’s underwriters will take orders for the stock.
Depending on the price investors are willing to pay, the banks will then price the IPO at a healthy discount to where they think it will trade, and then they will allocate the stock.
And at 9:30 the next morning, or thereabouts, Groupon’s stock, GRPN, will “open” for trading.
(And lots of the institutional investors who were allocated stock will immediately “flip” it to suckers for an instantaneous gain, but that’s another story.)
So let’s do what many institutional investors are doing right now: Let’s figure out what we might be willing to pay for Groupon’s stock.
What factors should we consider?
- Groupon’s “fundamentals”: Specifically, most importantly, our revenue and earnings estimates for the company for the next couple of years. The stock will trade at a multiple of these fundamentals, so we should have a sense of what they will be.
- Groupon “sentiment”: Our sense of the market’s perception of Groupon relative to what we think the reality will be. If the reality is better than the market thinks, the stock will go up. If the reality is worse, the stock will go down.
Some market observers like to pretend that all stocks have a precise value that analysts can determine by studying the company and then running the right numbers.
Alas, this is a crock.
The theoretical value of any stock is the “present value of future cash flows.” And that means that, to estimate the intrinsic value of the stock, you have to know two things:
- The future cash flows
- The rate at which to discount the cash flows to get a “present value.”
Regardless of what you may think from watching financial TV, no one knows either of these things. And how could they? We have no idea what Groupon’s cash flow will be this quarter, let alone two years from now or 10 years from now or 50 years from now, all of which count in the “present value” calculation. And we also don’t know what the “right” discount rate is. And adjusting the discount rate by even a percentage point or two makes a huge difference in the present value calculation.
So don’t believe anyone who tells you they know what Groupon’s worth. They don’t. All they know is what their estimate is of what Groupon is worth. And, unfortunately, the range of “reasonable” estimates of what Groupon (or any stock) is worth is wide enough to fly a 787 through.
But still, we have to try.
So let’s start with the big picture.
The big picture is this:
- Groupon generated ~$300 million of revenue last year and should generate about $1.7 billion of revenue this year.
- Groupon is now operating basically at break-even, with the North American business earning a modest profit and the international business losing a modest amount.
- Groupon is cash-flow positive and has ~$250 million in the bank
- Groupon’s growth rate is decelerating sharply, and this deceleration is likely to continue for at least several more quarters.
Based on my experience (15 or so years of following tech stocks), that last factor is very important. “Momentum” investors HATE deceleration. And momentum investors have a big impact on the prices at which stocks trade. So we need to keep the deceleration in mind.
In fact, let’s start with the deceleration, because it will have a big impact on our fundamental estimates for the next couple of years.
The reason Groupon’s growth is decelerating is:
- the law of large numbers — the company’s already huge, and
- the company is cutting back on marketing spending
The second factor is very important. To become meaningfully profitable, Groupon will have to continue to clamp down on marketing. And this will likely lead to further deceleration.
Here’s a chart from Yipit that shows Groupon’s deceleration. Growth is screeching to a halt:
There may be another factor at work in the deceleration, which is “daily deal fatigue,” as the novelty of Groupon’s offering wears off. We need to keep that one in mind, too.
WARNING: Deceleration Can Be Hazardous To Your Wealth
Now, in my experience, when companies decide to transition from hyper-growth-and-losses to sustainable-growth-and-profitability, as Groupon is, the transition can be very rough.
Importantly for this exercise, it also can be absolute hell on stock prices.
The example that jumps to mind is Amazon.com.
From 1996-2000, Amazon grew like a bat out of hell, in part because it was spending boatloads of money on marketing. In 2000, however, the funding markets for unprofitable Internet companies dried up, and Amazon had to change tack and focus on becoming profitable. This transition took two years, from 2000-2002. It led to major deceleration in the business. And it was absolutely brutal on Amazon’s stock price.
Specifically, as Amazon cut back on marketing spending and other profligate expenses in its drive to become profitable, the stock collapsed more than 95%, from $100+ to, if memory serves, about $6 a share. See the right half of the chart below.
Photo: Google Finance
Importantly, through this period, Amazon kept growing. It’s just that its growth rate slowed sharply.
During this period, Amazon also had some problems that Groupon probably won’t, which is that many investors were convinced it could “never make money” and was going to “go bankrupt.” Groupon’s most recent quarter should have helped put these concerns about Groupon to rest.
But Groupon’s deceleration is a big issue for the stock price. Such a big issue, in fact, that I personally would not even consider buying the stock unless/until one of two things happened:
- The growth rate stabilised
- The stock price was so low that I felt like my downside was limited regardless of what happened to the growth rate.
So where will Groupon’s growth rate stabilise?
One could certainly make the case that Groupon’s growth rate will eventually go negative — the company will begin to shrink — because management will be forced to cut back so sharply on marketing costs.
I think that’s probably too negative a scenario. Groupon already has a huge base of email subscribers — more than 150 million — that it can market to for free. And the company should also be able to continue to spend $150+ million per quarter. And when revenue grows, the company should be able to increase this spending.
So I think it’s reasonable to assume that Groupon’s growth rate will settle in the mid single-digits (sequential), which might translate to 20%-30% year-over-year growth.
That transition will probably take a couple of quarters to play out.
One, Two, Three … Estimate!
So now let’s sketch out some numbers.
If Groupon ends this year with a $500 million quarter, it will be operating at a $2 billion revenue run-rate. If the company can grow 20%+ next year off this run-rate, it would post 2012 revenue of ~$2.5 billion. And if it can grow another 20% in 2013, it will post 2013 revenue of about $3 billion.
And what about profits?
I realise I’m probably in the minority here, but I think Groupon will eventually have a nicely profitable business. The North American business had a 12% operating profit margin in Q3, and I think there’s probably upside from there (there’s also plenty of downside, obviously).
International will likely drag the company’s overall margin down for some time. But I think it’s reasonable to assume that Groupon might generate a 10% operating profit margin in 2012 and a 15% operating margin in 2013.
So what does that give us for preliminary estimates?
Revenue: ~$2.5 billion
Operating Profit (assuming 10% margin): $250 million
Net Income (assuming 35% tax rate): ~$150 million
Revenue: ~$3 billion
Operating Profit (assuming 15% margin): ~$450 million
Net Income (assuming 35% tax rate): ~$300 million
So what might the stock be “worth” on those estimates?
A fast-growing market-leader with a huge global opportunity should eventually trade at 20X-30X earnings. More in the early years, when the growth rate is faster and the company has not yet achieved its steady-state profit margin, less in the later years.
So if Groupon were to trade at, say, 20X-30X 2013 earnings of $300 million, it would trade in a valuation range of $6 billion to $9 billion, with a central value of $7.5 billion.
Notably, that’s well below where the company is hoping to price its offering (over $10 billion).
So … Groupon Already Looks Overvalued
In other words, investors willing to pony up for Groupon’s stock at a price over $10 billion need to believe that it will do much better than the scenario I have laid out.
Could Groupon do much better than that scenario?
Of course it could.
Its growth rate could stabilise at, say, 40%, and it could become much more profitable than I currently think.
Of course, Groupon could also do much worse than that scenario.
Namely, it could stop growing, and, thanks to competition or pushback from merchants, it could have a much lower profit margin than I think. And it could therefore be worth much less than the $6-$9 billion range I laid out.
I think there’s as much chance that the negative-case scenario will play out over the next couple of years than the positive-case one. So I would only consider buying the stock at a discount to “base case” scenario I outlined above.
So, What’s Groupon Worth?
So what might I be willing to pay for Groupon’s stock?
Right now, based on the information I have and the assumptions I’ve made above, I wouldn’t buy Groupon’s stock unless it were trading at or below $5 billion, which is about half of the valuation that the company is seeking in its IPO. This is in part because of the “deceleration” pattern I described above and in part because of the high level of riskiness I think goes along with owning the stock.
So if I were managing a big institutional fund, and Groupon’s underwriters told me the stock would be priced at $10 billion, here’s what I’d do:
- I’d place an order for 1 million shares
- I’d get my allocation of, say, 200,000 shares
- I’d keep my fingers crossed that the underwriters targeted an IPO discount of at least 20%
- I’d flip the stock to other investors at 9:31AM and pocket a nice ~20% gain.
(It’s great to be a big institutional investor.)
Then I would sit on the sidelines and watch Groupon and Groupon’s stock for a couple of quarters.
And if Groupon’s growth rate stabilised at a much higher rate than I expected, I’d say, “you dope — you missed a big opportunity.”
And if Groupon’s growth rate stabilised where I thought it would or below, I’d say, “Glad we dodged that bullet.”
And, of course, as time went by, I’d keep running new estimates, which I would compare to Groupon’s stock price. And if the stock price ever dropped to a level relative to those estimates in which I thought I had a nice margin of safety in buying the stock, I’d buy it.
After all, Groupon does seem to have identified a massive new e-commerce opportunity, and I’d like to go along for that ride.
But that’s me. And it’s not a stock recommendation. I have no idea what your particular circumstances and investment goals are, and I couldn’t care less whether or not you buy the stock.
And now I want to hear from you. This, after all, is just one preliminary sketch of Groupon estimates. As researchers have proven time and time again, the “wisdom of the crowd” is generally wiser than any one individual. If you make some smart points in the comments below, I might change my preliminary estimates. And I might be willing to pay more or less for Groupon’s stock.
(And I should add here that, for me, at least, this exercise is totally academic. I don’t buy individual stocks. I don’t buy them because, having been a consummate Wall Street insider for a decade, I learned firsthand just how much of a disadvantage most outsiders are at. I also learned that even the smartest, best-informed insiders are wrong about 50% of the time. And I learned that, beyond a shadow of a doubt, the most intelligent investment strategy for part-time investors not paid to manage someone else’s money is to assemble a diversified portfolio of low-cost index funds. And that’s what I’ve done for myself. So I really couldn’t care less what Groupon’s stock does.)
But now I want to hear from you!
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