Why Groupon's IPO is no deal

Commentary: I'd want more than 50% off to buy into this offering.

By MSN Money Partner Jun 8, 2011 1:50PM

Image: Family eating burgers © Bananastock/JupiterimagesBy Brett Arends, MarketWatch

 

Like most of you, I have a close, personal relationship with Groupon.

 

I signed up with the online coupon company sometime last year to get a cheap deal on a local restaurant. It was a place we'd never heard of. When we got there, clutching our coupon, we found out why. It was deserted, had the ambience of a railroad station and specialized in "alternative" sushi.

 

Alternative to what? Alternative to the kind you want to eat.

 

I initially had an idea we'd be using Groupon a lot to go out and visit exciting new restaurants and the like. Instead we used it once. Now the e-mails pour into my inbox every day and sit there ignored. I'm going to get around to unsubscribing one of these days. Until I do, I count as one of their subscribers.

 

According to the IPO prospectus, published a few days ago, there are 83 million of us.

 

And there are 83 million good reasons why this IPO is one of the most ridiculous things I've ever seen.

Maybe this stock will fly to the moon when it goes public. Maybe it's going to make you rich. Maybe I'm just being a spoilsport, once again. Maybe it's the next Apple (AAPL), Google (GOOG) and Exxon Mobil (XOM) rolled into one.

 

But I've just trawled through this 280-page prospectus, and I have only one question for the management.

Seriously, dudes?

 

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Their company was only founded in November 2008, and already it has accumulated $522 million in losses.

Sure, it has 83 million subscribers. But just 15.8 million of them have ever bought anything at all. Really. That's fewer than one in five. And how many of those 15.8 million are like me -- they've bought one thing, or two, and that's it?

 

Sure, the number of subscribers is booming. But look at the conversion ratios.

 

In 2009, the company sold 69 Groupon deals per 100 subscribers.

 

In 2010 it was just 60 deals.

 

In the first quarter of 2011: just 34. No kidding. And although Groupon likes to boast about its booming international business, the numbers are even worse there.

 

Just 18% of its Berlin subscribers have ever bought anything.

 

The number in London? 9%.

 

The real problem with Groupon

 

But the real problems with Groupon are twofold: Its astronomical gross profit margins and its hefty bottom line losses.

They sound like they conflict, but they don't.

 

Groupon boasts enormous gross margins. They were 42% in the first quarter, down just a shade from 45% last year. That means, in laymen's terms, that if you pay $20 for a Groupon voucher giving you dinner for two at a deserted "alternative sushi" restaurant, Groupon the company pockets $8.40 of your money. The restaurant itself gets only $11.60.

 

Yet that's only half the story. A typical Groupon voucher costs $20, but gets you a meal that would normally have cost you $40. That's why you buy the voucher.

 

So in this case the restaurant is selling a $40 meal through Groupon and it gets just $11.60.

 

Yes, restaurants may agree to this for a while to try to get new customers. But they can hardly agree for long. If they could survive by giving their business away at nearly 75% off, they would be doing so already. If someone comes along offering them a better deal, they'll jump.

 

And Groupon-type companies are easy to set up. The merchants are local, after all, so the business can be local. You can set up an online Groupon clone in New York or San Francisco or Dallas or Yazoo City, Miss. Cut the merchants a better deal than Groupon and you'll get their business.

 

So a competitor will inevitably let the merchants keep $13 out of $20 instead of $11.60. Then another will let them keep $14, then $15, and so on.

 

Ultimately this is a low margin business. It may, indeed, end up as a zero margin business, or even what is sometimes called, on Wall Street at least, a "negative margin" business.

 

At the moment Groupon has first mover advantage. It has almost no competition. That's why it can keep 42% of the money and stay in business. That may also be why it is going public while it can.

 

Yet even today, with little competition, it already has to spend a fortune on marketing and advertising in order to grow and keep out competitors.

 

Between the first quarter of 2010 and the first quarter of this year, Groupon's sales rocketed 14-fold. But marketing costs soared 50-fold.

 

As a result, even though the company sold $645 million worth of deals, at a 42% gross margin, it nonetheless ended up losing $146 million at the bottom line.

 

Profits, schmofits

 

The average Groupon deal cost $23 in the quarter. Yet the company actually managed to lose $5 per sale. No kidding.

No wonder the management prefer to avoid talking too much about real profits. Instead they talk about a mysterious financial metric called "Adjusted Consolidated Segment Operating Income," or Adjusted CSOI.

 

What's Adjusted CSOI? It's what Groupon would have made if it didn't have to pay its bills. It's a measure that excludes online marketing costs, acquisition costs and stock-based compensation. What a riot. Why not exclude payroll and overhead too?

 

We are totally partying like it's 1999 again. Profits, schmofits.

 

We still don't know what valuation Groupon will put on its IPO. But as recently as March 31, for stock option purposes, management valued the stock at $15.80. That would value the entire company at $5 billion. Is that too much for a start-up with massive losses, little track record and no defensive moat around its business? I don't know. I don't know what a business with those characteristics is worth.

 

During the dot-com bubble, I once heard a story from a venture capitalist about a start-up that wanted to be valued at a multiple of headcount. At $5 billion, Groupon would be valued at nearly 10 times accumulated losses. Who's to say that's too much?

 

And if history and Wall Street's nefarious ways are any guide, the sticker slapped on this stock for the public will be a lot higher than this anyway. The $15.80 price was just for insiders, when they last handed out options. LinkedIn (LNKD), for illustration, doubled its stock price in the weeks leading up to the IPO. A similar stunt now would price Groupon at $10 billion.

 

Trade this IPO if you like. There may even be short-term profits to be made. Good luck. But I'll be sitting this one out.

 

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