Time to Sell the Coupon King

02/07/2012 10:45 am EST


Paul Larson

Editor, Morningstar StockInvestor

Just as quickly as it rose from obscurity, so is the threat of a quick downfall for this popular internet stock, writes Paul Larson of Morningstar StockInvestor.

While Groupon (GRPN) has quickly made a name for itself, this recent IPO appears ripe for selling. The company does not appear to have an economic moat, and even after falling after the IPO, the stock still looks richly valued. Caveat emptor!

Heavy spending and rapid expansion has helped Groupon establish a market for “daily deals” and e-mail promotions for local businesses. With a database of more than 115 million e-mail subscribers, Groupon has built a large audience to market deep discounts (called “Groupons”) offered by local merchants.

We do not believe the company has an economic moat, however. In our view, the lack of an economic moat, coupled with an unproven business model, creates an inappropriate and elevated risk profile for public investors.

Groupon’s business presents investors with three critical challenges:

  • The business does not scale well
  • Short-term advantages are neither durable nor profitable
  • The business model is unproven, leading to a wide range of potential outcomes for the company’s overall valuation. We believe that investors face a nontrivial risk of permanent capital impairment

Moreover, while the company has benefited from a massive first-mover advantage coupled with solid execution and a unique approach, the business is easily imitated. And we believe several competitors have a collection of assets that provide advantages versus Groupon, ultimately making preservation of market share a difficult task.

Exhibiting Weak Economies of Scale
The company is the largest provider of daily deals, and its growth in customers, merchants, subscribers, and revenue has been nothing short of stratospheric. (We project sales to increase more than fivefold to nearly $2 billion in 2011.)

However, the company has not been able to achieve profitability, as expense growth continues to outpace revenue gains. For our purposes, we are increasingly concerned about the firm’s sales, general, and administrative (SG&A) expenses, which represent a disproportionate percentage of overall costs to the firm.

In 2011, for example, we estimate that SG&A expenses will still represent 50% of projected full-year revenue, despite the significant ramp-up in top-line growth.

While this reported expense may seem astronomical compared to other companies, we don’t expect substantial improvement in this metric going forward. Each deal sold by a salesperson has to be negotiated, closed, and managed.

Additionally, Groupon manages an editorial staff (400-strong) that writes up a creative description of the offer to help drive consumer interest in the daily deal. Essentially, every deal requires a minimum number of allocated resources (people), whether it generates $10,000 or $3,000.

We believe that Groupon is primarily a local e-mail marketing company that is hoping to transform into a local advertising powerhouse. This potential opportunity is not lost on the market, as companies including LivingSocial, Travelzoo (TZOO), Amazon.com (AMZN), OpenTable (OPEN), and Google (GOOG) have launched daily deal services as well.

Although Groupon has incredible brand recognition, it’s not clear to us why merchants would avoid using the competition, particularly if they receive other services or better terms.

For example, Google has the ability to manage loyalty programs (through Google Wallet), bundle in other forms of web advertising, and even offer better pricing for local merchants. Barring significant innovation by Groupon, we expect its lack of a durable competitive advantage to become more obvious over the course of the next two years.

The company has a very small window whereby it needs to build additional services to create customer loyalty and switching costs for the merchants. Consider us skeptical.

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