As Groupon’s IPO nears its debut on November 4th, the company is rumored to want to increase its stock issuing price due to the positive reception of its IPO roadshow. Some call this “not leaving money on the table”.
It would be a risky game for the company to raise its price in this already highly speculative and risky IPO. Groupon needs the cash. Investors need to see a high upside. VCs need liquidity. Nobody wants to see an IPO that flops, and even less so Groupon collapse, as argued by Rocky Agrawal in Venturebeat.
Groupon’s IPO stock price could at first rise well above the current asking price of $16-$18 as a result of the well orchestrated speculative rally. Past the IPO fever of the first day(s), many smart investors will take their profit and the price will fall to the lower levels more closely related to the company’s financial outlook – as happened in most recent IPOs.
By raising its price, Groupon could chill investors and prevent the rally.
There are major flaws in Groupon’s fundamentals : 1) growth slowdown, 2) commission erosion, 3) short-term liabilities, 4) diminishing revenue per subscriber, 5) questionable operating efficiency, 6) questionable management ability to lead a quoted company. This issues are not addressed in the rosy picture painted by the company’s roadshow. According to these fundamentals, Groupon does not command the price it is currently asking for, and even less so a higher price.
But Groupon could be one of many stock prices decorrelated from their companies’ fundamentals.
These issues are discussed in the remaining of this post which updates and expands on a detailed analysis I published in June under the title Groupon Bashing Unleashed …
An Orchestrated Speculative IPO Rally
If Groupon’s IPO remains at the current $16-$18 price, the stock could rise by as much as 50% on the first day(s) of IPO, before falling after the first week, as did 64% of the new issues this year. Past the first IPO fever, Groupon’s stock could fall harder than most because, most analysts agree, the company’s fundamentals are unsound at many levels. They do not warrant the current $11 billion valuation, and even less so a more inflated market cap.
What will pump up the stock price in the first day(s) of the IPO will not be the rationale of expected future cash flows but a well orchestrated short-term speculative rally driven by:
- High publicity: Groupon’s rapid growth into a global household brand earns it a lot of attention. In his roadshow, Groupon’s CEO Andrew Mason does a great job at ignoring critics and painting a positive picture of the company.
- Scarcity: the company is offering only 30 million shares which represent less than 5% of its stock — a very low float for such a highly publicized IPO. As was the case recently with LinkedIn’s IPO, scarcity will drive competition, which in turn will drive prices up. The IPO could even be oversubscribed.
- Lack of alternatives: the IPO market is at an all-time low. Risk-friendly investors don’t have many other opportunities.
The rally will attract two types of investors, where the second stands to make a handsome profit off the first:
- The naive: Typically a roadshow attendee who has faith in Groupon’s goodwill and its smooth talking. The naive retail investor will be eager to get in on the action when the stock starts rising after the first hours or even days of trading… i.e. too late.
- The speculator: Typically an institutional investor who has preferred access to the IPO and will attempt to make a quick profit by flipping the stock – offloading it to the naive investor at the peak of the first day or days.
To win the IPO speculative game, investors won’t be concerned with Groupon’s fundamentals but rather with each other’s behavior in order to determine the optimum point at which to dump their shares.
Major Flaws in Groupon’s Fundamentals
In my earlier post on the subject, I argued that Groupon did not rationally qualify for a valuation higher than a low single digit multiplier of sales – which at $1.7 billion sales estimated for 2011 means less than the currently expected $11 billion and possibly less than the $6 billion Google was prepared to pay in 2010.
Since June, Groupon has reduced its expected market valuation by more than half, from more than $25 billion to around $11 billion. The company also restated its financials twice to address the SEC’s critics on exagerrated accounting creativity — such as accounting for the entire local deal value (merchant share and commission) as company revenue and accounting for marketing costs as a one-time investment rather than as an operating expense. Groupon also proceded to reduce its marketing costs and selling expenses in order to cut its losses down to $214 million for nine months (against nearly $400 million in 2010) and nearly break even in Q3. It also announced that it would fire the 10% least performing sales people.
However these attempts at addressing critics have not been much more than window dressing before the IPO.
Henry Blodget in his post I Wouldn’t Touch Groupon’s Stock At The IPO Price With A 50-Foot Pole presents his detailed analysis of why Groupon stock remains overvalued.
The rosy picture of the company painted in its roadshow (slidedeck here ) is indeed far from an acurate reflection of Groupon’s business risk. Major flaws remain and cast doubts on the company’s future revenue and profitability:
- growth slowdown: This is the major critic addressed by financial analysts like Henry Blodget. Groupon’s rapid and phenomenal revenue growth is the cornerstone i.e. the major/one and only argument that could justify a high market valuation, based on a much higher multiplier of sales than even Amazon.
But Groupon’s growth speed is not sustainable. Groupon is not a network à la LinkedIn or Facebook that benefit from viral network growth. Groupon’s growth is entirely driven by traditional customer acquisition methods, i.e. marketing expense, and it is already slowing down fast. As pointed out by local deal aggregator Yipit in its blog post The Slide That Will Scare Away Many Groupon Investors: As Groupon cut down its marketing costs by nearly 20% in Q3 to improve its profitability in view of the IPO, it drastically slowed down its main growth engine .
- commission erosion: Groupon’s success was based on asking merchants a whopping 50% share of the discounted local deal price it was advertising. This high level of commission on the deal value was originally justified by the unique visibility and conversion rate provided by Groupon’s local deal marketing. However, this commission level is clearly not sustainable: 1) intense competition in Groupon’s core local deal business is giving power back to merchants. The average deal margin has already eroded from 50% down to the 40% level; 2) this type of commission may be viable for services such as hair dressers who mostly sell their time, but not for product retailers, an area into which Groupon is moving; 3) more generally Groupon is seeking growth by expanding into other businesses such as cash back and traditional couponing where commissions are generally single digit commission. One more reason why future revenue growth is questionable.
- short-term liabilities: Groupon’s balance sheet is all but balanced. At the end of Q3, Groupon owed $366 million in accounts payable to its merchants, i.e. the merchants’ share of the local deals purchased by customers and paid to Groupon. This short-term liability is not matched by short-term cash reserves on Groupon’s balance sheet. The company’s working capital is negative by more than $300 million. This is why some have argued that Groupon likens a risky Ponzi scheme, where past deals are paid with the revenue from new deals. Groupon could have used the $946 million it raised in December 2010 to build some reserves but it chose to repay early investors instead.
- declining revenue per subscriber. Groupon’s takes pride in its fast growing customer base. In Q3 2003, the number of subscribers grew by 23% to 143 million. Growth is slowing down from the +39% observed in Q2, but still very impressive. However, subscriber numbers are quite meaningless in the Internet business where subscribing to a newsletter costs nothing. Analysts have questioned Groupon’s lack of clear information about its customer churn. Yipit points out that the number of Groupons sold in Q3 grew only by 1% in spite of the fast growing subscriber base. In fact, Groupon’s average revenue per subscriber is constantly declining, by -20% in Q3. Preventing attrition and growing its customers’ share of wallet is a major challenge for Groupon.
- operations. Groupon claims to demonstrate operational excellence in its superior ability to design deals, market them to customers, and service users and merchants. But there are many dark areas in the company’s operations. The redeeming of local deal coupons, for example, is largely a manual and opaque process. Again, one would have liked to see more of the total $1.15 billion raised by Groupon from VCs invested into operating systems. Instead, Groupon increased its marketing, selling, general and administrative expenses. Two chief operating officers resigned — most recently Margaret Giorgiadis from Google in September 2011.
- management ability to lead a quoted company. Groupon’s CEO, Andrew Mason clearly is a very smart and articulated young man. But incidents such as Ms Giorgadis’s departure after only six months and Groupon’s failed entry into China call Groupon’s leadership into question. The way the IPO was introduced, requiring multiple prospectus re-filings also called into question the company leadership’s ability to be accountable to investors in a public company. Last but not least, the fact that co-founder and Executive Chairman Eric Lefkofksy already cashed out more than $300 million from its investment into Groupon raised concerns. The concern is heightened by Groupon’s dual class share system which gives to its founders supervoting rights of 150 votes per share.