Is Groupon a bubble stock or the new Amazon?

1Executive Summary

Ever since it emerged from Chicago’s small startup community in 2008, Groupon has had nothing short of a spectacular story in terms of its growth: With estimated annual revenues of more than $4 billion after just three years of existence, the poster child for the “group buying” phenomenon is now one of the fastest-growing companies in recent memory — and that includes Google, Facebook and Microsoft. After expanding into multiple foreign markets and gobbling up dozens of competitors, Groupon was set to be one of the year’s most eagerly awaited stock offerings, having filed for an IPO that was expected to give the company a market value of more than $20 billion.

But will it ever get there? According to a report in the Wall Street Journal, the company is reconsidering its public offering due to “stock market volatility.” While Groupon hasn’t actually canceled the IPO, it sounds like the startup could be heading in that direction. And while market conditions could be part of the problem, the Securities and Exchange Commission is also reportedly looking into the circumstances surrounding a cheerleading internal memo from founder and CEO Andrew Mason that was leaked during what was supposed to be the company’s pre-IPO “quiet period.”

Some analysts and investors remain enthusiastic about Groupon’s promise. The reality, however, is that the company’s security filings have raised questions about whether the business it has built is actually sustainable or whether Groupon is just another example of a startup that has managed to generate billions in revenue but will never actually make a profit — the kind of company that was commonplace during the last tech bubble. If Groupon can’t manage to make the group-buying business work by becoming profitable, that could mean that none of the other smaller contenders in that market will be able to either.

A simple idea for “group coupons”

The original idea behind Groupon was simple enough: convince retailers, restaurants and other businesses to offer discounted products and services to new customers, provided enough of them sign up.

Still, despite this simplicity, it took off like a forest fire. Soon, Groupon was hiring hundreds of people a month just to write the deals up — a group that included many professional writers, since Groupon emphasized the humor in its offers — and hundreds more to act as salespeople for the concept, signing up retailers and merchants. And businesses signed up in droves: According to the company’s securities filing for its IPO, its revenues grew from $30 million in all of 2009 to more than $800 million in the second quarter of this year alone.

Groupon’s costs, however, have also been growing at an exponential rate as the result of all the hiring, acquisitions and the need to market the company’s services to all of those businesses. That’s where a lot of the skepticism comes from about the sustainability of the Groupon model: If the company has to continually spend more on marketing and “customer acquisition” costs than it does on bringing in revenue from the deals it offers, then it could grow to be a gigantic business and still not be worth investing in, because it will never become profitable.

Fears about questionable accounting

These fears were compounded when Groupon filed its S-1 securities document. Analysts noted that the company was using a controversial accounting method to make its results look better. In a nutshell, Groupon reported what it called “adjusted consolidated segment operating income,” which allowed it to exclude marketing and customer acquisition costs. By this measure, the company had an operating profit of $60 million in 2010 and $80 million in the first quarter of 2011. But as critics pointed out, this method removed the bulk of the company’s costs from the picture: Without that adjustment, Groupon actually lost about $450 million in 2010 (after some discussions with the Securities and Exchange Commission, the company agreed to re-file its S-1 and de-emphasize the ACSOI number).

Since then, Groupon co-founder and CEO Andrew Mason has written an internal memo to employees regarding what he sees as a campaign effort to make the company look bad and to say that Groupon has a bright future despite its critics. In the memo, he lays out a case for why the company’s massive marketing costs are not something to worry about. The crux of his argument is that these costs are effectively a onetime charge that Groupon takes on in order to build the kind of scale and awareness that it needs, and at that point its costs will actually start to decline. Said Mason:

Our marketing — at least the customer acquisition marketing that we remove from ACSOI — is designed to add people to our own long-term marketing channel — our daily email list. Once we have a customer’s email, we can continually market to them at no additional cost.

The bottom line: Mason is arguing his company is better than just about any other kind of real-world retailer because it doesn’t have to continually market its products via advertising and other methods; all it has to do is build up a giant email database of users who are interested in its deals and then send those offers out whenever they appear. In other words, after it spends billions to sign up users and to market its services to retailers and merchants, it will then be able to simply rake in money from those offers without having to spend much at all.

Is that a realistic picture of how Groupon’s business will operate? Not everyone is convinced. Email marketing has been around for some time now, and it definitely has costs for both the entity doing the emailing and the business offering its services. In some cases, those costs are just as high (or higher) than those of traditional retail businesses. There’s no reason to believe that Groupon is any different.

Are Groupon’s marketing costs really going to decline?

Groupon has also come under fire from retailers who have used its program, some of whom are saying that they were inadequately prepared for the onslaught of new customers looking for discounts and wound up being cleaned out by a horde of shoppers who would likely never return until there was another massive discount. Overcoming that kind of perception is likely going to cost the company over time, and those marketing costs aren’t going to disappear. If anything they could increase as the company gets larger and loses control over some of its far-flung operations.

Another cost that could add up is competing with the growing number of other group-buying companies that have joined the field. Among them are Google, which recently launched a test of a Groupon-style service called Google Offers (after trying and failing to buy Groupon for an estimated $6 billion), and Amazon, which has a local discount-offer platform called AmazonLocal and has invested $175 million in Groupon’s largest competitor, LivingSocial. Although it is still far behind Groupon in size, LivingSocial is expected to have revenues close to $1 billion this year.

There are also signs that consumers might be getting fed up with the group-buying business to some extent, or that it may not be the cash cow that everyone assumed it could be. While Facebook looked to be going after Groupon with its Facebook Deals program, the social network has recently scaled back that offering. Yelp also cut back on its version of group-buying offers. According to some estimates, traffic to both Groupon and LivingSocial declined in July, something that might also indicate the need for further marketing costs, since it could be a result of people losing interest in the service.

Groupon’s assuming that it can simply build up a huge database of users and then send emails to them forever and thus reduce its costs seems simplistic at best and deluded at worst. Could Groupon get its marketing and other costs down to the point where it can make a profit? Perhaps. In contrast to what Mason argues in his memo, however, there are already some signs that the company’s ability to push new deals into a mature market is declining. This means that its revenues will either take a hit in those kinds of markets or that it will have to step up marketing, with all the costs that that entails.

The next Amazon or the next Pets.com?

Some see Groupon’s expanding out of the simple restaurant-meal or beauty-supplies discount business and into other services that are more appealing to a broader group — possibly even becoming a little like Amazon, giving retailers with electronics and other products that they want to move a way to reach new customers cheaply. While that could expand the company’s business and possibly generate new revenue, it’s going to require even more marketing dollars. And it would pit Groupon head-to-head against Amazon itself, which has deeper pockets than the Chicago company can muster, even if it does go public at a high valuation.

Even the group-buying aspect that gave the company its name isn’t as relevant as it used to be: At this point almost every Groupon offers “tips” or is triggered, and so the social networking element isn’t as much a focus at it once was. That’s why some critics have argued that Groupon can’t pull off the same kind of trick that Amazon or Facebook have — by first becoming huge and then figuring out how to make money — because Groupon arguably doesn’t benefit from the same kind of “network effects” that those companies have. Those network effects allowed them to reduce their costs over time as the network effects spread the message about their services. Groupon doesn’t really fit into that kind of model.

Has Groupon managed to invent a new form of email marketing that will become a cash machine once it reaches a certain size? Or will the company simply keep growing as long as it can until the money runs out, but never generate any substantial profits? If it does follow through with its IPO, investors will soon get the chance to place their bets on either side of that question.

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