reDesign

Dear Andrew:

As you may have heard, I am coming back to Chicago in the next couple of weeks for another round of Groupon research. Although you didn’t take me up on my invitation the last time I visited Chicago, I’d like to encourage you to re-consider this time.

Since I started writing about Groupon last June, I’ve been right about most things. Here are some of my predictions that have come true:

• Groupon would have to abandon ACSOI.
• Groupon would have to use net accounting instead of gross accounting.
• Groupon Getaways wouldn’t be meaningful.
• Groupon Now wouldn’t be meaningful.
• Consumers would fatigue of daily deals.
• The deal quality would go down as better merchants figured out that running Groupons is a  bad idea.
• The Groupon Promise would turn out to be too expensive. During my last visit, I very explicitly told your PR team that they were underestimating the refund rate. This, as we know, was the cause of your restatement that has sent the stock into freefall.

I’m happy to chat with you about the current state of Groupon and the steps that management is taking to fix these problems.

There are a few other reasons you should consider meeting with me:

• I will be meeting with current and former Groupon employees during my trip. I can only spend so much time in Chicago, so any time I spend with you is time that I’m not talking to employees.
• I talk to most reporters who cover Groupon. Because I have spent more time than nearly anyone studying the space, I give background information to many others who are looking to learn and write about it.
• I talk to money managers about Groupon and the local space. Before the IPO, I talked to many money managers about the offering. Most everyone I talked to listened to what I had to say and didn’t buy at the offering. (And they’re now very thankful — considering that the stock is down 35% in less than 6 months.) If there’s a better story to tell for the future, I’m sure they’d love to know.

And, who knows, after meeting, we may decide that my April Fool’s joke isn’t such a bad idea.

From this morning, a search on Groupon returned these results:

Google News algorithms put the Enron logo next to a story about Groupon

I think I’ve made the Groupon and Enron comparison myself. In both cases, you had high-flying companies that focused on short-term growth while ignoring the underlying risks of what they were creating.

One of the challenges of negative press like this is that Groupon is dependent on cash flow from selling new deals to pay off merchants from old deals.

The right way to think about Groupon is as a currency. Such constant bad press could create a confidence crisis in the Groupon currency. Small businesses who do the most basic due diligence (Google “Groupon”) will see the negative news and refuse to run new deals. It will exacerbate Groupon’s adverse selection problem, meaning only shakier and shakier businesses will run Groupons, increasing Groupon’s refund liabilities. (If you were on the bubble about running a Groupon, the bad press will sway you toward not running one.)

Consumers will also stop buying deals. It could also lead payment processors like Chase Paymentech and American Express to terminate their merchant relationships, which would also lead to cash-flow issues for Groupon.

If the Groupon currency market were as efficient as bond markets, this news would cause Groupon to collapse overnight like Lehman Brothers. Fortunately for Groupon, the market is not that efficient.

Groupon customers outside of the United States and Canada will also be hurt because Groupon generally holds on to their money until a Groupon is redeemed.

When Groupon collapses, it will cause some serious pain for Chase Paymentech and possibly American Express. I estimate that Chase has at least $500 million in chargeback liabilities if Groupon goes under. But because Groupon doesn’t accurately track which Groupons were redeemed, this liability could be much higher. Any consumer who had purchased a Groupon could claim they didn’t get what they paid for. I called on credit card companies to take a look at their exposure from Groupon months ago in a Bloomberg West appearance.

The biggest losers in a Groupon collapse would be the small businesses who run Groupons. As of the end of the 4th quarter, Groupon owed small businesses $520 million. This number is likely at least $100 million higher. These are people who can hardly afford to take a hit of several thousand dollars.

The other potential loser is Ernst & Young, the auditor that signed off on revision after revision of Groupon’s bogus financial statements. (Though I don’t expect Groupon to take down Ernst & Young like Enron took down Arthur Andersen.) I’m not ordinarily one to call for Congressional hearings, but E&Y deserves to be raked over the coals for sanctioning Groupon’s financials.

Oh, and a note to the Los Angeles Times: I fully expected this.

See my worst-case scenario of what happens if Groupon collapses. Also see my collection of Groupon stories following the restatement.

Disclosure: I have investments and several ongoing bets related to Groupon.

Groupon was forced to restate fourth quarter earnings, sending its stock down 6% in after-hours trading. This surprised me as much as my $2 investment in the Mega Millions jackpot not paying off.

The reasons for Groupon’s restatement were higher refund reserves and weakness in internal controls. These are issues I’ve repeatedly discussed. I raised them directly with Groupon PR in September (back when they still would speak to me) and I was assured that refunds weren’t an issue for Groupon.

I also spoke with a former Groupon salesperson who claimed he was fired because he raised concerns about poor internal systems that didn’t track deals correctly and complaints about poor risk management when it comes to running deals.

So what’s happening at the coupon company?

Well, for starters, it’s not a coupon company nor a marketing company. At its core, Groupon’s U.S. business is a receivables factoring business, as I wrote last year. They give loans to small businesses at a very steep rate (the price of the discount plus Groupon’s commission). They get the money to fund these loans from credit card companies such as Chase Paymentech. Groupon is essentially a sub-prime lender that does zero risk assessment. And as word continues to spread about what a terrible deal running a Groupon is for many categories of businesses, the ones that will choose to run Groupons are the ones that are the most desperate. For U.S. based businesses, the only time I can definitely recommend running a Groupon is if it is otherwise going to go out of business.

Another factor is that Groupon is selling bigger and bigger deals and many of these have requirements for use. Some deals have medical qualifications. The former salesperson told me about Groupons for a procedure called “cool sculpting”. In this procedure, fat is frozen off the body. In order to get the treatment, patients must be medically qualified. But Groupon has no way of medically qualifying purchasers and will sell it to anyone. When they go to the doctor and find out that they aren’t eligible, they call Groupon for a refund. If this is several months later, after Groupon has paid out the entirety of what it owes the provider, this can mean a refund loss for Groupon.

Travel is another risky category for Groupon. Unlike Expedia, Travelocity, Priceline, Jetsetter and nearly every other major travel provider, Groupon does not require consumers to pick their dates and confirm availability at the time of purchase. When a consumer finds he can’t use his Groupon months later, he calls for a refund. Groupon also hides material restrictions on travel deals, something I pointed out in September and Groupon still hasn’t rectified.

Because these are higher ticket items that cost hundreds or thousands of dollars, consumers are more likely to ask for a refund than on lower ticket items. In the short term, it means a revenue boost to Groupon, which the company needs as its once torrid growth itself cools. In the long term, it means refund losses.

The “Groupon Promise” is another risk factor. It’s an overly broad promise designed to allay consumers’ concern about using Groupons. Because it is so broad, it results in higher refund rates than would otherwise be the case.

Yet another concern is that Groupon does not track how much outstanding Groupon “debt” there is. There is no one in the world who can tell you how many and how much Groupon value is outstanding. Unlike typical gift card sales, Groupon books revenue immediately and then does not show the Groupons on its balance sheet. By my estimates, Groupon has between $500 million and $750 million in liabilities that it doesn’t show on its balance sheet.

In theory, Groupon’s exposure to that risk is covered by its refund reserves — but we don’t know the size of those reserves. And as yesterday’s restatement shows, they’ve calculated them poorly. Unless Groupon begins to do risk assessment on deals before they run, changes its payout terms to businesses or drastically changes its refund policies, I expect refund rates to continue to rise. If they do any of those things, I expect revenue declines because it will make running Groupons less attractive to businesses and buying Groupons less attractive to consumers.

Groupon has also worked hard to hide their refund rates. While going through their S-1 process last year, Groupon continually revised its accounting. At one point, I discovered a way to calculate their refund rates and found that refund rates had likely increased more than 40% year-over-year. In the next amendment to their S-1, they changed their accounting again to bury that data.

Investors should also be concerned about the fact that Groupon’s lock up should end in early May, releasing a lot more shares on to the market. I wouldn’t be surprised to see Groupon trading in single digits after that and heading to zero within the next 36 months. Groupon’s best bet is if they can acquire their way into a sustainable business model; I’m doubtful that will happen considering the companies they have purchased to date.

With its restatement, Groupon said that its guidance for the first quarter remained the same as earlier. Given that their lockup should end shortly before they report first quarter results, I would take that assessment with a mine full of salt.

See some of my previous writings on Groupon:

• Why Groupon is poised for collapse
• Who gets hurt if Groupon collapses
• Groupon’s cost of revenue is soaring
• Groupon’s other funny numbers