The third amendment to Groupon’s S-1 shows significant changes. Although the prospectus is cleaner and better reflects the company’s financial position, it brings to light more bad news about an already troubled offering.
The most significant new issue I see is that Groupon’s cost of revenue is soaring.
Cost of revenue
Groupon changed the way it reports revenue from gross to net. This change from gross to net reporting also provides us with insight into Groupon’s operational costs. Groupon revised the cost of revenue metric dramatically. Before cost of revenue was defined as the merchant’s share of total Groupon revenue. Now it reads:
Cost of revenue is primarily comprised of direct costs incurred to generate revenue, including costs related to credit card processing fees, refunds provided to customers under the Groupon Promise and other processing costs.
Cost of revenue increased more than 40% from 6.8% of revenues in the first half of 2010 to 9.6% in the first half of 2011.
I believe this is an incredibly important number to watch for Groupon. It is a bad sign that as the company gets larger this number is increasing as much as it is. An increase in absolute terms is to be expected; a dramatic increase in percentage terms is dangerous. If anything, the cost of revenue as percentage of revenue should decline with scale. (For example, Groupon should be able to negotiate better rates for credit card processing due to much higher volume.) I will write about this in more detail.
Change to revenue reporting
The latest S-1 shows a reduction in revenue by more than 50% as the result of a change in how Groupon books revenue. Groupon had been reporting the entire price that a customer paid for a Groupon as revenue, including the significant portion that was paid out to the merchant. Groupon is now only reporting the portion that it receives.
This is an issue that I’ve talked about extensively during the last 3 months. Although all of the same numbers were available in the previous S-1s, they were much less prominent.
It’s a positive change for many reasons:
- Given how most media outlets report the headline revenue numbers, it’s an important change in shaping the public perception of the company. Breathless headlines calling Groupon the fastest growing company in history were largely driven by relying on misleading metrics like gross revenue. (I’ve done all of my analysis based on net revenue numbers.)
- Net revenue reporting is also less susceptible to gaming by the company. Tricks like buying gift cards at full price and selling them for half off won’t help a company’s revenue numbers.
- A focus on the net revenue numbers means that collapsing economics of the business model will be harder to hide. In 2Q2011, Groupon retained approximately 39% of a Groupon’s price. I expect that to fall to 15%-20%.
- It makes for a more meaningful comparison against subscriber acquisition costs. For Groupon to be a meaningful company in the long term, it must generate more revenue from each subscriber than in costs to acquire her. The change had the effect of reducing revenue per subscriber from $18.00 to $8.30. I estimate that Groupon spent $24.08 per subscriber in 2Q2011.
A departing COO
Groupon announced that COO Margo Georgiadis is leaving the company to return to Google after about 5 months with the company. That is the third significant executive departure for the company in the last 6 months. Her predecessor as COO, Rob Solomon, left earlier this year.
Groupon’s head of PR left after about two months. Shortly after he left, Andrew Mason’s email to the team was “leaked” to the media during Groupon’s quiet period.
Andrew Mason’s email to employees
The revised S-1 advises potential investors that Mason’s email to employees “should not be considered in isolation.”
It also provides clarification on the gross revenue numbers provided in Mason’s email, which stated that “gross billings” increased 12% over July.
Travel revenue was a significant portion of August’s numbers. I believe Groupon Getaways has significant problems and is one of the riskier offerings in Groupon’s portfolio.
Groupon wants you to look at marketing expenses as a percentage of gross billings. I think the better way to look at marketing expenses is as a percentage of revenues. By that metrics, marketing expenses were 67.6% of revenue in the first half of 2010 and 62.8% of revenue in the first half of 2011.
Cumulative repeat customers
Groupon added a new metric, presumably to make itself look good called “cumulative repeat customers.” My take is that the numbers are actually quite bad given the value that Groupon executives repeatedly tout – that once a subscriber has signed up, Groupon won’t have to spend any more money market to that subscriber.
Instead of looking at the absolute number, it’s better to look at percentages. This is the percentage of Groupon customers who have ever purchased more than 1 Groupon.
2009 – 43.2%
2010 – 49.6%
1H2011 – 52.2%
For a company whose premise is repeat buying will offset marketing costs, it’s a bad sign when nearly half of customers don’t buy again. Also keep in mind that 80% of Groupon email subscribers have never purchased anything.
By these metrics, at 15 Groupons purchased, I’m actually one of Groupons better customers. (Most were purchased before I knew how terrible the economics of Groupons are for merchants; I now only purchase Groupon for testing purposes.)
Free cash flow
Groupon continues to report “free cash flow”.
A key aspect to Groupon’s cash flow that investors should be aware of is that float from credit card companies is essentially providing the company’s working capital. Groupon charges a consumer’s credit card and then pays merchants in installments over a period of about 60 days in the U.S. and Canada.
By the time the payment is due, Groupon has already spent the money it received from the credit card companies. If merchants stop signing up for Groupon, there will be no money to pay merchants. The same is true if payment terms have to improve for merchants to be competitive (LivingSocial pays out in about 15 days).
Lawsuits and regulations
Groupon added a purported class action lawsuit in the province of Ontario related to gift card handling.
There is no mention of a recent filing of a purported class action by Groupon’s sales employees who allege violations of overtime rules.
There is also no mention of recent moves by Oregon chiropractors and dentists to bar practitioners from issuing Groupons. The chiropractors have already banned Groupon; the dentists have advised against Groupons while the issue is being reviewed. Given that an increasing number of Groupons seems to be for such services, a state-by-state review and battle on these fronts would be problematic for Groupon.
Groupon deleted Facebook as a competitor. Although Facebook recently killed its directly competitive deals product, I believe it’s a mistake to count Facebook out as a competitor in the local space. The space is not really daily deals, it’s local marketing.
- The SEC should have Groupon start over on its S-1
- The terrible numbers that Groupon doesn’t want you to focus on