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By Jeremy Glaser | 11-03-2011 05:10 PM

Groupon No Bargain, Even at Half Off

Shares of the daily deal giant would have to fall well more than 50% before they'd look at all enticing.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Is Groupon a great daily deal? I'm here today with Jim Krapfel. He's an equity analyst and IPO strategist at Morningstar. We're going to take a closer look at the Groupon IPO to see if investors should be considering it.

Jim, thanks for talking with me today.

James Krapfel: Thanks for having me.

Glaser: So let's go ahead and look at Groupon, the business, first. I think this business model has been sliced and diced in the financial press a lot over the past couple of months. What's our view of Groupon's business model? Do we think that they have an economic moat, and that they are going to have these sustainable advantages?

Krapfel: I'd say that's in effect, no. The firm does have a good scale right now. They have 53% market share or thereabouts. They've led the growth of the market they are in. However, we think that the competitive advantage is not sustainable. There are just no barriers to entry here. We don't think the company has been able to scale their costs appropriately. They've continued to generate losses, and likely will continue to do so unless they ratchet down their marketing spend, which they have been doing recently, but that's come at the expense of growth.

Three quarters ago the company was growing at over 100% on a sequential basis, and that has slowed very rapidly. In the third quarter, the growth has only been 10% on a sequential basis. So, we are of a mindset where either the company spends the money to maintain a growth level and keep the market share or they slow down spending, as they've been doing, maybe generate some level of profit, but see growth that slows or even maybe turns negative in the quarters ahead.

Glaser: So Groupon had been billed at one point as the fastest-growing company ever. That just doesn't look like something that's sustainable over the long term.

Krapfel: Yes, we have some reservations regarding the overall daily-deals market in the first place. It's really uncertain whether it's a model that works for the merchant. Right now, it seems like merchants are really in a trial phase with Groupon and other companies that are offering the service. They want to see that they get a payback, that customers return to their service, because the first purchase, you know, they are losing money on that, and they want to see those customers come back. If they don't, then they are less likely to offer deals in the future.

Glaser: Now, a lot of Groupon's growth has come from moving into new markets, both domestically and internationally. Is that basically tapped out? Have they basically expanded as far as they can or could there still be future growth in going into new markets?

Krapfel: They've expanded into just about every major international market already, and they hold pretty strong positions, one or two, in basically every market. Within each market there probably is some room for growth, but again in each market, we don't think that their market share is sustainable. We think that any company could basically offer the service, generate scale quickly, and compete against Groupon effectively.

We look at Google, Facebook, Amazon--these are all major companies with a potential to grow the daily-deals business. We've seen Facebook exit, but we've seen Google come out with their product, where they're basically aggregating their service along with several others to generate more scale to compete more effectively against Groupon, and we think that, longer-term, that's a potential for them.

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