Before Buying Groupon's (IPO) Deal, Read Our Fine Print

Heavy spending and rapid expansion has helped Groupon establish a market for "daily deals" and email promotions for local businesses. With a database of more than 115 million email subscribers, Groupon (GRPN) has built a large audience to market deep discounts ("Groupons") offered by local merchants. As the largest provider of daily deals, Groupon's growth in customers, merchants, subscribers, and revenue has been nothing short of stratospheric. The company has not been able to achieve profitability, however, as expense growth continues to outpace revenue gains. Below we outline why we believe IPO investors considering Groupon face a nontrivial risk of permanent capital impairment.

Primarily, Groupon's business presents investors with three critical challenges.

The Business Does Not Scale Well
Selling, general, and administrative expenses represent a disproportionate percentage of overall costs at Groupon. Despite the significant ramp-up in top-line growth, we estimate that SG&A expenses in fiscal 2011 will still represent 50% of projected full-year revenue. More importantly, we don't expect substantial improvement in this metric going forward. Each deal sold by a salesperson has to be negotiated, closed, and managed, and the firm requires a substantial editorial staff (400 strong) for writing offer descriptions to drive consumer interest in its daily deal. These are fairly fixed costs, so whether a deal generates $10,000 or $3,000 it requires a minimum number of allocated resources. While management has indicated that it is spending aggressively for growth, we are concerned that the company may not reach profitability before 2013. Although the company can ratchet down some expenses, we believe decreases in marketing spending may actually lead to revenue declines. Additionally, changes in the average price of a voucher, number of purchases by each customer, and uncertain benefits to the merchants may curtail the company’s growth. Although the company benefits from a negative cash conversion cycle, any declines in revenue could lead to substantial negative cash flows, even if the company is posting GAAP profits.

Short-Term Advantages Are Neither Durable nor Profitable
While the company has benefited from a massive first-mover advantage coupled with solid execution and a unique approach, the business is easily imitated. Groupon is essentially a sales agent and intermediary between local merchants and consumers. Customers and merchants have no switching costs and are free to use competitors such as LivingSocial, Amazon Local, or Travelzoo's Local Deals and gain little to no benefit from using Groupon repeatedly. Consumers typically subscribe to multiple email lists, and we believe the value of the deal and the quality of the merchant drive the transaction--not the company that emails the offer. Moreover, we think several competitors have a collection of assets that provide advantages over Groupon, ultimately making preservation of market share a difficult task. As competition escalates, the increased number of offers may also become distracting, with consumers potentially experiencing "deal fatigue."

The Business Model Is Unproven, Leading to a Wide Range of Potential Outcomes for the Company's Overall Valuation
There is no business model (in the digital world) that directly compares to Groupon's. Currently, the company is able to collect a substantial toll from local merchants for selling the deep discounted vouchers, keeping 40-%50% of the money collected and passing through the balance to the merchant. However, the firm's expenses are largely driven by the gross amount of the voucher and the number of offers it is able to create. We believe Groupon is primarily a local email marketing company that is hoping to transform into a local advertising powerhouse. This potential opportunity is not lost on the market, as companies including LivingSocial, Travelzoo (TZOO), Amazon (AMZN), OpenTable , and Google (GOOG) have also launched daily deal services. Although Groupon has incredible brand recognition, it's not clear to us why merchants would avoid using the competition, particularly if they receive other services or better terms.

Barring significant innovation by Groupon, we expect its lack of durable competitive advantage to become more obvious over the course of the next two years. The company has a very small window whereby it needs to build additional services to create customer loyalty and switching costs for the merchants.

Finally, with the IPO the firm is projected to sell 30 million primary shares at $19-$21 (up from $16-$18 previously), valuing the firm at $12.0 billion-$13.3 billion, still well below the $15 billion-$20 billion range circulated in the press earlier in the year. Existing shareholders are also no longer selling stock and as such, only approximately 5% of shares will float, raising the odds of a big first day "pop." Following the proposed offering, Groupon will have two classes of outstanding common stock: Class A common stock and Class B common stock. The rights of the holders will be identical, except with respect to voting and conversion. Each share of Class A common stock will be entitled to one vote per share, while each share of Class B common stock will be entitled to 150 votes per share and will be convertible at any time into one share of Class A common stock.

From what we have seen of Groupon so far, this is not a moaty business and the firm's growth trajectory is opaque at best. We recommend investors pass on this daily deal and stay on the sidelines.