Groupon Amends S-1, But Key Numbers Still Missing

Editor’s noteRocky Agrawal continues his in-depth guest series looking at the daily deal industry. Agrawal is an entrepreneur who has worked on local products since 1995. He blogs at reDesign and Tweets @rakeshlobster. Groupon is currently in a quiet period in relation with its planned IPO.

Groupon’s amended S-1 IPO filing is out. The revised filing tamps down some of the enthusiastic tone of the original and highlights a number of risks, several of which were covered in TechCrunch’s in-depth series on daily deals.

Potential investors looking for good news will be disappointed—I didn’t see anything in the document that would lead me to believe the business is any better than I’ve written before.

Among the highlights:

Controversial accounting metric de-emphasized. Groupon’s filings use a non-standard metric called Adjusted Consolidated Segment Operating Income. To arrive at this, Groupon takes the revenue generated by a deal and subtracts only the money paid to the merchant. Significant costs like subscriber acquisition, marketing and sales are ignored. I describe it as “the best possible way to view our business if you took out all of the things that make it look terrible.” The revised S-1 walks back its importance. “We believe Adjusted CSOI is an important measure of the performance of our business” has been revised to “We believe Adjusted CSOI is an important measure for management to evaluate the performance of our business.” Later, it says, “We do not view Adjusted CSOI as a valuation metric.”

Gift card laws and compliance. In the revised S-1, Groupon states “Groupons generally are included within the definition of “gift cards” in many of these laws,” an issue I reported on previously. Groupon updates the risk section to include the possibility that Groupon or merchants may in some states be on the hook for the full value (including promotional discount) of the Groupon for years or indefinitely. Unlike retailers who issue gift cards, Groupon does not record Groupon issuance as a liability. (Technically, Groupon considers itself a marketing agent and the Groupon is really issued by the merchant.) This presents a significant risk for investors. Further, many merchants use Groupons as an introductory promotion to build a book of business; if they become aware that they may be on the hook for Groupons indefinitely, there is an increased likelihood that they won’t issue Groupons. “In addition, we have received inquiries from the attorneys general of various states regarding the operation of our business under state laws.” Connecticut’s attorney general is among them.

Calling out impact of international growth. Much of Groupon’s revenue growth has been the result of international expansion, not organic growth in existing markets. “The increase in our revenue, key operating metrics and employee headcount from 2009 to 2010 is partially attributable to these acquisitions and the subsequent growth of our International segment as a result of such acquisitions.” International growth is also very important to Groupon for cash flow. In the U.S. and Canada, Groupon pays businesses within 60 days of the Groupon run. Elsewhere, merchants are paid as Groupons are redeemed. As a result, Groupon can hold on to that cash much longer. Groupons gross margins are higher internationally and Groupon also benefits from unredeemed Groupons. (In the U.S. and Canada, the merchant benefits.)

National deals. Groupon specifically acknowledges that national deals are offered at lower margins. “Gross profit is influenced by the mix of national and local deals we offer. We tend to accept lower gross profit margins for national deals because such offers are made, in part, for the purpose of acquiring new subscribers and establishing our brand.”

Deal mix. The revised S-1 shows the deal types split between North America and International and the results are very different. For example, food and drink was 29% of deals in North America and 19% internationally. Retail was 16% in North America and 4% internationally. The data are reported in an opaque way making deeper analysis difficult. But food and drink and retail are the toughest categories for merchants to make profitable using Groupons. But they’re also the categories that sell the best.

No longer “wildy profitable”. Groupon says that a Bloomberg report that Groupon co-founder and Executive Chairman Lefkofsky said  “Groupon was going to be wildly profitable” does not “accurately or completely” reflect his views. (Bloomberg stands by its story.)

Employees. In less than 45 days, the company has grown from “over 7,000 employees” to “over 9,000 employees”.

General softening. Several sentences were added softening the S-1. “We had net income of $21,000 for the second quarter of 2009 as compared to a net loss of $102.7 million for the first quarter of 2011. ” The data was already in the S-1 before, it has just been made more obvious. Another addition: “As a result of our limited operating history in a new industry and because the majority of our subscribers registered for our service or made their initial purchase of a Groupon in the past 12 months, it is difficult to discern meaningful or established trends with respect to the purchase activity of our subscribers or customers. ” A letter from Andrew Mason has been moved from the front of the S-1 to page 32 and now says, “As with any business in a 30-month-old industry, success for our investors is not guaranteed. We have yet to reach sustained profitability and we have no shortage of competition. Our path will include some moments of brilliance and others of sheer stupidity.”

A whole lot of beans to count. Starbucks chief Howard Schultz will make $200,000 a year and get 60,000 stock options for serving on Groupon’s board.

Despite all of these changes, the S-1 doesn’t address the things I most want to know. There are a number of key metrics that should be known to the company that I’d want insight on before investing:

Email subscriptions and open rates. What is the trend in email open rates? Are emails being opened more or less frequently? A decline in email open rates would indicate deal fatigue on the part of consumers or a decline in deal quality for consumers. The rapid growth in subscriptions can also hide the people who have dropped out. What is the unsubscription rate? Companies like Netflix report churn and it would be useful to have the data here.

Fraud and refund rates. The S-1 makes scant references to fraud and refunds, though it does show reserves of about 4% of revenue for refunds. Given their generous refund policies and a strong focus on small businesses, this can present a significant risk to investors. Small businesses are subject to failure and Groupon’s expensive merchant terms result in a big risk of adverse selection. To date, Groupon has refunded money to consumers who have had difficulty redeeming vouchers.

What proportion of their subscription list was “bought” and hasn’t returned. Just like small businesses who use Groupons to draw customers in with amazing prices, daily deal providers occasionally subsidize deals for customer acquisition. Deals for things like Amazon gift cards and movie tickets are often subsidized by the deal providers. This can work as long as those customers continue to purchase. But if they don’t make further purchases, it’s just a loss. Those deals are also expensive because it’s virtually guaranteed that existing customers will buy them.

Subscriber and customer acquisition costs and their trends. These are critical metrics to understand whether Groupon can be profitable in the long term. If customers can’t be acquired for less than their value, that’s a problem. I would expect that these costs go up over time as the low-hanging fruit has already been picked. The S-1 mentions that high acquisition costs are a concern but doesn’t directly provide them.  Doing the math based on other numbers provided, I estimate the cost of a list subscriber at $6.40 and the cost of an actual purchaser at $26.50. That’s a big number for a business with few barriers to entry. For Netflix, this number is $18.03—but Netflix has a subscription business with recurring revenue.

Revenue by deal type. Groupon runs deals across a wide range of categories. For some businesses, the underlying economics work. For others, they don’t work. If most of the revenue is coming from restaurant deals, that would raise serious red flags. If revenue is predominantly from events, that’s a good sign. (Some of this can be estimated from external sources, but it would be good to have validated data.) The revised S-1 has charts that shows breakdown of types, but it doesn’t provide revenue.

Voucher redemption rates. These are going to be imperfect due to poor tracking technology. But for businesses that are doing online tracking, it would be useful to have the data. It could be used to estimate any potential risk if states hold Groupon responsible for compliance with gift card laws.

Proportion of deals purchased by high volume customers. Groupon is selling businesses on the value proposition of customer acquisition—that all they have to do is show off how great they are and customers will come back. But if deals are primarily purchased by deal seekers, it may not really be in the business’ control whether they come back. Over time, businesses would stop running Groupons if they knew that they had no shot at converting a customer. Cheapskates are not good acquisition targets for most businesses. (Except for Groupon and its many clones.)

A statement on risk management practices. In North America, Groupon is essentially in the factoring business. Credit risk management is important to being successful. Take on too much credit risk and the company could face a lot of problems. As far as I have been able to determine, the daily deal companies are not sufficiently vetting credit risk.

Split between national/regional and local deals. National merchants will likely provide a lower share of revenue to Groupon than local merchants and will generally be more sophisticated about the structure of the offer. A higher portion of national merchants will results in margin compression (the amended S-1 notes that national deals do indeed have lower margins). The trend line on this split is also important. My observations indicate that deals are trending more national.

Of course, no company will provide all of these things. But an informed investor might want to ask these questions before buying the stock or projecting Groupon’s current growth forward indefinitely.

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