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It looked like Christmas came early this year for Groupon!

18 Dec

Summary
Groupon is an Internet based voucher distribution company which has seen astronomical growth in revenue in its short 24 months of existence. Google is the Internet giant whose very name has become synonymous with Internet searching. Over the years, Google has not gotten much traction promoting local searches for small businesses, which is thought to be a growing and lucrative market!

There have been mailing lists and deals from the beginning of time (figuratively speaking), so the Groupon model is not defensible per se, however in their short existence they have had runaway success in multiplying revenue month after month. This exponential growth rate has naturally attracted the interest of all the major Internet players, including recent multi billion dollar takeover offers from both Yahoo and Google!
What puzzles me is that the next biggest player in this market, “LivingSocial.com”, is not far behind Groupon in revenue and has been raising prodigal capital through private equity. Just last week, Amazon infused $175 million for what is rumored to be a 10% stake in the company. In fact there are nearly 200 Groupon clones in the US and over 500 worldwide. So much for a defensible business model!

Judging by the amount of the recent buyout offer made by Google, Groupon, while being younger than many toddlers, has a perceived valuation of $6 Billion. This valuation hints at an impending bubble in valuations for recent startups. Most of the post-war time in the US, the rule of thumb has been that the price of a home should not exceed 3-4 times the homeowner’s income. This principal was not followed for the past decade and resulted in the most severe recession in over 80 years. Similarly, the generally accepted P/E or Valuation to revenue ratio, which has traditionally been a multiple of 3, has gone out of the window in recent times. Groupon is widely expected to have $800 million in revenue this year, so a $6 billion price tag would give us a revenue multiple of 7.5.

Another big concern relating to the valuation is the quality of Groupon’s revenues. Do the IPO’s of pets.com, webvan.com, and AOL.com ring any bells? If history says anything it is that people don’t learn from history!
Groupon-like companies are offering less than 10 deals per day for even metros as big as Los Angeles. The market is in its infancy stage and there is a long way to go before consolidation. It might make some sense for companies like Google or Facebook to offer high valuations for Groupon because of the potential synergy that might be realized, which could lead to its ability to sustain if not exceed current growth! Groupon, by having decided to go it alone, has lost out on the added value of having an industry leading partner and has thus chosen a difficult path, potentially spawning new competitors without having a defensible business model that can stand on its own. The market is too big to ignore and it is growing very fast!

Ultimately, Groupon did a huge favor to Google and huge disfavor to itself by rejecting the $6 billion offer! According to recent news reports, Groupon is apparently considering an IPO in 2011, but in light of their rejection of Google’s offer, they had best pray that current and rampant valuation bubble doesn’t burst before then!


Introduction

Coupons are supposed to be difficult to obtain or use, so that only very motivated or needy shoppers will use them. While not offering coupons in the traditional sense, Groupon’s online offering of bulk coupon-like discounts has shaken up the industry and met with runaway success. Given that Groupon takes a hefty commission, in addition to the eye-popping discounts, businesses are puzzled as to what to make of this new phenomenon of frictionless distribution of coupons/vouchers!

Groupon started in late 2008 as a side project for ThePoint.com but rapidly took on a life of its own. It offers a daily deal in each market in which it operates, but each deal is conditioned upon reaching a specific minimum number of customers before any of them can purchase it! The idea had wild success and after nearly 35 million subscribers and numerous acquisitions of competitive sites around the world, it is poised to rake in more than $800 million in revenues this year alone!
So effective is this group purchasing model that Andrew Mason, Groupon’s founder, claims Groupon now has 35,000 companies eager to make the deals. Wanting to have an offering on the site, however, is not enough to meet Groupon’s criteria as only one in eight applicants make the cut. The vendor must already be well reviewed on online review sites such as Yelp, CitySearch and TripAdvisor, the deals must offer a substantial discount from normal prices, and finally they must not be similar to other promotions regularly offered by the vendor.
Mason has aggressive plans to scale up and the capital to back it up. Groupon now posts 100 deals per day in the U.S. and that number is set to go up to 400 by January 2011. This should quadruple the number of vendors served to 5000 per city. To meet these targets, the company’s sales staff will be increased by 80% (200 people) and deal writers by 100% (70 people).
If one takes a look at the wildly successful 8-hour sale of 19,822 tickets to a Chicago boat tour, it raises questions of the general sustainability of Groupon deals. The same is true with The Gap’s one day Groupon sale of $11 million worth of “50% off” vouchers. Are other retailers with a strong brand willing to give similar steep discounts and then give a cut to Groupon for bringing in the business? The gag works only until these businesses realize that vast majority of these customers are not coming back, but are instead chasing the next deal elsewhere!

It’s not every day that a 2 year old company, started from scratch, would command a $6 billion offer and have the nerve to reject it! Is this daily deal website really looking for a better deal than that? This started me on a quest to estimate a reasonable price for Groupon and also to analyze the sustainability of growth for the entire online coupon market.


Google

All searches are not created equal. Some searches are more easily monetized than others, and local searches are that kind. Most searches are for information seeking or researching, and the ads that Google sells for these are not very lucrative. Many local searches are for keywords like “Restaurant”, “Dentist” or “Hotels”, so the ads that go with these are lucrative!

Google might be a man-made 8th wonder with a major role in shaping the Internet as it is today, and most likely for a long time to come. However, Google has been having problems getting traction in the local search business. A local restaurant that I own has received a $100 Google search credit in the mail 5 times in the last 6 months. Only after the 5th credit voucher showed up did I finally decide to take advantage of the offer. The process requires a little technical knowhow and it is likely that many local business owners are intimidated by the whole process of selecting key words, writing up an ad, choosing a daily budget and deciding on a proper price-per-click!

Groupon is that missing piece in the puzzle connecting local customers to local businesses! The idea behind the acquisition would likely have been to deploy Groupon technology all across Google’s platform. People search when they need something, so why not entice them with a Groupon coupon?! A note of caution is that since Groupon deals change daily, this would require tight integration with Adword/Adsense servers, however if done properly could generate vastly more revenues for Google.

An easy extension would be to use Groupon ads with Google maps, as millions of users use this service to look up directions and traffic. I can imagine a scenario where Google pushes deal updates dynamically to a user’s phone depending on their location! (you heard here first !)


Acquisition Analysis

It is estimated that Groupon will post $800 million in revenues this year with a very straightforward revenue model. Groupon sells vouchers on behalf of small businesses (vendors), keeps its cut and passes on the remainder to the vendor. But it is prudent to note that certain controversy exists whenever pass-through revenue is recognized! An interesting fact here is that Groupon is assumed to be operating capital negative due to this reason.
As a typical deal involves 50-50 split between merchant and Groupon, we can assume a $400 million gross margin for 2010. Now it is safe to think that after accounting for operational expenses, Groupon would have $200 million in EBITDA. The EBITDA multiples of some major Internet players are Ebay.com (11.92), Google.com (13.62), Yahoo.com (13.3) Amazon.com (40.32). If we use an EBITDA multiple of 15, we come only at a valuation of $3B. How does Google plan to squeeze more value by acquiring at double this price? We have not even talked about quality of revenues for Groupon. If the company is generating so much cash, then why the need to raise 135 million back in April? Was that all used for foreign acquisitions? Also, even a $3 Billion valuation is very generous to Groupon as free cash flow arguably is lower than EBITDA (because of less amortization/depreciation in Internet business)

The revenue multiple is high even for a new business. The industry average is 3 times revenue, and for high-margin, high-growth companies, it is 6. But this number comes up to nearly 8 for Groupon and the kind of revenue used to calculate this number is pass-through revenue! The margin on revenue recognized from Gap-like offers can be assumed to be wafer-thin! Pets.com and Webvan.com all had revenue but were losing on each sale. Many companies like these went bust during the dot-com bubble, ultimately evaporating billions of dollars of investors’ capital.
We cannot use CAPM model to calculate required rate of return, as we have the beta neither for Groupon nor for any publicly traded company in the same market as Groupon! An important question to ask here is why not issue debt? Debt is very profitable for stockholders as it is cheaper than equity and comes with a tax shield, but with increased financial risk. This raises a red flag!

These are groupon statistics visible on its homepage !
12/4/10 1:30 pm
Total dollars saved
$804,640,273
Total Groupons bought
18,664,813
12/7/10 1:50 pm
• Total dollars saved
$814,932,477
Total Groupons bought
18,914,735

If we take the numbers on its face, 3days= ~$10.3 mil= ~$3.4 mill savings a day- this is the savings but you can backtrack and calculate revenues! As deals on Groupon save an average of 60%, we can assume that revenues equal to savings! Mind you, this is a big ”IF”, but given lack of public financial data, this is a decent assumption! Even if you discount for the fact that it’s holiday season, the company might be still on target for $800 million in yearly sales!
Google’s realized return on equity is 21%, so I don’t know how much patience it would exercise, if they had acquired Groupon! Even if Groupon generates value year after year, that value is already priced into $6B deal. Groupon is very far away from fully returning $6B in free cash flow, adjusted for time value of money and Google has to generate 21% value per year on top of this value.

The deal’s breakup seems $6.3B cash $.7b in performance (weak earnout provision), the performance part is good but at least some part of $6.3B should have been in stock (learning from AOLs acquisition of Time Warner in stock!)
By rejecting Google’s offer, Groupon potentially spawned a competitor; this is too big a market and is growing fast! Google has practically unlimited resources, very talented people and lots of patience (read Youtube buyout!) Groupon claims to have 35 million subscribers, and this number is less than the total number of groupons ever bought! We can safely conclude that many members never bought a groupon and the vast majority never bought a second one!
Myspace had 150 million users at its peak and had terrible time monetizing the site. Myspace did spawn the creation of Youtube and Flickr, so let us hope that something good comes of Groupon too! Also, this is good time revisit Yahoo’s statement about the 1999’s $3.6 billion acquisition of GeoCities, “This is a very substantial and very strategic acquisition for us. This will help us accelerate our company’s leadership position.” Yahoo ended up winding up Geocities operation in 2009, and the other notable acquisition Broadcast.com for $5.7B with similar fate. It is important to note that not all acquisitions by Yahoo were failures. Overture.com acquisiton has been a great success, and indeed Yahoo still licenses this lucrative technology to Google!

I have a feeling that Google was thinking on the same lines of Yahoo circa 1999! Are these the same people who revolutionized search and brought us street view maps? Is it safe to conclude that the “gung-ho” factor is out from Google! I should have got the hint when they gave 10% raise across the board to stem the outflow of employees! However you slice or dice Groupon numbers, “make” option seems to better for Google than “buy” option (I am sure they have a Groupon clone already in the pipeline!). However Google needs to bring in small business experts to weigh on the local coupon model! Right now it seems to do anything to stop employees from employees jumping into the flavor the year (month?) companies!! (read, MS to Google, Google to FB, and now FB to Groupon?)


Facebook/ Twitter
Facebook can arguably not content with 500 million members (no reason to!) as there are more than 6 billion people on our dear planet and the majority of existing members are not active! FB too might be a logical fit for Groupon. With its treasure trove of demographic/ lifestyle information, FB can leverage that to target members with laser like precision. It can go one more step further and create deals based on the users’ preferences. Hyper location specific deals can also be implemented in conjunction with the deals above. FB can show what their friends have purchased and create trust and or peer pressure! This would result in increased usage of the social network by its members and potentially entice more people to sign up.

Actually FB is already pushing location based deals but only limited to fans of that business and that too free of any FB fees!
http://www.allfacebook.com/facebook-hopes-to-end-business-as-usual-with-location-based-deals-2010-11

It is interesting to note that Groupon’s highly successful Gap deal took off because of Groupon’s ads on Facebook/Twitter, so doesn’t that make a natural place for Groupon here? No discussion about FB is complete without the mention of Facebook Connect. The new thinking at FB is not to hoard information, but to share with 3rd party websites (Google,Twitter all been doing it). The information sharing is only for one user at a time and happens only when the person consents the website/app. FB keeps the complete demographics information close to its chest (and its marketers arguably!)

Linkedin also is a good fit as the average person on it is high-incomer comparing to the average member on FB. Similar cases can be made for Twitter/MSN.

Competitors
Groupon is not only one of the fastest growing companies ever but also the highly copied business model ever. There are approximately 212 in the US (1106 worldwide and growing by the hour!). Here are some web traffic statistics I pulled from Alexa.com,
Groupon 95 in us (500 worldwide)
LivingSocial 187 in US (1035 worldwide)
Buywithme 4056 in us (8127 worldwide)- no app
Tippr 9176 in us (31424 worldwide)- has app

Traffic rankings are not indicative of only clicks and not revenue. Some of these sites have extensive informational only sections which are not e-commerce related!
LivingSocial is the closest competitor to Groupon and not too far behind Groupon in the race, judging by Amazon’s investment in the company. One advantage going for LS is that area experts are on the ground well familiar with each market unlike Groupon, where all of the salespeople are centrally located in Chicago. While both Groupon and LS have apps for customers, LS doesn’t have a merchant app yet! Both of them have been promising hyper-local deals for a while but area experts are the bottleneck here. This can never be completely automated. It takes human expertise to vet businesses and their offers.

If a competitor can get around this problem, it can see explosion of revenues. Crowd sourcing of offer leads is a good idea but not just any crowd sourcing! Some discrimination should be made based on followers on review sites like Yelp/Citysearch etc. The people to be crowd sourcing from have to be well connected socially, and trusted to be an authority on that business. Also, the idea of dynamically pushing deals to customers can be implemented by anyone, as long as it has the right connections to GPS/smartphones! (you heard here first )
Yelp or Citysearch are also trying to become big players in this market. I’ve been getting deals from Yelp for past 6 months, but have not played much attention to them. Yelp must take initiative to solicit subscribers to give their preferences as to the deals newsletter instead of mass mailing to all members! This way Yelp can expect higher click-thru rate, and also adjust frequency suitably (currently Yelp indiscriminately emails everyone weekly)

A friend of mine is starting a Groupon competitor called Yeshtu and I sincerely hope that he stays ahead of the curve in this business and gets lot of traction. I hope the new entrants use less draconian split than 50-50 with the merchant (which Groupon is notorious for!). Groupon signs up merchants on two-year exclusivity deals, but Groupon suing a small business over an exclusivity clause would be a PR nightmare! Would Groupon sign a reverse exclusivity clause with a restaurant that they wouldn’t sign up another restaurant in the same area for 2 years?

Groupon has to do more to motivate members to stick and not move to deals in LivingSocial, etc. Pyramid system like Amway is a good idea where a tiered membership exists and continued loyalty is rewarded. Some kind of better value proposition like managing members spending, marketing, collective buying, or credit for merchants own use. Some of the extensions can be personalized coupons, flash deals, extra discount for members who “Like” their Facebook page/ share the deal on Twitter/ or write a Yelp review!

The demographics for this market seem to be educated, female, young, and metro dwellers. New entrants should target different demographics. A metro like LA has more than 100,000 businesses and 15 million people patronizing them. The market is large enough to go around for everyone.

Without preaching I believe these are some of the pros and cons for consolidation being far off in this market,
Pros//
Small businesses open and close, so only the deal websites that stay most updated can survive
An incident like recalls can shake off even well respected brands like Toyota. How trustworthy is the Groupon/ Living Social brand?
Low barrier for entry into the market
Not much of IP in this segment
Unlike enterprise customers, consumers are fickle with constant change in preferences/tastes!
Cons//
Google has something like 77% of search market, how about that for consolidation?
Master/visa card have 90% of credit/debit card processing market between them, and they serve millions of small businesses (this is where Groupon,LS etc. are aiming for,right?)
Customers are creatures of habit (how many people use Bing.com/Ask.com even though most search results are almost as good?)


Conclusion

The growth of the industry coincides with recession time, when people are looking for deals, and willing to grab anything and everything they can save on! As the economy recovers, would customers be equally enthusiastic to save, or more importantly, would businesses continue to offer eye-popping deals? When coupon fatigue sets in, consumers will demand higher discount, or move to the next fad!

My finger is always itching to click on some of the deals that these websites offer. But my pet peeve is that the vast majority of these deals serves wants and not needs. How about discount on must-need things like OJ and eggs. For the last 4 months, my restaurant has been solicited everyday from Groupon-like companies, to offer them special deals! From a business point of view there is limited appeal to friction-less vouchers/coupon distribution. Actually some of the businesses are unable to handle the business brought by Groupon-like companies! Groupon will be sorry to reject Google’s offer. Given the barrier-less entry into this market, Google, with it is seemingly unlimited resources can easily “make” a Groupon competitor!

p.s: I have not explored the idea that Groupon spurned Google more out of desire to stay independent, and less to do with supposed under valuation! Groupon might want to be counted among Internet elite like Google, Facebook, Amazon, and that is perfectly fine! Google might still come back with a bigger offer when there is less annoyance of antitrust concerns! Talking about hyper over valuations, FB valuation went from $6.9B last August to $60B today! Will FB have the fastest $100B valuation ever?? Happy Holidays!


References//
http://seekingalpha.com/article/239979-groupon-turns-down-google-what-just-happened-here?source=hp_latest_articles
http://seekingalpha.com/article/239646-in-defense-of-google-s-groupon-acquisition
http://www.forbes.com/forbes/2010/0830/entrepreneurs-groupon-facebook-twitter-next-web-phenom.html
http://www.groupon.com/pages/press-kit
http://www.allfacebook.com/facebook-hopes-to-end-business-as-usual-with-location-based-deals-2010-11
http://www.alexa.com/search?q=groupon.com&r=home_home&p=bigtop
http://www.marketwatch.com/story/googles-groupon-deal-a-sign-of-net-bubble-2010-12-03?reflink=MW_news_stmp
http://www.Finance.Yahoo.com
http://xedant.com/researches/top_500_adsense_keywords

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1 Comment

Posted by on December 18, 2010 in Uncategorized

 

One response to “It looked like Christmas came early this year for Groupon!

  1. Murali

    December 19, 2010 at 4:24 pm

    nice one Vamsi.

     

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