- The Groupon investment thesis remains intact after conducting analysis on historic ad conversions.
- While there are limitations to the current addressable market, I don't believe those issues will surface in the immediate time frame.
- Therefore, I continue to reiterate my contrarian idea and anticipate additional upside for Groupon stock from current levels.
Groupon (NASDAQ:GRPN) remains one of my more interesting turnaround ideas, and while I can acknowledge that there are downside risks to investing in Groupon stock, I believe there are enough near-term catalysts to sales/earnings to drive the stock valuation higher. But then again, while I was doing research I came across the most compelling counter-argument for why Groupon may not deliver meaningful sales growth after announcing a doubling in advertising spend.
Morgan Stanley makes a very good point in its most recent note on Groupon:
This implies that from Groupon's North America addressable user base, nearly 60m individuals will have used the service. It is difficult to precisely predict the size of Groupon's real addressable customer base, but we contend that is unlikely to be materially above 60m. Even though there are 190m US Adults who live in Urban/Suburban settings, we contend that a far smaller sub-segment are addressable as the product 1) skews female (per comscore), 2) is used in cities more than in towns, and 3) has a niche use case.
It’s hard to make a cogent counter argument against the analyst’s points. However, even if the product is targeted at a niche and there’s an upper limit to the total addressable market, ad-metrics should be a better leading indicator than broad demographic studies. Even if the app generates a high churn rate over a five-year period, capturing a small portion of those subscribers, given the current customer acquisition cost/life time value should result in meaningful upside to sales/earnings.
Morgan Stanley estimates that Groupon had a churn rate of 5.4 million users in FY’15, and that 50% of active users stopped using the app since 2010. Therefore, Groupon’s retention dynamics are weak, but after factoring for that weak retention dynamic I still come away with the impression that if Groupon spends $500 million in advertising over the next year, and app installs cost $4.23, the company will grow its subscriber base quite significantly in North America. Now, obviously, Groupon’s app installs will cost significantly more than the industry average as the company has generic targeting requirements and has a budget that competes with other large digital properties in the e-commerce space. Therefore, I'm going to use Groupon's historic subscriber acquisition rate to arrive at a more compelling argument.
So, to arrive at a more realistic figure I use prior year’s churn rate of 5.4 million users (as per Morgan Stanley figures) plus the incremental subscriber growth to arrive at customer acquisition cost. To sustain a 3% growth rate in active users, GRPN would have had to offset the 5.4 million plus add 2 million on top. So, after Groupon spent $254 million in advertising last year, the acquisition cost for active Groupon members was approximately $254 million divided by 7.4 million active users, which amounts to $34.32 in customer acquisition cost per subscriber. Therefore, if Groupon invests $500 million in advertising this year, the company will acquire 14.56 million additional users or 63.56 million active users in total, but we then factor for a 9.66% churn rate against the projected user base to arrive at 57.42 million active customers. Since investment is concentrated in United States, the subscriber mix will drive North America active customer figure to approximately 8.42 million adds against a current base of 25.9 million North America active users. Therefore, I'm anticipating the North America active user figure to reach 34.32 million, which amount to 32.5% growth. Since each incremental user has relatively similar spend rates to older active users, the impact of those added users is felt immediately. As such, I adjust my growth estimate for North America billings growth to 32.5% y/y and forecast $3.644 billion and $535 million in revenue and adjusted EBITDA, respectively.
Since I’m revising my estimate higher on user/sales growth, I’m also reassessing my intrinsic value estimate for Groupon stock as well. I believe Groupon will report beyond the very high-end of the consensus estimate range by the end of FY’16. As such, I’m valuing Groupon stock at $5.92 per share, which is higher than my prior value estimate of $5.74. I arrive at this valuation by discounting my end of five-year valuation of $6.757 billion by 14.08% (the current weighted average cost of capital).
While there are risks to my investment thesis, I feel like much of the concerns weighed by other analysts don’t necessarily apply here. I don't believe Groupon is near full saturation in the U.S. Therefore, several years of active user growth remains feasible. As such, I reiterate my contrarian buy recommendation on Groupon stock.