Groupon Stock A Big Risk Going Into Q4 2015 Earnings

  • Groupon is now transitioning its strategy towards more aggressive marketing. Customer acquisition costs will increase.
  • Now if the company doesn't reach its growth target and maintains an incremental spend of $20 million in advertising, the stock will plummet in response to a revenue miss.
  • Investors should not rely on management's outlook on FY'16 revenue. The year is shaping up to be a total nightmare for investors.

Groupon (NASDAQ:GRPN) is set to report earnings on 10 Feb 2016, after the bell. Clearly Groupon has gone through a downward spiral after it became abundantly clear for shareholders that user growth was slowing quite considerably and many of the moves by Groupon's management have proven to be relatively short sighted in nature. Groupon is trading at a relatively low valuation when compared to other e-commerce peers, but the risk factors still weigh heavily on the minds of investors.

Amazon struggled to report revenue growth due to F/X comparisons. Further, if eBay earnings were any indication of what could happen to mid-single digit organic growth rates as a result of F/X, it’s worth anticipating near-term downside. You would also assume Groupon will lower its outlook range for the upcoming fiscal year.

Groupon's customer acquisition cost has declined, and life time customer value has also declined in the subsequent years following 2010. However, to be fair, Groupon is now re-prioritizing marketing spend in the United States and is ramping up its efforts to improve its customer acquisition rate.

2-10-16 GRPN pic 1

Source: Groupon

The company anticipates that it can reverse the trend in gross billings per customer upon acquisition, but for now, things have started to stabilize at approximately $80 to $75 in gross billings per customer by year three upon acquiring the customer. However, the consistent trend in declining life time value is disturbing, so I’m somewhat dubious of management’s commentary with regards to marketing ROI.

The customer acquisition cost has also gotten higher in an environment of rising mobile ad CPMs, as many firms are competing aggressively for mobile impressions, which has resulted in significantly higher pricing for app installs. I do anticipate the company’s strategic focus on developed markets to be more viable for sustained growth, as the United States is the largest market opportunity, and penetration has been relatively limited. Furthermore, U.S. based growth reduces F/X volatility, so that’s an added positive as well.

However, the path to profitability from U.S. based customer acquisition will take longer than in prior years, which implies that Groupon’s comments on payback periods varying between 12 to 18 months seem somewhat aggressive. Groupon’s management operates on the assumption that gross billings per acquired customer will sustain at $80. Given the reduction in consumer electronics listings in its product categories, the incremental revenue from new customers should be negatively affected.

However, consumer electronics carry extremely low gross margins, so reducing the scope of this category should result in more profitable customers on a per dollar basis, but it doesn’t change the underlying dynamics of fewer consumer electronic products equals lower billings per customer. Furthermore, I can’t imagine how Groupon will simply overcome the higher cost of ad impressions through better ad targeting or retargeting methods. The incremental return from better ad creativity/engagement metrics isn’t likely to offset the massive inflation to ad prices.

Investors should anticipate Groupon to shut foreign investment, and close some foreign web/apps. Groupon can then use the operational synergies saved costs to fund marketing. This should result in U.S. based customer growth of 20% in a best case scenario, but I actually anticipate growth of 15% or less due to the changing dynamics of digital marketing and exaggerated claims on ad productivity. Further penetration into the United States markets will attract less engaged users, as die-hard bargain hunters become less valuable as Groupon penetrates into the lower value demographics (basically people who have less disposable income).

But then again, Groupon might as well invest in developed markets where large vendor ecosystems are established, and incremental customers provide more value than in developing markets. As such, it’s the right strategic step, but the lack of foresight with regards to marketing is mind boggling.

2-10-16 GRPN pic 2Source: Groupon

Groupon faces stiffer competition within the United States from Amazon in the goods category. Therefore, growth will primarily come from the deals section where services will be the primary growth area. The company’s strategy for gaining incremental customers within the United States will cost more, but assuming spending does ramp, the incremental user growth will eventually justify the marketing spend. I just think the payback period will occur two to three years down the road (FY'17 to FY'18). Even so, returning the company to a higher user growth rate has more favorable implications on the stock as opposed to improving billings per customer.

What’s alarming is that it took Groupon five-years to realize the importance of customer acquisition. All the efforts in developing markets proved worthless from a financial perspective. Assuming 20% billings growth by 2018, I could see marketing spend increasing to 15% of total revenue, which implies marketing spend of $457 million by the end of FY’16. The company forecasts $100 million in incremental marketing spend, and that it will shift roughly half of its marketing spend to the United States. The management team signals that it can reach its growth target with $351 million in advertising assuming a $20 million incremental increase (based on Q4'15 guidance) to advertising expense per quarter over prior year. However, I find it extremely unlikely that they can miraculously boost billings growth to 20% by 2018 in an environment of weakening billings per customer.

In other words, investors should be prepared to be disappointed with either costs or revenue (perhaps both). Hopefully, the management is smart enough to emphasize revenue growth at higher marketing cost, otherwise, the company will never escape from being a niche service. Furthermore, the outlook of $2.7 billion to $3.05 billion revenues for FY’16 shouldn’t attract much confidence from investors as it’s a pretty wide range, and the consensus estimate is at the high end of the range at $2.97 billion. I’m anticipating break-even on a non-GAAP basis (best case scenario) in FY'16. Furthermore, if marketing costs prove to be higher than expected, investors should anticipate continued non-GAAP earnings losses to further damage sentiment around the stock.

As such, I have to initiate a sell recommendation. The sell side is way too optimistic about the management's guidance. I see the guidance range tightening but certainly not improving in terms of revenue for FY’16. Furthermore, if the management lowers its FY 16 outlook, the stock will waterfall down to the $2.00 level. In other words, investors should not buy here. Estimates are aggressive, and analyst expectation risk is heightened and overly optimistic when pertaining to revenue.

I anticipate the cost structure of the company to worsen, and incremental revenue from new customers to factor favorably into operating profits by the middle of FY’18 as opposed to the middle of FY'17. Assuming weakening profits, a slower ramp rate of revenue and further analyst revisions down the road, Groupon is a big risk right now.

I’m not offering a price target, but will offer one as we exit out of Q4’15 earnings.

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Comments on this article and GRPN stock

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sugi
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Do you think Market Value could go below Groupon Cash?...Cause if we consider 900M $ Cash - 250M $ Debt + 300M $ Ticket Monster value = 950M $ that means 1.60 $ per share....So...do you really thing Grpn could gp below 1.6$ per share? So why TWTR with more than 500M loss and less than 2B Revenues is at 14$? (P/S almost 5 vs Groupon P/S less than 0.50)
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