Why Groupon’s Year-To-Date Rally Could Be Coming To An End

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Submitted by George Riley as part of our contributors program.

As Groupon, Inc.’s (GRPN) latest financial reporting nears, the investment community is divided as to what the future holds for the daily deals giant. The company is 63% institutionally owned, suggesting the so-called smart money is bullish, but fundamental analysis of the company’s performance seems to suggest otherwise, raising the question, “Should investors buy or sell GRPN?”

Financials

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In May of this year Groupon released its results for the three months ended March 31st 2013. Revenue for the period was reported at $60M, up from $559M for the same period a year earlier. Net loss for the period was $3.9M, or $(0.01) per share, down from just over $11.5M, or $(0.02) per share, a year earlier. At first glance, increased revenue and an improved bottom line indicates that the recovery in Groupon’s stock is supported by its financial performance. It also suggests that if this financial performance can be emulated, or improved upon, in the upcoming release there could be further upside potential in the company’s stock. In reality however, things are not that simple.

Resource Re-allocation

In the past 12 months Groupon shifted a considerable amount of its resources away from the coupon business, and towards direct goods sales. Direct sales accounted for $162M of the $601M revenue that the company reported, up from $19M the year before. In contrast, revenue generated form the coupon business fell, from $540M for the three months ended March 2012 to $439M for the same period this year. The problem with this shift in focus is rooted in the difference in cost to Groupon associated with generating both types of revenue. It cost the company $152M to generate the $162M direct sales revenue, and $70M to generate the $439M coupon derived revenue. The result of this increased cost of revenue is a quarter-over-quarter fall in gross profit from $439M to $37M, which does not support the recent share price increase, and is not indicative of further upside.

Industry Growth

Current financials aside, consider the industry in which Groupon operates. Discount purchasing increases in popularity in times of economic hardship. The growth that Groupon experienced during its first 3 years in operation coincided with the 2008 recession, and the resulting economic downturn. Although specific timeframes remain uncertain income levels, and in turn disposable income, will at some point stabilize. With income stabilization will come a diminished demand for discount purchasing. In other words as the economy grows, the market for Groupon’s offerings will shrink.

Patent Infringement

Looking much nearer-term, Groupon is also involved in an upcoming patent dispute. Blue Calypso, Inc. (BCYP), a social media marketing company, claims that Groupon infringes upon a number of its patents. The patents that Blue Calypso holds protect the company’s right to use computer based technology to promote goods or services based on consumers’ specificities; location, for example. They also protect the company’s right to incentivise, and facilitate, peer to peer promotion via a mobile device.

Last week MyLikes, another social media marketing company, reached an out of court settlement in an infringement dispute with Blue Calypso that involved the same patents. The result being an agreement to pay Blue Calypso the equivalent of 3.5% of revenue in return for the continued use of its patents.

If Groupon are found to be infringing upon the patents, or if the company chooses to settle out of court, and assuming similar terms to the MyLikes agreement, analysis suggests it could end up paying in excess of $60M per year to Blue Calypso in licensing revenue. This figure is conservative, when considered with recent press releases made by Groupon stating its near term growth is focussed around increased mobile device operations, and refined location based services.

The hearing for the dispute is scheduled to take place in East Texas in November. The Eastern District of Texas is known for its judges’ history of recommending patent dispute cases for jury trial. To avoid the risk of going to trial defendants in such cases will generally settle out of court. An out of court settlement to the levels previously mentioned could make it very difficult for Groupon to generate any retainable earnings.

Competition

Finally, adding to Groupon’s difficulty is the competition it faces in both sides of its business, direct and indirect.

With regards to the company’s indirect business, Groupon has three main competitors. The first of these is LivingSocial, majority owned by Amazon (AMZN). The second is Google Offers, which offers location based targeted discounting in just the same way as Groupon. The third is Facebook Offers, a facility that enables a company to share discounts with its customers by posting them on a Facebook page. Although Groupon is currently the market leader in the daily deals industry, Amazon, Google (GOOG) and Facebook (FB) are all financially superior and have bigger user bases. With limited financial resources, and no quantifiable advantage over its competitors, it might be difficult for Groupon to maintain its market leader status.

In its direct sales business Groupon is competing with eBay (EBAY) and Amazon. The dominant position these two companies hold in the online sales and distribution industry will make it difficult, and expensive, for Groupon to gain any sort of meaningful market share.

Conclusion

To conclude, while a number of analysts are shifting their Groupon recommendations to a buy, fundamental analysis of the company’s current, and prospective, position suggests this is unfounded.

Expansionary difficulty, pending patent litigation, and declining profits all point towards current overvaluation of the company’s stock.