Here Are The Key Drivers And Barriers For Groupon’s Business

After posting better-than-expected results in the third quarter, Groupon (NASDAQ:GRPN) has seen its stock price increase by more than 25%. The earnings indicated progress against the company’s growth strategies of accelerating growth in local businesses served (in North America and other international regions), enhancing profitability in the goods business, and optimizing operations in the international business.

In this article, we assess some of the key drivers and barriers in Groupon’s business model, to understand where the company could gain or lose going forward. There are various drivers (or tailwinds) to the company’s business including – success on the mobile platform, introduction of new features (such as Pages, Gnome, time-based deals), growth in the travel business and reduction in the number of unused deals. We expect these drivers to spur demand and to also result in expansion of Groupon’s merchant network in the future. Moreover, we think Groupon’s measures to boost its goods margins and reduce operating losses in the international geographies could favorably impact its profitability in the long run.

However, we’d advise investors to monitor the intense competition in group-buying and e-commerce markets. This impedes Groupon’s ability to raise its margins significantly and make its business more sustainable. Further, the heavy reliance on ‘Push’ strategy is undesirable and Groupon needs to achieve more success with its ‘Pull’ strategy to sustain and grow its subscriber base.

Check out our complete analysis of Groupon

Key Drivers:

Increasing mobile penetration: Groupon’s mobile strategy has gained traction in the recent past – its cumulative app downloads crossed 100 million in the third quarter. Mobile platform currently comprises for over 50% of Groupon’s business and in certain markets, this figure stands at more than 65%. ^[1] This bodes well for Groupon considering Internet usage is increasingly shifting towards mobile usage, and average spend by mobile customers is higher than by other customers.

In addition, Groupon’s recent move to introduce a mobile app ‘Snap’ (which offers deals related to household products) was successful, since over 1 million people downloaded the app over the last few months. Since mobile commerce market is seeing rapid growth, higher mobile adoption will help Groupon strengthen its position in the local business.

Recent innovations: We believe the launch of two new features, namely Pages and Gnome could result in significant expansion in Groupon’s merchant network in the long run. Pages creates an online listing for local merchants with useful information (including contact information, maps and reviews). While over seven million such pages have been built, only half a million pages have been currently rolled out. As the feature gets launched more extensively, we expect it to drive additional traffic to Groupon apps and to also help in search engine optimization (SEO) strategy.

Gnome is a new operating system for merchants that gives them greater insights regarding item-level sales and allows easier redemption by consumers. The recent acquisition of Swarm Mobile, a start-up that helps retail outlets with customer analytics and engagement tools, is expected to strengthen this operating system and connect Groupon’s platform to merchants in real-time. In addition, the company recently came out with time-based deals for establishments that take reservations or appointments. Local restaurants have responded well to this feature, and we expect this deal category to gain popularity in the coming quarters.

Growth in the higher margin travel business: The travel business has higher profitability than the goods’ business – travel gross profit as a percentage of overall travel gross billings in North America was recorded at 16.5% in Q3 2014; in comparison, the similar figure for goods business’ was seen at 9.9%. Since the mix of travel gross billings in overall gross billings is rising, we expect it to positively impact margins in the future. Travel gross billings as a percentage of total gross billings in North America rose from 9.7% in Q3 2013 to 11.0% in Q3 2014, and we expect this trend to continue in the future.

Measures are being taken to boost margins in the e-commerce and international businesses: Groupon is trying to raise its goods margins (especially in North America) by shifting additional business to drop-ship, adding more fulfillment to its own distribution center, and raising the number of units per order. These measures are producing results as goods’ gross margins in North America expanded to around 10% in Q3. We expect goods’ margins to see improvement in 2015 as well.

In addition, Groupon is also making efforts to curb operating losses in the international segment by standardizing best practices globally. These efforts have begun to pay off as the ‘rest of the world’ geography posted positive adjusted EBITDA in Q3 2014 for the first time in several quarters.

Reduction in the number of unused deals: During the recent earnings call, the company’s management indicated that redemptions have stabilized as the backlog related to unused deals has now been cleared. The increase in redemptions now corresponds more closely with growth in local billings, as compared to being considerably higher than the latter in previous quarters. We expect this development to positively impact demand for Groupons in the future. ^[2]

Barriers:

Dependence on push strategy can be detrimental in the long-term: Groupon is heavily dependent on its Push strategy, which involves sending hundreds of millions of emails everyday to its subscribers. We believe the user experience generated through this strategy could somewhat dilute the company’s brand image and value proposition in the long-run. Groupon is undertaking measures to mitigate this issue by encouraging subscribers to search for deals and explore its marketplace (‘pull’) strategy. However, this move has met with only partial success as the share of searches on marketplace as a proportion of Groupon’s traffic in North America increased only slightly from 9% in March 2014 to 10% in June 2014 ^[3]

Intense competition: Groupon faces intense competition in both its group-buying and e-commerce businesses. A number of online companies have a similar business model as Groupon such as LivingSocial, Tippr, etc. Moreover, traditional offline coupon and discount providers also present additional competition for the company. Further, since the Internet business is characterized by relatively low barriers to entry, we could also see the competition heat up from more established players having greater financial resources. The intense rivalry in the industry boils down to price-based competition, where certain players accept lower margins or share higher percentage of revenue with merchants. This caps Groupon’s ability to raise prices and take rates in its business model.

Lack of profitability: Owing to intense competition, the lack of profitability has been one of the dominant concerns for Groupon’s investors. Its GAAP operating margin has varied between -2.6% and 4.5% over the last nine quarters, with an average margin of 1.2%. While the previously discussed measures will raise profitability to an extent, it still remains to be seen whether Groupon is able to raise its margins significantly given the complex competitive dynamics at play. The high sensitivity of Groupon’s valuation to its margins can be easily seen in our model — while we forecast Groupon’s adjusted EBITDA margin to rise from 5.6% in 2014 to 10% by the end of our forecast horizon (2021), if we raise our EBITDA margin estimate to 12% by 2021, then it would lead to a 15% increase in our valuation.

Our $7.09 price estimate for Groupon’s stock, is around 5% below the current market price.

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1. Groupon’s (GRPN) CEO Eric Lefkofsky on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 30, 2014 [↩]
2. Groupon’s (GRPN) CEO Eric Lefkofsky on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 30, 2014 [↩]
3. Groupon’s (GRPN) CEO Eric Lefkofsky on Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, August 5, 2014 [↩]