Groupon’s (NASDAQ:GRPN) lack of profits has been a long-standing concern among the company’s investors, and this has resulted in more than 60% fall in its stock price since its IPO. The company’s GAAP operating margin was seen at -14.5%, 4.2% and 2.9% for the years of 2011, 2012 and 2013, respectively. During the nine months ended September 2014, the margin further deteriorated by 490 basis points annually to -1.5%.
In this article, we try to assess the key factors behind Groupon’s low margins, by analyzing its operations across different geographies and businesses. We find that, whereas North America, Europe, and the Middle East and Africa (EMEA) are more profitable geographies for the company, its operations across the rest of the world generate significant losses. Though Groupon is trying to reduce losses in the international region by standardizing its best practices globally, we are skeptical that this could result in large-scale improvement in its profitability from the region. Margins within North America and EMEA have also come down recently, due to a decrease in gross profit, coupled with increase in marketing and SG&A expenses. Moreover, we expect these headwinds to persist in the near-term.
Similarly, assessing profitability from a business category perspective, we find that Groupon’s margins are lowest in its goods’ business, which contributes over half of its revenues. Though the company is making efforts to lower its shipping and fulfillment costs, intense competition in the e-commerce market, in all likelihood, will limit margin increase in this segment. Additionally, profits in its local business are also falling, due both to the addition of higher quality, lower take-rate merchants, and to investments to drive growth in the pull marketplace. Finally, we conclude that while the gross margin could continue to decline with an increasing proportion of direct sales, marketing and SG&A expenses as a percentage of revenue could decrease in the future.
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Rest Of World Geography Is A Drag On Groupon’s Earnings
Analyzing Groupon’s profits across different geographies, we find that while North America and EMEA regions generate operating profits for the company, its operations across the rest of the world generate operating losses. Groupon pursued international expansion through the acquisition of different businesses, which resulted in several technology platforms and business processes being adopted by the company. This in turn has led to increased expenses. In order to mitigate these losses, Groupon is trying to standardize its best practices globally. These measures have begun to reap results, as the rest of the world’ geography contributed positive adjusted EBITDA in Q3 2014 for the first time in several quarters. Still, we think that the company will have to do much more over the long-run to achieve meaningful profits from the region.
During the nine months ended September 2014, operating margins in North America and EMEA came down on a year-over-year basis due to a decrease in gross profit coupled with rise in operating expenses. We expect margins in these regions to be impacted by various factors such as a higher proportion of direct sales, a change in the sales mix, and an increase in marketing expenses in the coming quarters.
Goods Business’ Has The Lowest Margin And Its Share In The Overall Business Is Rising
Groupon’s businesses categories include: 1) local business (where it partners with both local and national merchants to offer deals across various categories such as food and drinks, events and activities, beauty and spa, etc.); 2) the goods business (where it provides attractive discounts on product lines including electronics, apparel, jewelry, etc.); and, 3) travel (where it offers travel-based offers such as hotels, airline and package deals).
While the goods’ business contributed for 28% and 32% of overall gross billings in 2012 and 2013, respectively, its share has increased to 39% over the last twelve months (ending with September 2014). The rising share of direct sales as compared to third-party sales in the overall goods’ business has been responsible for this trend. Additionally, this has also impacted gross profit as a % of gross billings in the goods’ business, which has come down from 21% in 2012 to around 11% recently, as direct sales have lower gross margins. Since the goods’ business comprises over 50% of the overall revenues and its share is increasing, we expect this factor to negatively impact gross margins in the future. Groupon’s shipping and fulfillment costs historically have been double the level of other e-commerce businesses. Hence, the company is trying to improve these goods margins by moving additional business to drop-ship status, adding more fulfillment to its own distribution center, and raising the number of units per order. We expect these measures to boost its margins slightly. However, considering the low profitability of e-commerce players such as Amazon, we do not expect Groupon will achieve a large improvement in its goods margins in the near future.
Gross profit as a percentage of gross billings within the local business has declined from 36% and 35% in 2012 and 2013, respectively, and on to 32% during the last twelve months ending September 2014. This decline was due to the increased proportion of higher quality, lower take-rate merchants, as well as to discounts made to attract customers to Groupon’s pull marketplace. In addition, there was a negative change in sales mix. The company’s management forecasts local take rates in North America to stay in the range of 35% to 38% in the future.
Groupon faces intense competition in both its local and goods (e-commerce) businesses. A large number of online companies have a similar business model as Groupon, such as LivingSocial, Tippr, etc. In addition, offline coupon and discount providers also increase competition for the company. This intense rivalry leads to frequent price-based competition, whereby certain companies accept lower profits or share a higher portion of revenue with merchants. This limits Groupon’s ability to raise prices and take rates in its business model. Similarly, with the likes of Amazon, eBay, and now Wal-Mart and Target vying for additional market share in the e-commerce sector, we doubt Groupon’s ability to win in the goods’ business.
Though Cost of Sales As A % Of Revenue Will Continue To Go Up, Operating Expenses Could See Some Leverage
Evaluating Groupon’s profitability in terms of individual expense line items, we find that the overall cost of revenue for Groupon has risen rapidly over the past, due to the rising proportion of direct-sales in overall sales. The share of third-party sales in the overall goods’ business was seen at 38% and 100% in EMEA and Rest of World geography during Q3 2014. Hence, an additional share of this business could become direct in the coming future, impacting gross margins even further.
Marketing expenses as a percentage of revenue has come down significantly from 2011 to 2013, due to a change in focus from acquiring new customers to increasing the spending from existing customers and driving mobile application downloads. However, the same ratio has grown marginally over the nine month period in 2014, due to measures to enhance the active customer count and drive adoption of pull marketplace. Please note that certain marketing expense items including order discounts, free shipping on certain items, and offering lower margin deals do not get included in marketing expenses, but result in decline in overall billings.
Sales, general and administrative expenses as a percentage of revenue has declined over the past, due to higher operational efficiency. We expect this figure to further go down in the coming future, with reduction in general corporate expenses and consulting and professional costs. We expect SG&A and marketing expenses as a percentage of revenue to see some leverage in the future as top-line growth could surpass rise in expenses. Therefore, we estimate Groupon’s adjusted EBITDA margin to improve from 5.6% in 2014 to 10% by the end of our forecast horizon (2021). In the event, its EBITDA margin rises to 12% by 2021, then it would result in a 15% increase in our valuation estimate.
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