Should you Buy Shares of Groupon?

Congratulations to the founders and early investors in Groupon (Nasdaq: GRPN). What was just a humble new business idea a few short years ago is now valued at about $18 billion. That’s a higher valuation than RadioShack (NYSE: RSH), The Washington Post Co. (NYSE: WPO), U.S. Steel (NYSE: X), Whirlpool (NYSE: WHR) and Cablevision (NYSE: CVC) — combined!

While those companies sport a collective $50 billion in 2010 revenue, Groupon’s sales base won’t likely exceed $1.5 billion this year. Said another way, those companies are poised to earn a collective $2 billion this year. Groupon isn’t even big enough to generate any profits yet.

#-ad_banner-#What are investors thinking? Well, that’s a question that gets asked every time we see a popular dot-com-based IPO (initial public offering).

Blame it on Google (Nasdaq: GOOG). The company’s IPO may have seemed somewhat pricey when the company went public back in 2004, but has since generated a hefty 500% gain for investors. Since then, investors have been glomming onto other dot-com IPOs, in hopes of catching “the next Google.”

Make no mistake, Groupon isn’t poised to become the next Google. Google is a technology company. Groupon is a sales and marketing company. Technology companies build moats around their business. Sales-oriented companies hope to “make it up on volume” as increasing market sizes yield more price pressures. Just ask any company that has tried to compete with (Nasdaq: AMZN). In fact, there are a slew of other dot-coms looking to go public in 2012 that arguably have much more defensible business models than Groupon. And it’s only a matter of time — perhaps the next quarter or the quarter after that — that cracks start to emerge.

For those who have missed the entire Groupon story, a quick recap is in order. The company struck on a brilliant idea: Consumers like bargains and companies like customers, so why not bring them together? Hefty discounts have clearly lured customers to try new restaurants and other retailers, and those companies were grateful for the increased exposure at a time when consumers were pinching pennies.

Trouble is, many restaurants and retailers see Groupon’s proposition as a marketing effort squarely aimed at getting new customers to give them a try. Losing money on heavily-discounted offers can only be tolerated for so long, and surveys have shown that most firms that entice customers with Groupon offers have no intention of sticking with them once a client base has built up. The fact that Groupon instantly spawned a host of copycat competitors is really a testament for entrepreneurs to try any business model that gets buzz in these spending-constrained times. Indeed, a shake-out has already begun, as many of these “me-too” business models have ceased operations.

How long before Groupon morphs from fast-growing upstart into a mature, growth-challenged business model? Well, it may already be happening. According to company documents, revenue generated by the company’s Daily Deals service DROPPED 3% from the second quarter to the third quarter. Equally damning, the size of those deals is dropping, leading to a 22% sequential drop on a per deal basis.

To address the prospect of a faster-than-expected peak in the core Daily Deal segment, Groupon is expanding into new categories such as travel, hard goods and live events. Early results are impressive, generating more than $30 million in gross billings in the third quarter — up from nothing in the second quarter. Yet it’s fair to wonder how large these components can really grow, as companies such as (Nasdaq: PCLN), and others are have long-established links to bargain-seeking customers and will fight to defend their turf.

Frankly, nobody can say with certainty whether Groupon is nearing maturity or has a significant amount of growth left in the business model. Yet we can say with certainty that the company’s $17 billion market value bakes in some extremely lofty expectations. Let’s do the math…

In the third quarter, Groupon had sales of $430 million, but remained unprofitable. This is a high-cost business model, as an army of staffers needs to work with restaurants and other retailers to set up deals. (Most of the company’s 10,000-strong workforce are in sales.)

Let’s assume the company ends 2011 with an annualized revenue run rate of $2.5 billion ($600 million per quarter). The company is likely to hit break-even with quarterly sales at $600 million. (It’s worth noting that Groupon allegedly had 12% operating margins in the third quarter of 2011, but that is an accounting fiction. A number of operating expenses appear to have been capitalized as a “long-term investment” when they are really simply the cost of doing business.)

Assume 5% operating margins on any incremental sales gains above the $600 million mark, so for example, a $1 billion revenue quarter would generate $20 million in operating income ($1 billion – $600 million = $400 mil.; $400 mil. x .05 = $20 mil.). So if Groupon is generating $4 billion in annual revenue by 2013, then operating income is unlikely to top $100 million ($4 bil. – $2.4 bil. = $1.6 bil.; $1.6 bil. x .05 = $800 mil.). Again, we’re talking about a business worth $18 billion, or 180 times 2013 profits. A potential $5 billion in annual sales by 2014 would only yield $130 million in profits. You get the idea. Groupon’s potential profit levels and its current market value have no relation to each other.

It’s fair to quibble with those assumptions. Maybe they’re far too conservative. I’ve read some reports that predict Groupon will have 15% operating margins by 2013. This seems to be an impossible goal, by my math. Even if Groupon manages to generate $300 million or $400 million in operating income a few years out, this business model remains vastly overvalued. It will be interesting to update this math as subsequent quarters roll in. The odds that this company will ever live up to its lofty valuation seem remote.

Risks to Consider: In the near term, when the quiet period has ended, analysts will start to roll out research reports for Groupon. Some analysts will come up with ludicrous growth and profit-margin projections, touting a stock price target well above current levels. This could boost the stock temporarily, creating headaches for short-sellers.

Action to Take –> Shares are being propelled by the scarcity factor. Just 5% of the share count has been released to the public, and insiders can be expected to pour a lot more stock onto the market next spring when the lock-up expiration expires. And when these insiders begin to cash out, a shortage of shares may turn into a surplus of shares. You do not want to own this stock going into that event.