Groupon Inc (GRPN): Investors Better Hope This Bet Pays Off

As soon as you hear the name Groupon Inc (NASDAQ:GRPN) if you are like many people, you think of e-mails with deals for tanning salons, manicures, and vacation deals. However, Groupon is making a massive bet that customers want to buy all sorts of items from the company. Groupon Goods is the company’s answer for how they plan to grow in the future. To say that Groupon Goods is important to the company is an understatement. If this business reaches scale, Groupon can challenge major retailers across the board, if not, this business could pull Groupon down with it.

A tale of two Groupons
Today, buying Groupon stock is almost like buying two different companies. The original Groupon story is the company which offers daily deals, and deals based on mobile location to members. These deals are priced so that no one else can match them, and Groupon carries no inventory and has huge margins.

It has been argued numerous times that this business has no moat. I’ve heard it said that almost anyone can put together a mailing list of deals. However, as easy as this sounds, that is not the case.Groupon Inc (NASDAQ:GRPN) is increasingly focused on the local market. This means the company is trying to get smaller companies to offer deals through the site. The advantage of going after local businesses is that the company doesn’t have to fend off larger competitors, who can’t spend the time to do this sort of grunt work.

While the model is doing well in North America, they are doing terrible overseas. In the current quarter, domestic Groupon sales were up 42% and units increased 37%. Internationally, revenue declined 18%, on an 18% decline in units. That being said, Groupon’s traditional “third-party” business carries an 84% gross margin, and is a cash cow that the company must maintain.

Do they have the goods, or are they being set up?
In a prior article about the company, I noticed that Groupon Goods represented 35% of total revenue, but it carried a gross margin of just 2.93%. In the current quarter, this changed to 27% of revenue, but gross margin improved to 6.11%.

When you consider that companies like Amazon.com, Inc. (NASDAQ:AMZN), Best Buy Co., Inc. (NYSE:BBY), and Wal-Mart Stores, Inc. (NYSE:WMT) carry gross margins of 26.15%, 24.05%, and 24.85%, respectively, you can see just how far Groupon Goods has to go. What is at stake is honestly the future of the company.

While traditional Groupon offers might be something that anyone can replicate, an exclusively priced deal for goods is a different ballgame. Amazon has caused the retail industry to offer to match prices. Wal-Mart and Best Buy are willing to compete on price, but both companies saw negative same-store sales in the previous quarter. While Amazon grew its general merchandise sales by 30% to a total of 64% of revenue, Wal-Mart saw comps down 1.4%, and Best Buy saw comps decline 1.1%.

The advantage that Groupon Goods offers is, the company has just under 42 million active customers, and every day, they have the opportunity to contact these customers about Groupon Goods. In addition, Groupon is uniquely positioned for mobile performance, because these offers come from local retailers, and are constantly changing. The fact that 45% of North American transactions were done on mobile speaks to the strength of this model.

Though Groupon’s gross margin on Goods is tiny, their margin on third-party deals is huge. The end result is, the company’s operating margin actually beats Amazon and Best Buy. Groupon Inc (NASDAQ:GRPN)’s overall operating margin was 3.53%, versus 1.13% at Amazon, and 0.11% at Best Buy. Wal-Mart is more established, and isn’t growing nearly as fast, which accounts for their operating margin of 6.72%.

The ups and the downs of being Groupon
The good news for Groupon is that its Goods business is exploding. Even after a more than 1,500% gain in revenue previous quarter, Goods revenue jumped almost 744% in the last quarter. However, weakness in international third-party deals caused the company’s overall dollar growth to come in at 4%.

Two of the bigger challenges for Groupon Inc (NASDAQ:GRPN) are also huge opportunities. The company needs to grow its gross margin in the Goods business, and slow down spending in SG&A. Gross margin in the Goods business has already improved from under 3% to over 6%, but there is a lot of work left to be done.

When it comes to SG&A spending, this item represented 51.25% of total revenue last quarter. Relative to Amazon at 25.44%, Best Buy at 23.6%, or Wal-Mart at 18.13%, this is far too high. However, in my last article, I calculated if Groupon could bring its SG&A spending down to say 20% of sales, their earnings would jump from a loss of about $0.10 to a profit of $1.59 over the last year.

In the meantime, the company is sitting on $1.17 billion in net cash and investments, and with a market cap of about $5 billion, that means about 20% of the share’s value is just the cash on the balance sheet. Both of the company’s businesses offer exclusive pricing, so the company doesn’t have to worry about being undercut. With analysts calling for 24.68% EPS growth, but the shares trading for over 43 times 2013 estimates, the stock isn’t for the timid. However, if Groupon Inc (NASDAQ:GRPN)’s bet on Goods pays off, this could be the start of something…good.