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Back-of-the-Envelope: Are Groupon’s Q2 earnings as bad as they seem?

August 14, 2012
Investing, Investments
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Back-of-the-Envelope: Are Groupon’s Q2 earnings as bad as they seem?

Groupon (GRPN) released disappointing Q2 earnings earlier today and the stock immediately traded down nearly 20%.  Revenues grew 45% year over year, but only 2% versus last quarter, indicating that the growth needed to justify the company’s current valuation may never materialize.

While the earnings report was negative, some bullish investors may see a silver lining.  Supporters of Groupon believe that as a business with high fixed and low marginal costs that the company is poised for an earnings explosion now that costs are finally being covered.  They feel that years of negative earnings due to spending on geographic expansion, advertising, and technology will all pay off now that earnings are positive since each incremental dollar of revenue will go straight to the bottom line.  Doubters say that Groupon’s business model is based on sales and that costs in sales organizations unavoidably increase with revenue, limiting the company’s upside operating leverage.  The question boils down to whether operating expenses are significant or minimal for each incremental dollar of revenue.

Today’s results settle this argument in favor of the bulls.  For every extra dollar of revenue, Groupon’s operating income increases by 81 to 88 cents.  Each incremental dollar of revenues costs the company less than 20 cents in operating expenses.  This relationship is robust over both recent data (past 3 quarters) and the company’s entire history as a public company.  If this relationship continues to hold, a 10% increase in this quarter’s revenues would translate to a doubling of net income.

Groupon has shown that it has the organization in place to efficiently monetize growth, but first it will have to grow.  This is where the bears may have a stronger case.  Groupon’s year over year revenue growth was 45%, but quarter over quarter growth slowed to only 1.6%.  Continued growth at less than 2% per quarter would not justify the current share price.

So what is Groupon worth?  Using the relationship between revenue and operating income described above, we did a quick back-of-the-envelope estimate based on three scenarios suggested by the company’s recent revenue growth, plus the rate of growth implied by the current stock price, assuming a 10% required rate of return over the next two years.

So can Groupon deliver the strong annual growth needed to justify investing at the current price?  That is the billion-dollar question.  Continued expansion into international markets provides at least the potential for growth, but the recent reduction in marketing spending from $117 million in Q1 to $88 million in Q2 seems to suggest the company’s high growth days may be coming to a close.

Then again, none of this may matter if CEO Andrew Mason has his way.  He would like to shift the company’s focus from being an “advertising solution” to being an “ecosystem that local merchants use to run their business.”  If this becomes the company’s major focus, valuation will start to depend on their ability to compete in the mobile payments space.  As a late movers, Mason is likely hoping that the company’s existing relationships amount to an installed network of small businesses and not simply a pool of disgruntled former customers.