With Groupon’s IPO pricing at $20, it values the company at nearly $13 billion. The ultimate buyers for these shares, however, are likely to be Groupon customers, who feel that Groupon represents an amazing source of “free money.” However, few realize exactly how Groupon works. Here are some details.

The Groupon Transaction

The Groupon transaction starts with a Groupon salesperson selling a merchant on a coupon deal. For the examples below, we will use a restaurant example.

The Groupon merchant agrees to issue a group of coupons through the salesperson. For example, a restaurant might agree to issue 200 Groupon coupons.

These coupons have a face value of $40, redeemable at the restaurant. The coupon customer, who purchases the coupon from Groupon, pays just $20 for the coupon.

To the coupon customer, the Groupon coupon appears to be “free money,” where $20 instantly turns into $40 worth of meal purchases.

Of the $20 paid for the coupon, a standard deal with Groupon is a 50/50 split between the restaurant merchant and Groupon.

However, a key difference in how the cash flow operates in this scenario points to one of the weak underbellies of Groupon: cash flow.

Groupon’s Cash Flow Problems

All of the terms between a Groupon merchant and Groupon are negotiable.

Many restaurant owners are able to negotiate an immediate, upfront payment of the entire merchant share of the future coupon sales upon signing of the Groupon deal.

For example, in the example above, with 200 Groupon coupons issued with a face value of $40, the total redeemable meal value is $8,000.  The total revenue generated will be $4,000, as the coupons are sold at $20.

If the merchant negotiates an immediate payment, or even full payment within 30 days (which is common), the restaurant owner will receive his $2,000 (50% split) prior to a customer redeeming the coupons.

Groupon, however, has to wait for all of the coupons to be sold in order to make their $2,000 from this deal.

What this means is that a Groupon deal between a merchant and Groupon amounts to Groupon paying out cash prior to receiving revenue and the merchant receiving cash prior to redeeming the coupons.

A restaurant merchant, therefore, can rightly view this coupon deal as a very positive cash flow event: revenue is immediately accepted, in exchange for a future liability.

For Groupon, however, the event is a negative cash flow event: Groupon must pay out the full value of the merchant's share, prior to receiving the full value of the coupon from the purchaser.

In our anecdotal experience in conversations with restaurant owners, we found that this cash flow event was a prime element in the decision to use Groupon. In effect, a Groupon deal represents a short-term loan with zero percent interest, but with an associated liability for four times the cash received.

However, an intelligent restaurant owner can negotiate terms for the coupon that reduces that four-times liability.

For example, Groupon coupons typically cannot be combined with other coupons to make a completely cash-free purchase. In addition, terms such as minimum total amounts (against which the coupon can be applied) or a minimum number of patrons that can use the coupon can help the merchant preserve a profit margin.

A $40 coupon might have terms such as: minimum total check of $80, or only one coupon per table, helps to preserve some actual revenue received from a coupon customer.

Continuing the example, the customer might use a $40 coupon against an $120 total bill for four people. With food costs at an industry average of 35%, this means that an $120 meal has a food item cost of $42.

This means that the revenue-minus-food cost for a non-coupon customer represents $78 of profit, while a coupon customer generates just $38 of profit. (Note that this is not a gross margin analysis, as gross margin in a restaurant also includes labor costs, which we have not included in this analysis.) 

With gross margins in the restaurant industry varying between 40% and 25%, this means that a $120 tab would normally generate about $48 to $30 of gross profit. If issuing a Groupon adds tables to a restaurant that would otherwise be empty, this means that profit of $38 (from food costs only, since an empty table would not have labor costs) is right about in the middle of what the total gross profit would have been.

In other words, a Groupon customer still generates the same amount of profit as a non-Groupon customer (again, assuming it fills empty tables).

Furthermore, in our anecdotal evidence, it appears that between 10% and 15% of the Groupon coupons issued in a merchant deal are never redeemed. Whether these unredeemed coupons were not purchased or simply purchased and not redeemed is unknown to most merchants. Nevertheless, it helps improve the financials of issuing Groupon coupons.

Therefore, a restaurant merchant using a “controlled” number of Groupon customers actually does not suffer greatly in terms of expenses, provided they are not sacrificing a full-paying table for a Groupon table.

For a merchant owner, therefore, Groupon represents a combination of a reasonable marketing expense, combined with a cash flow positive event.

With the restaurant industry being primarily a cash-flow industry, this makes Groupon attractive.

However, one problem we hear anecdotally is that Groupon customers are often non-repeat customers. Restaurants, as many businesses, are built upon repeat customers. If Groupon customers do not become repeat customers, or turn out to be the type of customer that the restaurant does not want to attract, then Groupon is an unappealing marketing avenue.

The one danger that merchants have is issuing too many coupons that will dilute their total revenue so much that it begins to have an effect on the net profit line.  Merchants need to issue only enough coupons at any time that can be absorbed by their current revenue stream.

Groupon’s Expenses

In complete contrast to the merchant owner, however, Groupon incurs all of the expenses associated with it’s per-unit sales upon the close of the deal. 

Although Groupon’s S-1 states that they pay all merchants on a 90-day schedule, all of the individual merchants we talked to were able to negotiate terms of full payment of their share of coupon revenue either immediately or within 30 days.

This means that Groupon must pay the merchant well before all of the coupon’s are sold. In addition, we suspect that the salesperson’s commissions on sales are paid well before the 90-day time frame mentioned in the S-1.

What this means is that the larger Groupon’s revenues become, the more critical their cash flow problems become.

Any slowdown in coupon sales requires Groupon to dip into their working capital reserves.

For a company with extremely high sales, this means that Groupon has incredibly high cash flow needs.

They must have ready cash available to pay merchants for the coupon issuance long before all of the coupons are sold.

This is the core problem that we first outlined from Groupon’s original S-1 in the "Ahead of the Curve" column of June 10, 2011.

This is still a critical problem for Groupon. In the current S-1 filed for today's IPO, the most telling line of all is the balance sheet data for working capital.

After a level of $4.0 million in 2009, working capital fell to a deficit of -$196 million in 2010 and now stands at a deficit of -$301 million as of Sep. 30, 2011.

With the upwardly revised number of shares and price, Groupon will receive approximately $700 million in proceeds from its IPO, prior to offering expenses.

This will bring Groupon's working capital levels to a surplus of approximately $400 million (ignoring incremental sales of coupons since September 30). 

However, the history of Groupon in the last years has been one of working capital deficits increasing as the company gets larger.

This is in complete contrast to the pattern of most businesses, where working capital increases as revenues increase.

In the first nine months of 2011, working capital deficit increased by more than $11 million per month. 

If this rate continues, it means that Groupon exhausts its current working capital deficit in just 36 months.

In such a scenario, additional financing would be required, most likely on terms unfavorable to common stock holders (unless the speculative environment pricing the shares today continues.)

This detail is being completely overlooked by all of the persons purchasing Groupon stock today.

Conclusions

Groupon holds appeal to merchants who are able to use the coupon wisely, as both a marketing expense and a cash flow positive event. It seems reasonable that many merchants might issue Groupon coupons during slow months to improve their business.

However, the overall Groupon business model begs for deeper analysis. We suspect that many end-purchasers of Groupon stock are those very same purchasers of Groupon coupons, who have come to view Groupon as a source of “free money.”

That type of enthusiasm from a customer base, who do not take the time to analyze the business model of the company they invest in, is the root cause of all investor speculation. That leads to overpricing of stocks.

Groupon investors purchasing the stock today should be asking the following questions:

• How large does Groupon have to be before working capital increases, rather than decreases with growth?
• What happens to the Groupon model if revenues decrease, instead of increase?

There are several serious threats to Groupon’s growth curve on the horizon.

Competitors to Groupon are racing towards providing competitive systems for merchants. Merchants are learning to negotiate better deals with Groupon that make it harder for Groupon to improve their working capital problems.

Lastly, there is some concern that Groupon coupons are simply a current “fad” and that the customer base and the merchant base will eventually evolve towards a defined segment where fickle customers choose their merchants simply based upon the current coupons available.  That type of customer is not a great customer for those businesses in the long run.

We are very skeptical of Groupon’s long-term business prospects.  We think that buying Groupon stock with a long-term holding premise is extremely risky at this point.

This doesn’t mean that the stock might not rise, perhaps even dramatically, in the coming weeks or months. 

But unless the business model improves such that working capital begins to grow instead of shrink with revenue growth, we would avoid the stock on anything other than short-term trading premises.

Unless, of course, we could find a Groupon coupon that allowed us to buy 100 shares of stock for the price of 50 shares.

Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com.