The Brode Report  |  February 2011   Hi, this is David Brode. With the market offering bubble-like valuations again, the main article this month tackles Groupon's valuation - see my analysis below. Your comments back are welcome, especially if you think this is a buy. Also, if you haven't yet visited my new web site, feel free to stop by at www.brodegroup.com. Please share your feedback; I'm always happy to hear from you.

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Groupon: Not a Deal for Investors at $15B Don't want to read? Watch the video of me explaining this analysis. With all the hubub about eye-popping valuations (Facebook at $50B, Groupon rejecting $6B from Google and thinking IPO at $15B) I decided to devote spare brain cycles to evaluating the deal. It's interesting that all three companies listed so far are about connecting advertisers with consumers. Facebook is expensive, yes, but intuitively I can see why they are worth so much. It's one place in the world where everyone comes together. We know that they are hoovering data about us all and becoming very valuable to advertisers. There are no real substitutes to Facebook, due to network effects, and Facebook has a monopolistic position. I'm sure Zuckerberg will find a way to extract his rents. Groupon seems another matter altogether. First, consider the industry dynamics using Porter's Five Forces: Barriers to Entry: Low. Everyone can and has made a Groupon clone. All you need is a list and a deal to blast. Businesses know the drill, as do consumers. There will be a thousand variations on the theme. Some businesses will have success, but it will come through solid execution. Barriers to Exit: Low. No huge steel plants here. Just turn off the website and go home when you're done. Nobody will mourn the loss of another discount deal site. Customer Power: For these purposes, let's say the customer is the buying public who purchases the deals. I'd say Customer Power is Low. You either take it or leave it--a pretty simple proposition. Supplier Power: Low. (I consider the advertising business as the Supplier.) No one supplier is likely to mean much to Groupon. If their value proposition is that they monetize local advertising, then by definition all the suppliers are small time. However, if the strategy is to attract national advertisers, Supplier Power could be high, resulting in a less valuable position for Groupon. Substitutes: High. Here's the rub: both customers and suppliers have *many* substitutes for Groupon's product. Given low barriers to entry and exit, I predict they will face intense competition which will erode margins. Now consider the numbers. Good data on Groupon is still hard to find, but this is my best guess for 2010. Groupon 2010 Financial Results (Estimated)   % Revenue   $M     Revenue     1,000   Yes, they made about billion dollars last year. That's a lot of deals.   Net Income 50%   500   It's been well publicized that Groupon keeps 50% of the revenue and gives the other half to the merchant-advertiser. Even less than a year ago blogs were quoting 30%. Interesting how it took a while for the business model to be exposed.   Credit Card 3%   30   Everyone pays by credit card. These fees add up! Gross Profit     470     Opex 22%   220     EBITDA 25%   250   This is a tough one. The jury is out on overall profitability, but let's be generous and give Groupon 25% EBITDA. Taxes 40%   100   "That's one for you, nineteen for me … Yeah, I'm the taxman." Net Income     150     The bottom line for right now is that Groupon is making ~$150M Net Income. Now just to start, it's pretty easy to see that a $15B IPO valuation is rich at 100x. If you believe P/Es should be done on 2011 estimated earnings and Groupon will grow 100% this year then it's a 50x P/E which sounds more reasonable, so let's continue to look at what at 50x P/E really means.   Value   15,000   $M     Net Income   150   $M     P/E   100x       At times like these I fall back on my classic finance training from Marakon Associates. (Derivation of this equation appears here.) The terminal value equations we used twenty years ago can be useful. Well, the constant growth equations of ECF / (Ke-g) or the variants don't apply because Groupon isn't in steady state growth. (Note: ECF=Equity Cash Flow.) For now, let's assume NI=ECF, which is generous to Groupon. We did have another terminal value equation which offers insights: TEV = NI (1+g) * (1- (g/dROE)) / (Ke-g) where: TEV = Terminal Equity Value. g = growth rate (long term growth rate means net income, equity, etc. are all growing at same rate). dROE = delta ROE, the return on equity from all investments made in the future by the company. Ke = the cost of equity, the discount rate. What's cool about this formula is that it locks in Groupon's current revenue and NI of $1B and $150M, respectively. Then we can discuss the other factors. Incremental Method   NI 150   $M   As discussed above.     g 4.1%       A company can't grow much faster than this. If long term growth rate exceeds the economy's growth rate, Groupon would become the economy. While that's an interesting science fiction story waiting to be written, I don't see that happening!     dROE 30%       Earning a 30% ROE on every investment you ever make forever is pretty good, no?   Ke 5.0%       This says Groupon is about as risky as 30-Year US Treasury Bonds.     TEV 14,979   $M     So this is what it takes for Groupon to be worth $15B. I call that being priced to perfection. But wait, there's more! What about a classic DCF analysis? DCF Valuation Assumptions:     Ke 15.0% Planning period 20 years Growth as per chart below.       Discount Rate   growth   NI (ECF) ($M)   DCF   Rev 2011 1 1.15 100% 300 261 2,000 2012 2 1.32 70% 510 386 3,400 2013 3 1.52 60% 816 537 5,440 2014 4 1.75 50% 1,224 700 8,160 2015 5 2.01 40% 1,714 852 11,424 2016 6 2.31 30% 2,228 963 14,851 2017 7 2.66 20% 2,673 1,005 17,821 2018 8 3.06 15% 3,074 1,005 20,495 2019 9 3.52 10% 3,382 961 22,544 2020 10 4.05 8% 3,652 903 24,348 2021 11 4.65 4% 3,798 816 25,322 2022 12 5.35 4% 3,950 738 26,334 2023 13 6.15 4% 4,108 668 27,388 2024 14 7.08 4% 4,272 604 28,483 2025 15 8.14 4% 4,443 546 29,623 2026 16 9.36 4% 4,621 494 30,808 2027 17 10.76 4% 4,806 447 32,040 2028 18 12.38 4% 4,998 404 33,321 2029 19 14.23 4% 5,198 365 34,654 2030 20 16.37 4% 5,406 330 36,040   20 16.37 4% 49,146 3,003             15,987   This says that to justify a $15B valuation, Groupon needs to grow to $25B in revenue in ten years before leveling off to steady state growth. And they need to do all the growth without ever sacrificing margins. Remember the Porter Five Forces: with low barriers to entry and exit and easy substitutions, I see merchants keeping more of the revenue at the expense of Groupon's margins. Already 30-40% of businesses seem to say they would not do a Groupon deal again, and maybe they can only be brought back to the table with better pricing. So if you're thinking of buying the IPO, remember that the above justifies the IPO price only. If you want the stock to go up you have to believe still more aggressive assumptions. Call me a skeptic, but let's check in during 2016 and see what Groupon is valued at then. I think they should have taken Google's $6B. You may find a link to the Excel workbook with calculations here. Watch the video of me explaining this analysis. Go back

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