Much has been made of the recent Groupon S-1 filing. Many recent thought leaders, worried by the accounting losses and concerned by the scant detail available, warn investors to stay away. Some of the more thoughtful pieces from folks like Jeff Bussgang (Flybridge Capital) that analyze various subscriber/merchant ratios or the UK Guardian claims that the valuation is just not rational are worth a read. I’ve seen fewer votes of confidence – but many believe the awe-inspiring growth and market leading position Groupon has taken are reasons to build a position in Groupon, regardless of IPO and aftermarket pricing. For example, Reed Hoffman and James Slavet make a compelling case for why Greylock invested in the company and a recent blog post from Steve Cheney makes the case for why Groupon is worth $25 billion.
So who is right?
The best way I know to answer this question is to dust off the history books. After all, Spanish philosopher George Santayana preached: “those who cannot remember the past are condemned to repeat it.” That is highly apropos in the financial markets, where history often repeats itself.
Groupon is an online consumer service. Groupon spends money to acquire users. Then it markets to those users and makes money when they buy groupons. Simple. Groupon is unique as a consumer service, however, in that it is (1) growing REALLY fast, and (2) it is posting huge accounting losses. Two other online consumer services who were also growing really fast and losing money at their IPOs within the past 10 years are Netflix and Vonage.
Netflix, the popular video delivery service, IPO’d in 2002. At that time, the company was growing its top line by approximately 100% and was losing money. The stock debuted at approximately $7.50 on a split adjusted basis, representing a $300M market valuation. Today, Netflix shares trade hands at over $270, representing a $14Bn market valuation.
Vonage, the VOIP residential phone service, IPO’d in 2006. Similar to Netflix and Groupon, at the time of the IPO, the company was growing its top line by over 100% and was showing large accounting losses. The stock debuted at $17, representing approximately a $3Bn market valuation. Today, Vonage shares trade hands between $4 – $5, representing a $1Bn market valuation.
Why has Netflix been a rocket ship while Vonage has been a falling knife? In my opinion it pretty simply comes down to the fact that Netflix has shown it can continue to acquire lots of new customers at an attractive price relative to the lifetime value of those customers. Conversely, Vonage had trouble showing it could acquire enough customers to continue to grow rapidly relative to the lifetime value of those customers.
So will Groupon take after Netflix or Vonage?
The Case for a Netflix-type Rocketship:
Very Strong Initial Returns on Marketing Spend. Groupon reveals in its S-1 that the cohort of subscribers it acquired in Q2 ’10 for $18M has already produced $62M of gross profit through Q1 ’11. This is fantastic ROI. It looks as if Groupon’s cost to acquire an active user is trickling up, but as long as these users continue to transact at similar rates to past cohorts, Groupon is planting seeds for years of strong financial returns.
Positive Free Cash Flow. Groupon is showing huge accounting losses, but even as it is spending huge on marketing campaigns, the company is actually generating Free cash flow (cash from operations less capital expenditures). Groupon collects cash up front when people purchase groupons, but remits to merchants much later. Hence, the company is actually putting cash on the balance sheet. This is a big deal – it should help finance growth for the future. Interestingly, Netflix also was generating cash from operating at its IPO (it had big non-cash expenses, amortizing its DVD library). Vonage, on the other hand, was burning cash hand over fist.
Great Brand & Large Market. Groupon has quickly become a household brand and the number and breadth of merchants eager to use groupon campaigns is awesome.
The Case for a Vonage-style Flameout:
Decaying Lifetime Value of a Subscriber. The little cohort and local market data Groupon offers in its S-1 might lead one to conclude that subscriber value is decaying over time. If this is true, Groupon’s future prosperity is at risk. Any investor will need to watch these metrics closely.
Competition Drives Subscriber Cost Up & Gross Margins Down. There are several other well capitalized players aiming at Groupon. From Living Social to Facebook and Google, the competition to acquire subscribers could drive costs up, similar to what happened to Vonage with the cable company, national and local phone providers. Also, merchants may be able to drive better economics, driving down Groupon’s gross margins. This would cause the cost of future subscriber cohorts to rise while their lifetime value declines. Groupon may have to opt to grow much more slowly in that case to reach profitability, as Vonage has done.
And the winner is…
I think the smart money is with Groupon following in the footsteps of Netflix. Yes, there will be intense competition and the economics of their business may deteriorate slightly over time. But, as a category leader in a large market with rapid growth, great subscriber economics and positive free cash flow, the comparison to Netflix seems the right one. Either way, though, this one will be fun to watch as its handed off from Sand Hill Road (Chicago style) to Wall Street!