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No Need To Rush Into Groupon's IPO

Friday, 21 Oct 2011 | 11:05 AM ET
Groupon Live
Source: groupon.com
Groupon Live

Groupon may be one of the most harshly criticized initial public offerings in years.

It seems almost every market pundit has offered damning words on the company's valuation, business model, and its prospects.

The last time I saw a company so hated by pundits — and craved by short-sellers — it was a phone service called Vonage.

Vonage debuted at $17 a share. It immediately sank, and kept sinking.

At one point, the company had to consider suing its own customers because many of them had pledged to buy shares but balked when the price dropped below the IPO price. Once Vonage shares fell below $10, they never again traded in the double digits, and rarely even above the $5 mark. It's been a disaster for anyone who bought at the IPO.

Vonage had some very unique problems. The first was that it was, basically, a landline company IPOing in an area when mobile communications were taking over. There was a high degree of customer dissatisfaction. The company had trouble with regulators.

But some of Vonage's problems were very reminiscent of what people are saying about Groupon. Vonage had incredibly high marketing costs. On top of that, it had very high costs of just getting the phone line turned on to its service.

Basically, Vonage lost money on every customer, initially. In order to make money, Vonage had to keep its customers on board for years. It quickly became apparent that Vonage's churn rate — the rate of customers signing up then leaving the service — was too high. But to lower the churn rate, Vonage offered deep discounts to existing customers, which just lengthened the amount of time it took for Vonage to make a profit off of its customers.

Groupon also has very high marketing costs. In the latest version of its IPO prospectus, Groupon says it spent $613 million on marketing in the first nine months of this year. It added around 92 million subscribers during that period, which means new subscribers are costing it around $6.66 a piece. Groupon says that only $466.5 million of its marketing budget was devoted to new subscriber acquisition. Using this figure, the cost of acquiring a new subscriber is $5.07.

Average revenue per subscriber for the first nine months of the year was $11.60. So Groupon, unlike Vonage, isn't losing money just by signing up its customers. But the monthly average revenue number is shrinking rapidly, falling by 15 percent in September. This is one metric that should have investors worried.

Another point that is somewhat disturbing are the reports Groupon dramatically cut back on marketing expenses in this last quarter. It's easy to see why they would do this leading into the IPO. Their enormous marketing budget was one of the main digs against the company. They wanted to show that they could cut back on marketing and still grow. They've done that.

But I dislike these kind of moves. A temporary cutback on spending can make numbers look artificially good for a quarter because you can stop spending now and not feeling the slowdown until subsequent quarters. This is especially true for marketing when a lot of your spending from previous quarters can keep producing customers in subsequent quarters. This looks at least a little bit gimmicky.

My bottom line is Groupon is not necessarily the next Vonage. It may even be the next Amazon, another company that many Tech bears loved to hate for years.

But if Groupon is the next Amazon , it's probably best to avoid the IPO. Amazon did well initially but then fell as the air hissed out of the dot com bubble. For years, its management sacrificed profits for growth, which seems to be the likely path for Groupon. The idea being that Amazon had to scale up before it could start really making money.

Eventually this worked for Amazon, and it could work for Groupon, too.

Many early holders of Amazon, however, had to wait years and years before they made any money on their shares (assuming they didn't sell before the bubble deflated). Eventually, their loyalty was rewarded.

But you didn't have to get in on the IPO to make money on Amazon, and you didn't have to wait years and years. An investor who just decided to hang back and wait out the "scale up" phase would have done very well buying Amazon a decade after its IPO.

There's no need to rush in to Groupon. Better let someone else fund their long-period of low-profits and spending for scale.

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