Don’t Buy Groupon Inc (GRPN) Ahead of Earnings

Clearly, some investors are betting that Groupon Inc (NASDAQ:GRPN) stock will rise after its earnings report on Wednesday. GRPN stock is up about 9% since hitting a six-month low late last month. Groupon stock still looks cheap, and the acquisition of LivingSocial after the third quarter could be seen as a potential driver for the fourth quarter report.

GRPN Stock: Don't Buy Groupon Inc (GRPN) Stock Ahead of Earnings

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That interpretation seems optimistic. GRPN stock might look cheap — but by most standard measures, it isn’t. LivingSocial has struggled even worse than GRPN has in the “daily deals” business, and Groupon itself simply can’t quite get its house in order: shares fell 22% after the Q3 report and kept falling.

At this point, I’m not sure what’s really left to drive Groupon stock higher.

The Turnaround Strategy Isn’t Helping GRPN Stock

Groupon is making some changes to its business. For one, it’s “streamlining” its business. SG&A spending fell over 10% in Q3 year-over-year, excluding a litigation reserve the year before. The company has shrunk its global footprint: Groupon operated in 47 countries at the beginning of 2015, a figure that will drop to 15 going forward.

And it has lightened its headcount, which declined 20% year-over-year in the third quarter.

Groupon isn’t just playing defense, either. The company has ramped up its marketing spend, which rose from $62 million in Q3 2015 to $88 million the following year. GRPN management said on the Q3 conference call that the company also was increasing discounting, which it treats as another form of marketing.

Meanwhile, the company is trying to step away from low-margin product revenue, which CEO Rich Williams has called “empty calories”.

The moves haven’t done much for GRPN stock, however. Groupon stock has increased from levels below $3 in late 2015/late 2016 — but most of the market has gained over the same period. Other than a bout of optimism after Q3, the market simply isn’t that interested in GRPN. There are long-term concerns that remain — and should cast their shadow over the Q4 report.

The Long-Term Pressures on Groupon Stock

There’s a legitimate question as to whether Groupon’s business model can actually work. Many investors have argued that it isn’t a marketing company for local businesses. Rather, it’s a predatory lender, offering upfront cash from Groupon sales in return for deals that offer little to no profit over the following months.

That means GRPN’s business customers tend to be struggling — and it means that over the long term, it actually erodes pricing power in businesses like salons and restaurants. Why pay full price for any service if a Groupon is available for 50% or even 30% off?

That problem creates a potential “vicious cycle.” Groupon sales make profitability more difficult for local businesses. They then turn to the site for a cash infusion, and pricing drops even further.

That issue aside, the broader issue for GRPN stock is that the company isn’t really that profitable. 2016 Adjusted EBITDA is guided to $150 million-$165 million. Even excluding the company’s cash balance, that implies an enterprise value to EBITDA ratio over 9x. That multiple is higher than for most retailers.

And yet profits are declining sharply: Adjusted EBITDA in 2015 was $257 million. Free cash flow was $169 million; it’s just $14 million over the past four quarters. If that doesn’t change, and quickly, it’s hard to see Groupon stock rebounding.

GRPN After Q4 And Beyond

The core problem for Groupon stock is that there’s not a lot of good news at the moment. While the stock seems ‘cheap’ below $4 per share, GRPN still has a market capitalization over $2 billion. That figure is almost 150x its trailing twelve-month cash flow. Yet profits are declining, and the balance sheet is colored by worries about potential refund liabilities.

So Groupon has to make significant changes — but it’s not clear exactly what is left to do. It has cut spending and headcount, but used those funds to increase marketing spending. Higher discounting has lowered the company’s “take rate” (basically the cut it takes off each deal), which is pressuring gross margins.

GRPN is driving better revenue, particularly in North America, but top-line growth isn’t all that impressive. Billings in North America were up 6% in Q3, for instance. And Groupon is paying heavily in terms of margins for those modestly higher sales.

What seems likely to color the Q4 report is the question of, “What’s left?” Groupon needs to show investors it can drive consistent profits that support even the current price. But the company may be stuck between a rock and a hard place. If it continues to spend more on marketing and discounting, already-narrow margins will take a hit. If it tries to improve margins, revenue likely declines, and margins and sales may decline.

Even if Groupon’s plan does succeed to some extent longer-term, it seems too early to see those improvements impacting the Q4 report that much. The company isn’t pulling back on its spending, and profits still are guided to decline for the quarter. Until that decline stops, GRPN stock seems likely to struggle. And it’s not certain that decline will ever stop.

As of this writing, Vince Martin has no positions in any securities mentioned in this article.

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