What Groupon's CEO Didn't Tell His Employees in That Memo

What is it about pre-IPO Groupon? First, chairman Eric Lefkovsky made a remark about becoming wildly profitable, which the company had to retract in an amended S-1. Now CEO Andrew Mason sends a memo to employees about how he has "never been more confident and excited about the future of our business" and that all the naysayers know nothing.

This company is in a quiet period. Has anyone in the legal department told upper management to shut the hell up? Maybe the grand poobahs just ignore what the lawyers and investor relations professionals say and assume when they tell employees a memo is confidential, it will remain that way. (Andy, I've got a Groupon for a bridge, real cheap.)

In any case, for all that Mason said to the troops, there is plenty he didn't say that brings into question this glorious future he sees. Let's look at a few of his points.

Growth in the core business
First, Mason argues that the business is growing at a rapid rate -- revenue "appears" to be headed for 12 percent from July to August -- while marketing expenses dropped by 20 percent. Sounds good, right? But put it into context.

According to the numbers in the latest amended version of the S-1, net revenue (what Groupon calls "gross profit") for the first six months of 2011 was $611 million. For the same period in 2010, it was $54 million. That's huge -- 1030 percent growth, year over year.

But how about month over month? It turns out that the quarter by quarter numbers are available on page 57 of the same document. First quarter of 2011 had net revenue of $270 million. Second quarter net revenue was $341 million. That's a jump of 27 percent. So, yes, 12 percent month to month looks pretty good -- depending on a whole lot:

• What was the growth from June to July?
• What will the actual growth be between months?
• Is this regular growth? The results of an unusual promotion? The result of acquisitions that the company has been doing? The result of a changed accounting treatment or delayed revenue recognition?

We're cutting our marketing costs so much, it's insane
So supposedly Groupon has lowered marketing costs, too. Great! But Mason claims that marketing costs have been 20 percent of revenue. That's only close to true if he uses gross revenue, which includes the sums Groupon still owes to the merchants who provide the deals.

And even then it's false. For the first six months of 2011, marketing expenses were 25 percent of gross revenue. Make the more fitting comparison to net revenue, and you get 62 percent. Drop that by the 20 percent Mason claims (and he seems to be loose with other numbers, so there's no real reason to think these are accurate), and it's still nearly 50 percent of net revenue.

Next, Mason argues that people are unreasonable to dislike the adjusted CSOI (ACSOI) figure that looks at expenses without the costs of customer acquisition. Yes, Groupon is adding people to its mailing list, but it's also converting a smaller fraction into paying customers.

How to grow by standing still -- or not
To keep growing -- which is what companies that flash their Internet credentials do to please Wall Street -- they need to keep the signups flowing in, even if Mason wants to pretend that he'll eventually get to stop advertising. There's never been a business that could stop customer acquisition. If for no other reason, people move, email addresses are eventually abandoned, and the pool you had gets stagnant.

Mason, of course, is right that eventually Groupon could run out of new people to approach. On that day, though, it's toast -- average revenue per subscriber will drop just thanks to churn in its existing customer base (not to mention competition, which will drive down the share of deals Groupon can get out of its merchants), and so will the percentage of subscribers that are active as customers. Much of the company's growth will disappear.
Maybe Groupon will be profitable by that point, but there's no guarantee it would stay that way for very long. Unless, that is, cutting the marketing dollars also means cutting many of the very employees that have been reading Mason's memo.

New business lines are booming
Mason notes that new categories -- travel and product -- are "enormous opportunities." He gives some examples, like selling $2 million worth of mattresses in the U.K. in a single day. But as you get into products that are purchased from distributors, merchants have less discount to give. I suspect that this will drive down Groupon gross margins, which then adversely affects marketing and overhead costs as percentages of revenue.

By the way, although he (incorrectly) focused on marketing as a percentage of revenue, Mason ignored selling, general and administrative expenses. These are overhead and, in the first six months of 2011, represented 74 percent of net revenue. Marketing is not the only cost that has run away. Having an SG&A of 74 percent is simply mind-boggling. Maybe this, too, will come down when Groupon no longer needs to spend to grow (if that really ever happens). But it should be a much bigger red flag.

We are pulling away from competitors
Mason suggests that Groupon has become uncatchable:

Well, now the sleeping giants have woken up -- and the numbers are showing that what was proven true with literally thousands of other competitors is just as true with the incumbents of the Internet: it's kind of hard to build a Groupon. And since anyone with an Internet connection can track the performance of our competitors, I can be more specific:

Google Offers is small and not growing. In the three markets where we compete, we are 450% of their size.

Yelp is small and not growing. In the 15 markets where we compete, our daily deals are 500% of their size.

Living Social's U.S. local business is about 1/3rd our size in revenue (and smaller in GP) and has shrunk relative to us in the last several months.

Mason also doesn't mention some other companies, like Amazon (AMZN), which just opened daily deals in Manhattan. Maybe Mason thinks that such companies are no potential competition because they don't have Groupon's infrastructure -- which really means the sales infrastructure.

But they have the money to put it together, and some companies, like AOL, already have a network of sales representatives. All these competitors have the ability in aggregate to drive down the money Groupon can get for deals, to siphon away customers, and to otherwise play havoc with Mason's business model.

It may be that Mason is right and Groupon will succeed in the long run. But he's not playing it straight with his employees, and that's a pretty bad sign.

Related:

• Groupon Tries to Make the SEC Happy, but Loses More Than Ever
• Groupon's Wild and Crazy IPO Accounting May Be a No-Go With the SEC
• Desperate Groupon Tries to Fix Finances with Consumer Privacy
• 4 Ways Daily Deal Sites Can Avoid Becoming Toast
• 4 Reasons Groupon is Like Goldman Sachs and 1 Reason It's Not