Sell Groupon Before It's Too Late

At the Fool, we don't believe in timing the market or trying to outguess the pros which company will beat or miss earnings estimates by a couple pennies. Instead, we focus on finding great companies with advantages that can play out over the long term, regardless of what they'll do over the next few weeks.

However, in some cases it's important to know key events coming up that could affect your investments. And in Groupon's (NAS: GRPN) case, the near term looks like it's about to get ugly.

Groupon on a run
One of the key concerns surrounding Groupon is the company's recent run-up and the lack of positive news to justify it.

Groupon has been on a furious run heading into earnings; the company is up 36% across the past month alone with a series of big gains in the days following Facebook's S-1 filing. While we've seen other social media plays like Zynga (NAS: ZNGA) see their own shares skyrocket in that time, Facebook's filing pointed to just how dependent the company was on Zynga for its non-advertising revenue. That is, Facebook's filing was actually a positive for Zynga.

However, there's little positive news in Facebook's IPO for Groupon. If anything, Facebook getting $5 billion more in cash only hurts Groupon. Unlike Groupon, Facebook doesn't have to work -- i.e., shell out cash -- to acquire the consumer names it can market to. While Facebook killed its daily deals site in August, it also maintains a check-in deals service and can always ramp up competition with Groupon or future services Groupon ventures into. Finally, at $15 billion dollars, Groupon's beyond the size Facebook or any peers would be looking to make a bid for. Facebook having cash does not make Groupon a buyout candidate.

Finding profits
Concerns about Groupon's recent run-up aside, the bigger problem surrounding Groupon is the trajectory behind its business.

Groupon had initially concealed steep operating losses behind its incomprehensible ACSOI, or adjusted consolidated segment operating income. Investors cried foul, and rightfully so. The metric was essentially "profits when subtracting all expenses." One key area that ACSOI didn't include is certain marketing costs. The logic behind excluding this, as far as Groupon was concerned, was that it would have to market like crazy to build out a list of customers, but at a point could ratchet marketing costs back.

Here's the problem with that: Customers aren't "won" and permanently kept, especially in an email-based business. You need "hot leads" as customers will read a lot at first, but less later. We've all done it with an interesting series of emails we eventually lost interest in. Also, most established Internet companies don't bear out the fact marketing shrinks over time after establishing an online brand. Just look at priceline (NAS: PCLN) . The company grew its online marketing from $114 million in 2006 to $552 million last year. And that's without nearly the dependence on standing out in a crowded email inbox that Groupon faces.

Therein lays the problem for Groupon. After the company was criticized for ASCOI, it dropped the metric. That left Groupon deeply unprofitable and out of investors' favor. However, Groupon came up with a solution to solve its problem of continuing unprofitability: slash marketing deeply. Voila! After cutting its marketing costs to the bone, the company was suddenly on the cusp of profitability. Amazing how that works.

An uncertain future
As Groupon sells it, it's already engaged its customers and can now focus on a "normal marketing budget." The company believes marketing dollars are now a poor return on investment and customers will be retained through such measures as "high quality customer service."

On this, we call shenanigans. Consider that Groupon's subscriber acquisition cost was just south of about $25 in the second quarter. Yet its revenue per user only sits around $11.60, and that's with customers who had been recently engaged, the so-called hot leads. As users are less engaged by marketing the company will be able to come closer to profitability in the short run, but the move will also drag on revenue growth in coming quarters.

And you know how investors love barely profitable companies selling at more than 10 times sales that are seeing growth coming to a screeching halt.

What you should be watching
While investors have bid up Groupon on the belief that Facebook's coming IPO will bring investors back to recent IPO stars, the actual real news they should be fixated on is trouble in the broader daily deal space. LivingSocial investor (NAS: AMZN) recently disclosed that in 2011 LivingSocial lost $558 million on a mere $245 million in sales. What's driving these steep losses? You guessed it: marketing expenses! Groupon turning off its marketing nozzle just means other daily deal sites with comparable offerings are now targeting their customers.

The key point? We could be wrong about this quarter, but Groupon's gutting of marketing to attain profitability and investor interest will come back to hurt it eventually. We wouldn't short a stock like Groupon that can run for seemingly irrational reasons -- ahem, Facebook -- but we wouldn't want to own it going forward either.

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At the time thisarticle was published

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