Sunday, November 06, 2011

Haters Need Not Invest

This week, after false starts, drama, and much gnashing of teeth, Groupon went public on NASDAQ this week. IPO is always a time where the hype gets turned up a little high, but this was fairly exceptional, especially the spewing of vitriol about the company, their business and the fallacy of any investors foolish enough to go anywhere near the stock. Some samples:

"Investing in Groupon is like investing in a leaky bucket." - Rocky Agarwal, most vocal Groupon critic.
"Enjoy the ride, Groupon investors! I'm outta here!" - Henry Blodget, Editor in Chief, Business Insider.

And that doesn't begin to take into account the torrent on Twitter, Facebook, and LinkedIn. It's almost personal...and almost all of it is so hyper emotional, it ignores the basics and the fundamentals of investing.

Before I dive in, some caveats and clear statements. I am an executive of a company that provides similar services to Groupon's Daily Deal services to the media business. I am also a veteran retailer, marketer, and have been with a company who is sometimes held up as an example of the excess of the "dotcom boom," Inktomi. I have also been a critic of Groupon in the past, and expect I will be in the future. But for all of that, I'd like to lay out some facts.

When a company goes public, it is offering it's stock to the public for the opportunity to invest, primarily for the reason of raising capital to invest in the future. That last word is critical: this is all about the future. As every investment opportunity states as rote, past performance is not a guarantee of future results. When you invest, you invest in what you think the company will do, not what they have done. Much has been made of several items:
  • Groupon is a company with revenues in the billions, but costs that exceed what their revenue is.
  • Groupon turned down a $6 billion acquisition offer from Google months ago.
  • Groupon has been unbelievably arrogant in their roadshow for the IPO, ranging from their seeming inability to keep quiet during the pre-IPO "quiet period" to the attempt to disguise their costs with creative accounting interpretation.
  • Groupon's core business, Daily Deals, has been experiencing weakness in mature markets, as well as faced with increased competition.

Groupon may dispute the above, but they are generally accepted as fact. And none of it should matter if you are investing in the future. Let's look at some other "facts."

Groupon is a technology company.
Andrew Mason, Groupon CEO, is a former programmer. Groupon sells online only. They went public on NASDAQ, home of the technology elite. But no, Groupon is not a technology company: they are a sales and marketing company who takes advantage of the low costs, large reach of the internet and mobile apps. They sell online, same as Macy's and United Airlines. Are those technology companies? No, but they do innovative things with technology, but they are sales companies. The vast majority of Groupon's 10,000+ employees are salespeople, calling on local businesses; that's not a technology company.

Groupon grew faster than almost anyone.
Actually, pretty true. Groupon generated revenues at the same level of in about 1/4 the time. In 3 years, they grew from literally 0 to a company that generates millions every day, in dozens of countries. Like Amazon, they did this by taking large investments from venture capitalists, using that money to fund their growth, and operating at a considerable loss, while they grew their user base.

Groupon is the world's largest Ponzi scheme.
Much of this comes from two elements:
- The company founders cashed out a lot of their stock in an internal funding round, so they no longer have a vested interest in making the company profitable.
- The amount of stock they floated in their IPO is a small portion of available shares; the vast majority are still controlled by the original investors and the founders.
Looking at those, combined with the aforementioned pre-IPO activity and arrogance, it's a compelling statement. But the principal founders are still there, and are still expanding the business, so draw your own conclusion.

Daily Deals is a fad, so Groupon is destined to be the next failure.
Earlier this year, there were over 300 companies who were offering daily local deals. That makes it clear the market is ripe for contraction, and it has begun. For example, we used to offer a consumer brand, TownHog. It was successful, and profitable, but our chosen business was to provide software for media companies to offer their own daily deals, so we elected to sell it. After a bidding war, we sold it to BuyWithMe. A month later, BuyWithMe was gone, laying off their staff and selling the assets to Gilt. Companies have sprung up to just buy other daily deals companies. Companies like Yelp have elected to abandon Daily Deals, as it was too costly for them to offer compelling deals.

So are daily deals a fad? Consumers disagree. On the day of Groupon's IPO, for instance, Google offered a deal at REI that millions of consumers (myself included) snapped up. Living Social has refocused on quality deals, and seen their sales accelerate. And more consumers than ever buy daily deals, just not all from Groupon. Look at eBay: auctions were considered a game changer, and every company that sold things jumped in, offering their own auctions, or partnering with other auction sites. Today, auctions are a small part of eBay's business, but they seem to be doing just fine: they transitioned to other ways to sell to their excite, engaged customers, and the saturation of other companies have gone by the wayside. The list goes on, but the macro trend points to the fact that customers like good products at good prices, and that sells well.

So, the question is, should you invest in Groupon?
This is the only question that matters. Look at other successful companies today:

Apple. They are arguably the gold standard. Yet they were a distant 5th place in the home computer arena, appealing to mostly a niche group of educational and creative types. They were getting their clocks cleaned by Dell, HP and others. They went from nearly 90% market share to less than 5%. Steve Jobs came back, took a bailout from Microsoft, saw the future, gave us the iPod, the iMac, the MacBook, the iPhone, and iPad. He created an ecosystem that changed music and home entertainment, and communications, as well as all consumer electronics. And made one of the most profitable companies in the world. Current market cap: $372 billion.

Amazon. They sold books for under the cost, branched into categories they told investors would cause profits to be years away. They were dismissed as an unsustainable model, as thy spent $2 for every $1 they brought in. And yet, after a decade, they brought the Kindle, Amazon Prime, and are set to take on Apple in the tablet wars with the $199 Kindle Fire. Current market cap: $100 billion.

What do those companies have in common with Groupon? They all started in a weak position, but had a rabid, passionate fan base, with leaders that were innovative, seeing the future, and charting a course towards it. They spent more money than they had to get customers and innovative products to market, and
were rewarded with eventual success.

Now, let's look at Groupon's track record:

  • Daily deals existed before Groupon, but they saw the potential in it, and took it to a whole new level. They defined the market, and adjusted their margins. They recognized the importance of "showcase deals" such as the now infamous Gap deal. They took it internationally, and generated billions in revenue.
  • They recognized the importance of mobile and local, and launched Groupon Now. Instead of huge discounts on a single deal, that allowed local businesses to offer "evergreen" inventory at lower discounts that used immediacy and location to attract customers. Hungry for lunch? Fire up their app, and see who's around you offering 20% of, as long as you come in the next hour.
  • They copied other innovators in the space with high margin deals: Travel. Price points are higher, margins are much richer. And with their millions of subscribers, they can appeal to every one of them, instead of the more localized daily deals. 
  • They introduced Groupon Goods, their own flash sale brand. In one week, they generated $2 million in sales on the sales of 10 SKUs. There is not a retailer in the world who would not want that performance. 
The reality is for all of the hate spewed upon them, and their own public arrogance contributes heavily to it, they have led the space, innovated, and changed how the consumer shops. They continue to show they want to expand and experiment. Some will fail, and many of the other companies above have experienced their share of failures (eBay's acquisition of Skype, Apple's loved/hated cube, etc.). They have clearly assembled an amazing sales force, an innovative team, and have bolstered weakness in mature US markets in their core business with international expansion.

Here's another anecdote: at Inktomi, we powered nearly 90% of the web searches. Google came along, and we laughed. Heartily. In 4 years, Inktomi was gone and Google was well on its way to being what it is today. Our market cap at the time made it a joke to consider Google a serious competitor; after all, we defined what web search was. We charged companies to use our software; Google gave theirs away for the hopes of making a few bucks on some ads. It sounds ludicrous, I know. But Google made a better product that consumers liked better, and companies were thrilled to give them users instead of paying us. And they were backed by investors who believed in their vision of the future, and were rewarded handsomely.

So, if you want to invest in Groupon, it comes down to this: regardless of their current business, and the amazingly heavy load they bear in sustaining it, do you believe they can innovate and grow for the future? If you do, you should. If you don't, don't. If you are looking at the company today, and assuming that is all they will ever do, I would say absolutely not. But smart investors also said that Apple's foray into retail would kill them, or Amazon launching an eReader would destroy their business, and that eBay would never be able to shed their auction model. And they were wrong.

And then there is this: investing in Groupon is, in my opinion, actually patriotic. Apple reaps millions in profits on cheap Chinese-manufactured goods; so does Amazon. The oil companies are swimming in profits made by gouging US consumers and sheltering those profits in offshore accounts. But Groupon is all American: employees, products, innovation. They employ tens of thousands of people in this country, something our elected officials have not found a way to reward companies to do instead of outsourcing. Groupon's fastest growing market? China. That's right: an American company, besides the tobacco companies, getting the amazing Chinese economy to give America their money. They represent an innovative way to do business, and yet, they are actually inefficient. For their bluster as a "technology company," their processes are shockingly manual, but are ripe for increased efficiency by the application of actual technology company, and they are buying firms in Silicon Valley to help them do so. They are an American success story, and deserve to be celebrated for it.

Imagine, if the government announced a program that would put tens of thousands of Americans to work in jobs that would grow and allow anyone, regardless of background or training, and be paid a competitive wage. Our embattled president would be put up with Reagan, Kennedy, and FDR as a great economic innovator. Instead, it's the 21st century and the private sector is doing it, and Groupon is trying to deliver a solution to a market that wants it. Are they trustworthy? Only time will tell, but I think the average consumer and investor would find them more worthy of a chance than politicians.

Oh, and remember Henry Blodget, the Business Insider editor I quoted earlier? Yeah, he was engaged in insider trading and ended up being banned from the securities industry and paying $2 million of his ill-gotten gains. So, when you hear the haters hating, don't forget to have a look at their fundamentals. Investment is risky (I say that as a man who lost thousands on Webvan and other supposed "can't miss" investments), and only time will tell who's right. But let's not tear down those who are trying to innovate: raise the risks, trumpet the concerns, but let's remember: it's business, not personal.

Groupon's IPO yielded a market cap of about $15 billion. Let's turn down the vitriol, and see what they do with it.

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