An analysis of the Groupon S-1 filed last week for their upcoming IPO highlights some interesting trends. A single table illustrates how the Groupon business model is entirely based upon the concept of float. The payments the company owes to merchants are growing at much faster rates than actual revenue rates. In fact, the balance sheet shows that the company owes more to merchants than total current assets, an unusual situation.

The Revenue Curve

There is no question that Groupon's revenue curve is amazing.

From sales of just $30 million in 2009 to sales of $713 million in 2010, Groupon has shown incredible growth rates.

As if that were not enough, sales in the first quarter of 2011 were $644 million.

Assuming trailing twelve-month revenue of approximately $1.2 billion, this would give Groupon a price/sales ratio of about 160. This is an extremely high valuation metric for a company with revenues of over $1 billion. (The S-1 does not provide quarterly revenue data for 2010, so assumptions must be made; we assumed $550 million for the last three quarters of 2010.)

This type of growth rate is astonishing, frankly, but focusing on only the revenue growth is superficial with Groupon's business model.

Groupon's Business Model

Groupon sells coupons to customers on behalf of merchants who sign an agreement with Groupon. To the merchant, Groupon serves as outsourced marketing, with the hope that Groupon's incentive to customers increases business. The merchant sells their services at a steep discount through a Groupon coupon.

Why are merchants willing to sell their services at discounts as much as 50% below the retail cost?

Part of the value offered to the merchant is the potential that coupons will either be unredeemed or not redeemed at all. In the U.S., an unredeemed coupon means that the merchant is effectively paid for nothing.

If the coupon is not redeemed for a long time, the merchant has accrued a future liability, but has increased cash flow. Since many small retail businesses survive on cash flow, rather than accrual-based accounting, any increase in current cash flow is a positive factor.

If the merchant views the unredeemed coupon as cash and views the lower revenue for services from redeemed coupons as marketing costs, the Groupon value proposition can be attractive.

The delay of time between the sale of a coupon and its redemption is where Groupon has built nearly all of its value.

Accrued Merchant Payable

On the balance sheet, amounts that are owed, but as yet unpaid to merchants, is recorded as a current liability called "accrued merchant payable." This metric is in addition to the standard balance sheet lines of "accounts payable" and "accrued expenses."

A very interesting picture emerges when the trend of this metric, the accrued merchant payable line, is measured against revenue, gross profit, and current assets trends.

The following table illustrates the trends in revenue, cost-of-goods sold, and gross profit, as given in the Groupon S-1.

Source: Groupon S-1 Filing

When the trend of "accrued merchants payable" is compared to the trends in revenue, gross profit, and current assets, a curious development is seen, as illustrated in the table below.

Source: Groupon S-1 Filing, Briefing.com calculations

It is the accrued merchants payable line that is astonishing, particularly as a percentage of current assets.  The accrued merchants payable line simply gets larger and larger as an overall percentage the more Groupon grows.

In fact, the accrued merchants payable line is greater than gross profits, which means that if Groupon had to pay their merchants immediately, the payment would consume all of the gross profit for that quarter.

What this means is that Groupon is essentially staying just one step ahead of having to pay the piper. Instead of having accrued liabilities go down as the company grows, the accrued liabilities expand. Such a model is somewhat equivalent to paying your rent with your credit card, prior to receiving your salary check, but the rent is larger than your salary each and every month.

The revenue trend at Groupon is the first metric that the public has focused on, particularly the media. It is certainly the incredible metric curve that the very high valuation is based upon.

However, if there was any lesson from the internet bubble era of ten years ago, it is that valuations based upon revenue alone are extremely risky. The minute an incredible revenue trend stops, the valuation the market is willing to place upon a stock drops dramatically.

Such a stock is somewhat comparable to the game of hot potato, where the goal is to acquire the stock and then pass it on as quickly as possible before the potato explodes.

We think that such a scenario is likely with Groupon, eventually, although it is difficult to predict when. Nothing keeps growing forever. The ticking time-bomb, however, is the money owed to merchants, and it's an ever increasing trend.

Unredeemed Coupons Are Key to Groupon's Financials 

Imagine, for instance, what the balance sheet would look like if Groupon paid all merchants their entire amount due at the time of the sale of a coupon, on a per-coupon basis, instead of waiting until the sale of coupons reaches a pre-arranged, negotiated level.

There would be no accrued merchants payable line on the balance sheet, except for the single day when the sheet is generated and issued checks are uncashed.

In such a scenario, the balance sheet would show negative current assets, meaning that there is no buffer of cash with which the company can operate on a daily basis. The situation is roughly equivalent to a company operating without any checking account at all.

What this all means is that the faster Groupon grows, the more of its accumulated cash is owed to the merchants, as a percentage of revenues, profits, and assets. However, Groupon needs the cash from unredeemed coupons to finance its daily operations. It is somewhat similar to a restaurant charging its customers in advance for a meal a week from now, and then using the payment to go out and buy ingredients and hire a chef.

With the Q1 2011 accrued merchant payable line at 45% of total revenue and 78% of cost-of-goods sold, it simply begs the question of why the merchants aren't being paid.

We think the accrued merchant payment line is going to become the critical metric to watch as Groupon grows.

Unredeemed Coupons Are Groupon's Working Capital

Groupon is funding its entire working capital needs with the money that is owed to its merchants.

This type of situation is fine as long as the company never stops growing at fantastic rates, and customers take months or years to redeem their coupons.

However, both of these trends are likely to recede at some point as Groupon gets larger.

Merchants that have sold coupons that haven't been redeemed, and therefore, haven't been paid by Groupon, are likely to eventually either demand their share of the cash, or withdraw from using Groupon as a marketing tool. After all, they haven't gained anything in such a situation.

Customers that fail to redeem coupons are not likely to continue buying coupons in the future. The initial thrill of Groupon occurs when services are bought for half the retail price. That thrill fades, however, as time goes on and the coupon is not used.

How many Groupon customers that have yet to redeem their coupon are likely to buy another one? At some point, purchasers of coupons that are unredeemed will change their view of Groupon from one of "a real bargain" to one of "an unnecessary impulsive purchase."

At the moment, the thrill of "getting a deal" is the driver behind the Groupon explosion of revenue. Someday, however, that thrill has to be backed up by the merchants increasing their business and receiving revenue and the customers returning to buy more coupons.

Conclusions

Groupon's entire business model depends on the time frame between the sale of a coupon and the time it is redeemed.

Certainly, they have sold a lot of coupons. But the scale of the unredeemed coupons is immense, and without it, the Groupon financial statements would look horrible, even with the incredible revenue trends.

How large is the market for persons who buy coupons and never redeem them? With a business model so dependent on customers being slow to redeem coupons, combined with delayed payments to merchants, Groupon's long-term investors have to make such an analysis for themselves. 

Your guess is as good as ours, but we do think that eventually, people who do not redeem the coupons they purchase are not a long-term viable customer base. At some point, the game collapses upon itself.

In the final analysis, customers need to receive actual value for their payments, not a perceived future value that is never delivered. We think the tone of the S-1 indicates that Groupon itself understands this issue.

You might notice, for instance, that Groupon is not selling any coupons for a 50% discount in their own stock offering.

Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com