How I lost my Groupon bet

By Felix Salmon
November 10, 2012

Last year, when Groupon went public, I entered into a “small wager” with Rocky Agrawal. We would check back on Groupon’s market valuation in one year’s time, and compare it to the valuation of Priceline. At the IPO, Groupon’s market capitalization was 72% that of Priceline; if that number fell below 30%, I would lose. Otherwise, I would win.

Well, here’s what happened to that ratio:

ratio.tiff

This actually understates how badly I lost the bet. Shortly after the bet expired, two things happened: Priceline announced that it was buying Kayak, and Groupon plunged on disappointing third-quarter earnings. Today, Groupon closed at $2.76 per share, giving it a market capitalization of $1.8 billion. Priceline, by contrast, closed at $625.87; if you add its capitalization to that of Kayak, you get a total of $32.74 billion. Which means that the Groupon:Priceline ratio is basically down to about 5.5%.

Obviously, something went horribly wrong at Groupon after the IPO. So, what was it? Did Groupon suffer a massive loss in revenues? Did it start racking up enormous losses? Well, here’s the chart.

groupon.jpeg

The blue bars, here, are Groupon’s quarterly revenues, from the second quarter of 2010 onwards. The red bars are its net income. And the jagged line, of course, its its plunging share price.

The main thing to note is that Groupon’s results don’t seem particularly gruesome; they’re certainly better now than they were when the company went public. The share price didn’t fall because revenues were falling: it fell because revenues — and profits — weren’t rising fast enough.

This is why I’m generally so mistrustful of stocks: they just don’t behave in a remotely predictable manner. It’s impossible to know what kind of future growth rate is priced in to a stock, and it’s even more impossible to have a good grasp of what a company’s future growth will be. If you’re valuing fast-growing companies on some kind of discounted cash-flow model, then tiny tweaks to your growth assumptions or your discount rates can have an enormous effect on the share price which pops out the other end.

I knew this, of course, when I entered into my bet with Rocky. So what was I thinking? Three things.

Firstly, volatility cuts both ways. Groupon could fall precipitously — but it could rise very fast as well, in which case I’d be well in the money.

Secondly, I was already well in the money: Groupon stock could fall in half and I’d still win the bet. I don’t believe in the efficient market hypothesis, but I do believe that the markets are more efficient than any individual. Given the cushion that Rocky was offering me, I’ll take the side of the market against anybody.

Finally, the kind of things which hurt one bubbly tech stock tend to hurt them all. When we entered into the bet, Priceline had risen from just over $50 per share in the fall of 2008 to more than $500 per share in the fall of 2011. Rocky’s bet wasn’t just that the Groupon bubble would bust: it was that the Groupon bubble would burst and the Priceline bubble wouldn’t. Which, of course, turns out to have been exactly what happened: it wasn’t long before Priceline was trading at more than $750.

So, next time we’re in the same city, I’m buying Rocky dinner. At least I’m still winning the other bet, for the same stakes.

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Comments
13 comments so far

I would have taken that bet as well, Felix, for all the reasons you’ve stated. However, I think you shouldn’t mistrust Groupon stock pricing so much.

Buyers expected that Groupon was well positioned to turn early exponential user growth into either profitability or continued revenue growth; this has turned out, so far, to be untrue on both counts. Any high growth firms needs to shift from growth to profitability at some point, but Groupon’s post-IPO performance has been a shift from growth to an unprofitable revenue plateau. For a company whose value prices in either growth or profitability, the absence of both is a good reason for a share price collapse.

Posted by dmcdougall | Report as abusive

+1 to dmcdougall. Indeed, there are real questions whether Groupon’s business model is truly profitable or sustainable (the latter due to deal fatigue among both merchants and consumers.)

As for this point from Felix – “the kind of things which hurt one bubbly tech stock tend to hurt them all” – it completely misses the fact that Groupon and Priceline are very different animals. Priceline generated $1.2 billion in net income for the latest reported twelve months (ended Sept. 30, 2012). Trading at $625, the trailing P/E is 24x and forward P/E is 17x. Latest quarter y-o-y revenue growth was 17% and y-o-y earnings growth was 27%. It’s a solidly profitable company growing at a nice rate. In both 2009 and 2010 net income was roughly $500 million, with some growth from 2009 to 2010, but then a huge leap to current performance levels in 2011. I don’t know enough about Priceline to know the underlying cause of this growth, but the point stands that Priceline has been solidly profitable for several years.

Groupon, on the other hand, has the financial issues that dmcdougall points out. Basically, buying Groupon stock is making a wager that it can grow revenue and leverage expenses such that its earnings look something like Priceline’s in 3 to 5 years. No surprise that the stock craters as that possibility looks less likely.

Posted by realist50 | Report as abusive

Great Great Great article Felix!

You know what the best part about stocks is. When your entry point timing stinks but your thesis is sound you get the opportunity to double down. Be a player and go long a couple grand worth of GRPN and short a couple grand of Priceline.

If you think GRPN is likely to grow then you’re in good shape.

The one question I have for you is your use of the world “mistrustful.” That’s a pretty loaded word. It almost implies something sinister. I agree 100% with you that the market needs no reason to change the P/E on a stock from 15 to 10 the day after you buy something. You just can’t count on the short term “voting” function. What you can absolutely can count on is the longterm weighing function. If a company is growing sales and earnings then sleep well knowing that the value of your share is rising irregardless of the price you see on your screen.

You shouldn’t be any more mistrustful of the stock market than you are of the weather. Both are entirely unpredictable in the short term and entirely predictable in the longterm.

Posted by y2kurtus | Report as abusive

“This is why I’m generally so mistrustful of stocks: they just don’t behave in a remotely predictable manner.”

I think you mean, this is why you’re not a successful fund manager, trader or analyst.

“It’s impossible to know what kind of future growth rate is priced in to a stock, and it’s even more impossible to have a good grasp of what a company’s future growth will be”

Sure, you can’t know (legally) with 100% certainty but without institutional bias and with proper research, diligence, analysis, and a keen knowledge/appreciation for history, you can often get close. It isn’t pure luck (although a little luck never hurts) that our pick/pan performance absolutely destroys that of most analysts and funds.

You are correct though that DCF-style valuation (as well as other methods) is sensitive to even small tweaks to the inputs/drivers, but that is why we do sensitivity analysis and use that information to using prudent risk management based thereupon (e.g. having stops/limits in place). Of course since this was a bet, not a trade, you’d have to just alter the terms of the bet, but that’s neither here nor there.

I like that you’re willing to stick your neck out and make these bets public and write about the results in hindsight. That’s why our site says “Those who fail to learn from history are doomed to repeat it,” so it’s good to see you’re doing this sort of post-mortem evaluation of what happened.

Jordan S. Terry
Managing Director
Stone Street Advisors LLC

Posted by StoneStAdvisors | Report as abusive

I noted on your blog in the comments section of a previous post on Groupon that the company suffers from the fatal flaw of having a low barrier to entry. Because it’s business model is easily replicable, and because Groupon owns no valuable intellectual property, the company is a dead man walking.

Posted by mfw13 | Report as abusive

Felix, a year ago I elaborated on why Groupon would be a horrible investment.

(1) Low barrier of entry. I had already purchased one or two “Groupon”, but from a competitor, not from the original. Didn’t/don’t see any reason to prefer Groupon to an upstart.

(2) Very high cost of acquiring customers, much higher than the likely profitability of said customers. That is a business model with a negative ROI.

(3) A business model with merchants that has limited applicability, low likelihood of repeat business. Surely there aren’t many businesses that can regularly give away their product at a 75% discount (and any that makes a habit of doing so will encourage regular customers to seek the discounts).

(4) Essentially zero profits. Ever. I’m not arguing that net income trumps all other measures, but an unprofitable business is not a good investment.

I agree that you have no business investing in stocks if you couldn’t see a year ago that Groupon was a HORRIBLE investment. But I strongly disagree when you say that the market is unpredictable. Over time, price tracks earnings. (Or more to the point, price tracks the projected earnings a few years into the future. Thus the volatility when the trend shifts.)

Posted by TFF | Report as abusive

FWIW, your bet wasn’t necessarily a bad one. Even bad companies can persist at a irrational valuation for a long period of time, so it was improbable that your large cushion would have been used up THAT rapidly. Real markets don’t permit you that kind of a cushion.

If Groupon had managed to turn even a small profit, they might have “only” fallen 50%.

Posted by TFF | Report as abusive

Well in essence you are saying it is dangerous to buy stocks with extremely high PE ratios, since if those decline a stock can go into the basement even if its earning are increasing. A high PE ratio is a “bet” that future earnings growth will be high. If it isn’t the stock is rapidly punished.

Posted by Chris08 | Report as abusive

@Chris08, well put.

The greater problem with Groupon is that there has never been a clear path to profitability. The business model gives too much away to the consumer, leaving too little for the merchant and Groupon to split profitably.

Posted by TFF | Report as abusive

So Salmon just proved he can’t pick stocks – this is news?

Posted by ytwod3621 | Report as abusive

no mate, equities are often really quite predictable and this one in particular was a predictably awful call to make. I actually have to start the numbering below zero here so that my 1-3 will match up to yours:

-1) like hell do those results not look gruesome – the revenue has flatlined.

0) If you have a supposed “growth” company that ain’t growing sequentially for two consecutive reporting periods, then this is not a minor tweak to the DCF – it’s a totally broken investment thesis.

1) Volatility hurts higher-beta companies a lot more than low-beta ones. And given the disastrous performance of the IPO, this one was never going to suddenly go up a lot in a bear market

2) This is basically you betting ideology against reality; post-2000 we can all agree that the IPO valuations of technology companies with restricted free floats are not efficient prices. The restricted free float is very important here – if anyone had ever tried to float the whole of Groupon it would never have got that “market capitalisation” in the first place.

3) Priceline has earnings, and could probably pay a dividend if it wanted to. It was never going to fall as far or as fast as Groupon, so there really wasn’t a winning draw this way.

I think what this proves is that as you say, stocks are different from bonds (although actually I suspect that you could have constructed a similar bet on the credit and got similarly hosed).

Posted by dsquared | Report as abusive

Actually one more thing – what really caught you here was lack of stop loss discipline. You should have offered to buy him a sandwich when the trade moved 10% against you ;-)

Posted by dsquared | Report as abusive

It was pretty clear Groupon was going nowhere from before the IPO. It is not a business model that makes any sense in the long run.

Posted by QCIC | Report as abusive
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