Questions over the long-term viability of the daily deal model and Groupon’s finances emerged well before the company went public.
But these questions didn’t stop the company from debuting in what was one of the biggest technology IPOs since the first .com boom. Apparently hungry for tech IPOs, Groupon shares popped 31% on their opening day.
Despite Groupon’s successful IPO and its first day pop, many continued to warn that the daily deal model and the company that turned it into a billion-dollar business were simply not built to last. And if you watched as Groupon’s stock fell nearly 17% yesterday, it’s difficult to argue with that notion.
The tanking of the company’s stock is a result of an embarrassing financial blunder that Groupon revealed on Friday. The blunder: the Chicago-based company was forced to restate its fourth quarter earnings due to “material weakness” in its internal accounting systems. That “material weakness” resulted in overstated revenue (to the tune of $14.3m) and understated expenses. All told, Groupon will see its net income for the quarter decrease by some $22m once it cleans up its mess.
Some suggest that Groupon’s accounting mishap is a byproduct of the company’s rapid growth. In other words, the business is growing so fast that its accounting controls simply can’t keep up. Skeptics counter that Groupon has been coming up with ‘innovative’ financial hijinks since it filed its original S-1 to go public, and that the company finally made a faux pas that even the most bright-eyed investors couldn’t ignore.
Who is right? If you’re looking at the market, it’s clear that Groupon has made a big mistake — perhaps one it can recover from, but a big mistake nonetheless. Not surprisingly, the SEC is investigating and the lawyers are circling, so it seems likely that Groupon will learn an expensive lesson about the perils of making accounting errors as a publicly traded company. The only question now is just how expensive this lesson will be.
But the SEC and class action attorneys may be the least of the company’s worries. Groupon’s accounting problems are related to an unexpectedly high number of refunds it had to issue in the fourth quarter, which could be a proverbial canary in the coal mine for the daily deal company. As analyst Rocky Agrawal, a frequent commentator on Groupon and the daily deals space, explains:
At its core, Groupon’s U.S. business is a receivables factoring business, as I wrote last year. They give loans to small businesses at a very steep rate (the price of the discount plus Groupon’s commission). They get the money to fund these loans from credit card companies such as Chase Paymentech. Groupon is essentially a sub-prime lender that does zero risk assessment. And as word continues to spread about what a terrible deal running a Groupon is for many categories of businesses, the ones that will choose to run Groupons are the ones that are the most desperate. For U.S. based businesses, the only time I can definitely recommend running a Groupon is if it is otherwise going to go out of business.
In theory, Groupon’s exposure to that risk is covered by its refund reserves — but we don’t know the size of those reserves. And as yesterday’s restatement shows, the company’s calculated them poorly. Unless Groupon begins to do risk assessment on deals before they run, changes its payout terms to businesses, or drastically changes its refund policies, I expect refund rates to continue to rise. If they do any of those things, I expect revenue declines because it will make running Groupons less attractive to businesses and buying Groupons less attractive to consumers.
According to Agrawal’s analysis of one of Groupon’s S-1 filings, the company may have experienced an increase in return rates of 40% year-over-year. While that figure was never confirmed directly by the company, the fact that it underestimated refunds seems to confirm that refunds are becoming a problem.
That could be bad for the company for a variety of reasons, some more complicated than others. But the key takeaway — that a higher-than-expected number of consumers are asking for refunds — is perhaps the biggest reason Groupon should be worried. Up to now, the company, which serves a two-sided market, has largely been able to impose its terms on one side of the market (merchants) because it was wildly popular with the other side of the market (consumers).
If Groupon’s sway with consumers wanes, all bets are off.