Windward Management letter to Groupon, Inc

$GRPN

Sep 07, 2023

Dear Dusan,

I have very much enjoyed our conversations over the last several months and appreciate your initiative, on behalf of shareholders including myself, to help turn the ship around at Groupon. As long term deep fundamental investors, we are highly cognizant that turnarounds take time with bumps along the way. That being said, our diligence suggests that the opportunity here is vast and not even remotely understood by the market. There have been quite a few mis-steps by prior management and in spite of a legacy bloated cost structure and a company that was mired in a “blasé-faire” culture, the company managed to survive in spite of itself, a testament to the quality of the core business. We are extremely supportive and appreciative of your efforts thus far and believe, based on our numerous conversations and your swift actions to date, that our interests are aligned. In fact, we are quite impressed with the green shoots we are already witnessing, both in the reported financials and what we observe in our due diligence, which will hopefully foreshadow what is to come. Given our large investment in the company, we thought it made sense to file a 13D so that we could engage in a more comprehensive manner with the company and provide some input should you find it helpful.

Windward’s Investment in Groupon

At Windward, our strategy is to scour the investment universe for companies that are undergoing transitory profit pressures, causing them to be disregarded by the investment herd, thereby jettisoning them to the bottom of the proverbial investment barrel. These situations allow us the opportunity to accumulate positions at what we believe to be both trough profits and multiples at the cusp of inflecting. Windward employs rigorous qualitative & quantitative research to provide a nuanced view of key performance indicators and unit economics, enabling us to have a differentiated and convicted view. This research enables us to “skate to the puck” on material & extremely variant changes in the “investment winds”, which we believe will not only abate, but significantly inflect in a highly positive manner in the near future, causing asymmetric and potentially explosive returns in the investment over a defined catalyst path. Our conviction is measured not only by our degree of variance in our profit estimates from both the Buy and Sell Side, but the proximity of the impending fundamental inflection. In our opinion, what makes an investment extremely exciting is when these fundamental profit tailwinds are augmented by events such as management change, non-core asset sales, & large stock buybacks. While this generally is enough to get us to max position size, what makes an investment truly unique is when we can foresee inflections across all 3 financial statements occurring at once, as exemplified in our investment case for Groupon.

Despite the fact that our average cost is $6.42, our conviction level is higher, as we file today at $11, given we continue to build evidence that our thesis is correct and the catalyst path grows more imminent. Below, we will delineate our investment case for $55 or 5x from here over the next 12 months. Given the asymmetric upside we see over a relatively short period of time, we have structured our position with both stock and options. Our options positions, many of which are in the money, form the majority of our 8.9% position in the company. These calls are high delta and longer-term options, allowing us to pick up more leverage should we recognize the explosive upside we envision playing out.

Groupon Thesis – Counter cyclical recession investment play, borne out of the Global Financial Crisis (during that time was the fastest growing company in North America). Company has suffered headwind upon headwind and has been left for dead, trading as if bankruptcy is imminent. To the untrained eye, this screens as a do not touch & melting ice cube short, hence the top 25 Short Interest % of Float, hovering at what we estimate to be ~40% of the “tradeable float”. This set up has allowed us to accumulate a position at an implied negative Enterprise Value, which we believe will become apparent in the next few months as the company rapidly transitions from a “going concern” to one with excess cash that will likely seek to buyback significantly undervalued shares ($245M buyback authorization or 74% of market cap) at the same time revenues and EBITDA materially inflects, in a closely held shareholder base with significant short interest.

Macro & Self-inflicted headwinds, set to become tailwinds – Groupon is primarily a discount site that takes a spread for lead generation to local merchants for selling deals to its 13.6M active local user base globally. This is a high quality business with high margins and negative working capital, when run efficiently. Given the shutdown of services in early Covid and the resulting dearth of service workers, coupled with a once in a generation inflationary price taking environment, only exacerbated by sky high demand for participating in a services starved world, I’m not sure any other public business I have come across suffered a greater 1- 2 punch over the last several years. This fact pattern coupled with a potential impending recession augmented by the massively shrinking US consumer balance sheet could be one of the better headwind to tailwind stories we will ever see. It is our contention that a company which hadn’t seen revenue growth in almost 10 years is on the cusp of several years of +double digit growth just to get back to normalized revenues of a paltry 50% of 2019 levels!

Prior to Covid, Groupon had been considered a melting ice cube in Ecom land for ~5 years, with revenues declining ~MSD p/a after experiencing explosive growth from its inception until 2014; Despite this, Gross Profit $ hung in pretty consistently at $1.2B per annum from 2015-2019

The business got absolutely annihilated during COVID with GP$ -50% as services came to a screeching halt

Nail salons, massage parlors, restaurants, bowling alleys etc.

Stock ran to $60 March of 2021 as a COVID recovery play, given folks thought the company would recover half of the losses and get EBITDA back to $175M or implying 10x recovered EBITDA

Problem was two fold:

Service workers didn’t come back, they were too busy trading crypto, collecting stimulus and day trading stocks, thus many service businesses were severely under-staffed

Further exacerbating issues, massive supply chain disruptions coupled with massive stimulus, created a transitory euphoria around pricing and lack of discounting I have not seen in my 44 years on this planet

These two factors severely crimped demand for merchants to discount product to drive demand, given they had a massive supply imbalance and were looking to take price rather than reduce it

This led to a series of bad guides under prior management teams who have consistently under-performed and caused the stock to trade into no man’s land

To put it in perspective, the prior management team up until Dec of 2022 believed this company would generate 100M of Free Cash Flow (FCF) THIS YEAR!

This macroeconomic backdrop, coupled with some missteps from prior management, including poor alignment of sales compensation to inventory generation, bad marketing decisions and lack of focus led to Gross Profit $’s declining to an initial soft guide in 2023 of $425M or a paltry 35% of 2019 levels!

It is our contention that under the leadership of new management controlled by Pale Fire (activist who owns 22% of company –interests aligned section) that there is a lot of low hanging fruit against artificially depressed easy compares that should allow revenues to start accelerating towards 50%+ of 2019 levels

Management has commented that sales commission $’s exceeded Gross profit $’s generated from poor inventory deals under prior regime due to a mismatch of incentives and supply/demand alignment

We liken the prior inventory situation to selling parkas in Miami in the summer and bathing suits in Buffalo in the winter – demand and supply were severely out of whack

New management has quickly re-aligned the salesforce and changed incentives to match bottoms up demand driven by regional CEO’s evaluation of analytics, instead of letting rogue sales people drive the bus to collect negative ROI commissions checks

Company is now heavily leveraging AI to seamlessly generate improved lower cost local inventory

Management has started rolling out improvements in top markets and is already seeing a significant improvement in performance, with some markets back to 70% of pre-covid levels

As management rolls out to rest of markets and turns marketing back up to 25% of Gross Profit, we should see a marked acceleration against artificially depressed compares, especially given the return of service workers and macro backdrop whereby bowling lanes, for example, now need to drive traffic rather than have demand exceeding supply

Based on our in-depth research and nuanced understanding of comparisons, it is our belief that Groupon will return to growth by Q4 & likely is already flirting with it this quarter against expectations of -LDD% y/y

Mis-modeling & the imminent simultaneous inflection across all 3 of the Financial Statements – It is our contention that the company is on the cusp of a massive inflection across all 3 of the financial statements simultaneously, which should drive a “powder kegged” re-rating in the shares over the next several months

The impending inflection in revenues at the same time the company benefits from a $250M cost restructuring, which is just hitting its stride, will result in a material re-rating of EBITDA, more than doubling against street expectations; We believe it will become apparent this coming quarter that the company will do ~$80M+ of EBITDA ‘23 & ~$150M+ ‘24 against consensus of $40M & $74M respectively

Given the company does not provide formal guidance, there is some confusion around the trajectory of profits this year. Additionally, new management’s conservative posture, given prior management’s mis-steps, is taking the stance of under-promising and over-delivering as has been evident the last 2 quarters since Dusan has taken over as CEO

The company came in at high end of EBITDA in Q1 despite a massive top line miss

In Q2 the company hit our EBITDA estimate which was double consensus expectations

During the Q1 call, management gave, in our opinion, conservative guidance that the rate of revenue decline would be similar in 2Q vs 1Q and has kept a similar tone around conservatism in H2 despite beating their 2Q guide by 500bps; It is our contention that 2H revs will be flat to + and that coupled with lower 2H SGA, given trajectory of cost cutting, will lead to back half EBITDA of $70M vs $10M in 1H Roughly half comes from lower SGA with the other half coming from increased GP$ on stabilization of revs y/y.. This all includes marketing increasing to 25% of GP$

For ’24 the company will benefit from the annualization of $30M of the already announced cost cuts and it’s our contention there is likely more wood to chop on OPEX side (some of which will be reinvested); Furthermore, the company has guided to a return to growth starting in Q1 and given the tailwinds we have delineated, we think 10% top line growth is conservative

To put this in perspective, if the company were to return to just 50% of 2019 levels, they would generate 200M+ of EBITDA

Balance sheet inflection – While the inflection in revenue and EBITDA is powerful, we think the impending inflection in the balance sheet perhaps dwarfs this in the short term. Currently the capital structure is $225M in converts due in ’26 and a $75M revolver against $118M in cash

Company has publicly delineated 2.3% stake in Sum up and its intention to monetize that, it’s wholly owned stake in Giftcloud and goal to monetize some of its Intellectual Property

We believe stake in sum up is worth $150M+ and that there is real demand despite it being a less liquid VC investment. We estimate other assets are worth $50M cumulatively.

Unique ownership structure with Sumup founders owning 70% of equity and historical raises being debt driven, coupled with an already discounted raise last year during nadir of stock market in June at $8.5B valuation Vs. rumors at $22B imply stake could be worth $200M+

It is our view that these “late inning” sales, of which management disclosed they have already received several offers, per the last conference call, would be a massive springboard as this would allow them to immediately pay down their covenant heavy revolver and leave the company in a position of net cash right as the cash flow is also significantly inflecting, enabling them to commence their $245M buyback (74% of current market cap, we assume they use only $90M)

Cash Flow inflection – Over the last 2 quarters, the company has burned $130M of cash flow, causing cash to decline from $248M to $118M. This coupled with the going concern language, stemming from a last minute amendment to the revolver during height of regional banking crisis, unfortunately coinciding with trough EBITDA/Cash burn & further exacerbated by commentary about potential for a dilutive equity raise has spooked the market and thus created the unique opportunity

Given our nuanced understanding of working capital, we are very comfortable that these 1x working capital headwinds, which constitute $112/$130M burn will not only abate, but will soon turn to tailwinds

$25m of burn was operating lease liabilities – 1x step down due to termination of HQ and LT lease liability

Accrued expenses are 30m drain and have gone from $260M Pre covid to $119M currently, we believe both accrued and operating lease liability are both in the late innings of cash outflow

Merchant payables, which represents the money owed to vendors at the time services are rendered is -$48M YTD & is the biggest concern to the market; However their tunnel vision on past results, given the cash drain from $540M Pre-Covid to $178M currently, causes the market to miss the opportunity ahead for significant cash generation, which will completely dispel the bear case as revenue growth inflects +

Payables have been steadily declining as revenue has taken a leg down to 35% of ’19 levels. However, there is also a seasonal component to this as Q4 payables are a big generator of cash and Q1 sees a large drawdown. 1H was disproportionately affected given seasonal drawdown coupled with -20% y/y rev declines, we will see this reverse significantly in Q4

It is our contention that as revenues flat-line and start to grow in 2H that perversely not only do Merchant payables cease being a cash headwind, but in fact will become a massive tailwind & we could see upwards of $100M of cash infusion over the next year as payables were as high as $270M in Q4 2021, approximating a similar revenue base we estimate in ’24

Free Cash Flow will be significantly + in 2H – Management has given soft guidance that Free Cash Flow will be less negative in Q3 & + in Q4. It is our belief based on detailed analysis of working capital and + inflecting EBITDA that Q3 could be flat and that GRPN will be +FCF from here on out; Furthermore, Q4 will be a significant cash generating quarter as the company benefits form both EBITDA leverage & negative seasonal working capital leading to 2H FCF that could exceed $75M. We estimate ’24 FCF 100M+

Incentives aligned – Pale Fire largest owner/activist (owns 22% of GRPN at $19) recently took control of board and fired ineffective prior CEO and took over as CEO/CFO

Very sharp entrepreneur / VC CIO – created $1B of wealth for themselves over last 5 years (sold and turned around several global ECOM and fintech companies)

Turned around Groupon of Eastern Europe called Slevomat – plan to institute similar playbook at Groupon

Stepped down as CIO of Pale Fire $1B in AUM & foregoing salary, in exchange for 3.5M shares or 10% of company fully diluted at $6

Former Founder Lefkofsky owns 13%; Between the two, ~45% will be closely held should stock exceed $6

Dusan has already decided to exercise his first tranche of options, signaling he believes the company is significantly undervalued, given he had to come out of pocket to do so

Valuation & Target Price

It is our contention that the stock is worth $55+ or 5x where it currently trades. We believe that as we skate forward to The Fall of ’24 it will be apparent that the company will do $200M+ of EBITDA in ’25

8x $200M of EBITDA assuming only 10% share buyback/4M shares at $22 (100% up from current levels) over the next 12 months results in $55, even after accounting for dilution from Dusan’s options grant

To put in perspective, when GRPN hit $60 in June of ‘21, the stock was discounting 10x 175M of EBITDA, but this was on an OPEX base $250M higher. Top line recovery needs to be far less to achieve same EBITDA

If we are correct in our assumptions across all the financial statements, GRPN will have $100M+ of net cash pro forma after buyback exiting ’24 and could likely buy back significantly more stock than we model

Given stock hasn’t had any real revenue growth during the last 8 years, we wouldn’t be surprised to see the multiple expand to 10x EBITDA, if they could see multiple consecutive quarters of top line growth. If Groupon could return to 60% of 2019 levels, a number that wouldn’t be shocking to us, the company would generate upwards of $300M of EBITDA and the stock could flirt with triple digits in our Bull case

In closing, we look forward to working constructively with management to ensure Groupon achieves the value we believe is embedded within the company.

Sincerely,

/s/ Marc Chalfin
Marc Chalfin
CIO Windward Management LP

Source:

https://www.sec.gov/Archives/edgar/data/1490281/000091957423005134/d10804209_13-d.htm

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