Is Groupon a Scam or Just Misunderstood?

NEW YORK ( TheStreet) -- As beleaguered deals giant Groupon ( GRPN) prepares to report second-quarter earnings Monday, investors are asking some poignant questions, including whether the company is a scam.

They're asking that in part because of the company's past accounting irregularities, and as they've delved into the past of Groupon's chairman and co-founder, Eric Lefkofsky.

As Fortune detailed last year, Lefkofsky has made lenders, investors and customers in some of his previous ventures angry enough to sue him. One lawsuit, which was later withdrawn, accused him and another company he co-founded, InnerWorkings ( INWK), of "racketeering."

Fortune also related how Lefkofsky incurred the wrath of investors in a company called Ha-Lo Industries, which spent $240 million to acquire a company called Starbelly.com that Lefkofksy co-founded. Shortly after the acquisition, Ha-Lo filed for bankruptcy protection.

Considering that Lefkofsky profited handsomely from the sale of Starbelly, some investors may wonder whether Groupon's IPO was an attempt by insiders to cash out before the business hit the skids.

Another thing that has investors wondering whether Groupon is a scam is its business model: How can a company that puts its customers (in Groupon's case, merchants) at a disadvantage survive in the long run.

Since Groupon reached a six-month high of $25.84, the stock has lost more than 70% of its value.

I'm wondering whether this company will survive another year. I'm also wondering whether Groupon has a viable long-term business model.

A crucial question to ask is what exactly is Groupon selling. Just deals? Or an advertising platform? Or both? Do the merchants know the difference?

Some argue that successful and already well-established companies -- particularly restaurants -- do not use Groupon. Rather it is the typical start-up trying to make through its first or second year that sees the value in Groupon.

But these businesses risk losing 50%, 60% and sometimes 70% of their revenue just to get new customers. Is it worth it?

For Groupon, a related question is whether its business can survive by servicing predominantly start-ups, many of which may not survive themselves.

Groupon is accused of "preying" on these companies by using what are considered to be aggressive sales tactics and offering these new business entrepreneurs false hope. But is it Groupon's fault if these owners see value -- rightly or wrongly -- in what it is selling?

Another question Groupon needs to answer is how exactly can it ever earn a profit when it has little to no competitive leverage.

Can it compete with the likes of Amazon.com ( AMZN), a rejuvenated Yahoo! ( YHOO) or Google ( GOOG)? All of these companies have made local deals available to their users.

Groupon has to make its business work and can't skip a beat whereas a Google and Amazon are huge companies that have the resources to offset any potential deal-business weakness.

For that matter, even Facebook ( FB) can easily enter the deals business if it wants to secure more ad revenue -- it would only need to want it badly enough.

What's more, even if a company does not have a prominent name like the ones mentioned above, it might only take a targeted mailing list to select clients based on existing spending habits to put Groupon out of business. The perfect example is Opentable ( OPEN) when it first launched its Opentable Spotlight.

The result was overwhelmingly successful as it stole a great portion of Groupon restaurant market share. So just imagine what Amazon.com or Yahoo! might be able to do.

Investors have signaled their concerns by distancing themselves from Groupon's shares, which closed Friday at $7.44.

It is now management's job to stop the bleeding. It can do that during its earnings announcement by giving Wall Street what it wants. As it stands, analysts are expecting 3 cents a share in earnings on revenue of $576 million.

In its first-quarter report the company did an excellent job of convincing Wall Street that its model was working by reporting revenues of $559 million, an annual increase of 89%. It also also reported $68 million in consolidated segment operating income.

Even more remarkable was that North American revenue increased 75% year over year, helped by improved technology that focused on personalized deals.

If Groupon can continue similar performance, I suspect that it may deliver a strong second-quarter report. It guided conservatively for $570 million in revenue.

Analysts are looking for $576 million in revenue, and if the company can deliver slightly more than that with above-average third-quarter guidance, then the stock should see a rebound. What's more, Groupon will have gone part of the way toward demonstrating it may not be a scam and has long-term potential.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.