Though some believe that we may be in a secular shift away from “old tech,” this is a sector that I’m getting more and more conviction around. If you, too, are a patient, long-term oriented investor, the risk reward may be interesting for you as well. In fact, we may not have to wait long before the market shifts its views.

Full Disclosure: Author is long shares of MSFT and AAPL at the time of writing

Full Disclosure: Author long shares of TOT and LINE at the time of writing

Valuation

Let’s start by throw out the Twitter and Facebook valuation comparisons. Facebook recently reached valuations between $33 billion and $50 billion on Second Market. Various online sources appear to pin Facebook’s revenues anywhere from $1.2 billion to $2.0 billion in 2010. The Company only became cash flow positive in Q2 2009. Even by the loftiest of expectations, Facebook is trading between 16x and 25x revenue likely near 100x cash flow earnings. Twitter did not announce a monetization strategy until April of this year and was projecting just $140 million in 2010 revenue in 2009. If they hit their projection, this would equate to 28x revenue. But, let’s be honest, Groupon is a vastly different business than Facebook and Twitter so let’s literally “throw out” these valuations (for now).

To me, Groupon is best compared to an internet retailer. By way of precedent transaction, Zappos was purchased for $1.2 billion by Amazon in 2009 which was essentially a 1.2x revenue multiple. However, Zappos was well known to run razor thin margins, rumored to be well in the single-digits. If this is true, then Zappos likely changed hands at well over a 30x EV/EBITDA multiple.

Comparing to larger, more mature e-tailers, Amazon trades at 2.6x revenue and 39.7x EV/EBITDA. EBay trades at 4.2x revenue and 11.8x EV/EBITDA.* The disparity in these metrics likely lies in the fact that E-Bay runs high-teens operating margins and Amazon runs low-single digit margins, but Amazon has been growing revenues at over 30% year-over-year while E-Bay has seemingly hit a growth wall over the last few years.

So, what does this all mean to Groupon? Consensus seems to be that Groupon will have sales around $500 million this year. However, it has grown dramatically month-over-month and could be selling at a run-rate in excess of an annualized $600 million in gross sales. Assuming Groupon typically takes 50% of gross sales as its cut and then must pay overhead. Groupon’s overhead cost structure is likely to be significantly better than that of most tech companies with less of demand for hardware and most of its costs in personnel as the site doesn’t have to do any more than handle requests one deal at a time (no videos, photos, messages, etc.). It’s not hard to imagine that Groupon’s EBITDA margins are closer to that of an EBay, and possibly better. Let’s assume they are 25%. Additionally, relative to the tech startups and tech-heavy retailers I’ve described above, Groupon’s business model is likely working capital negative and lower capital intensity which would mean that Groupon’s EBITDA quality (as a proxy for cash flow) is likely higher than the others above.

Given these qualities of the Groupon business, it would seem fair that Groupon would deserve an EV/EBITDA valuation at the high end of the range for retailers. Groupon is a younger company than Amazon, but has a business model which is fundamentally more limited, so I’ll split the difference and apply the exact same multiple (39.7x). So, how much is Groupon worth? $600 million x 25% x 39.7 = $6.0 billion. Well, suddenly I feel a little better about Google’s valuation. Do you?

* I acknowledge that I’ve mixed enterprise value and equity value metrics, but Groupon is likely a debt-free startup, I’m taking the liberty of assuming enterprise value and equity value are close.

Considerations/Risks to the Valuation

Clearly, Google is paying a full price. Moreover, depending on which metric drive’s Google’s public valuation, this deal may prove to not be value accretive. Google is currently trading at 6.5x revenue but just 13.0x EV/EBITDA. Accretion/dilution aside, on a standalone basis, I wouldn’t call Amazon’s stock cheap and Groupon has some obvious limitations to its appeal and value proposition which could limit its trajectory.

Additionally, the above analysis is clearly based on some aggressive assumptions. Even assuming that some of them are accurate today, there are serious questions about whether Groupon can sustain high-levels of profitability given increasing competition and some criticisms by partners over the sustainability of offering 75%-90% discounts.

All this said, Google is not buying Groupon as a standalone business and a significant case could be made for valuation upside due to Groupon’s strategic value. Ostensibly, Google believes that it can integrate Groupon as part of a broader customer experience platform and enable various other parts of its service offering – particularly in local advertising. If this is true, could it be possible that Groupon can create value within Google more similar to the  stratospheric valuations that Facebook and Twitter and other “true web” startups garner?

Full disclosure: Author is long shares of GOOG at the time of writing.

Johnson & Johnson shareholders can breathe a sigh of relief as the author of this article comes to the conclusion that very little of JNJ’s cash flow comes from “questionable sources.” In fact, the author claims just 0.9% of JNJ’s cash flow is questionable. The author describes questionable cash flow as “changes in taxes payable, tax benefits from stock options, and asset sales, among others.” I can’t disagree with this definition as manipulating tax accounts and one-time asset sales are clearly not longterm sustainable sources of cash. That being said, from the perspective of trying to understand JNJ’s cash flow which I would assume is more geared towards understanding how secure its dividend is, I don’t think that these cash flow accounts tell the whole story. Changes in working capital accounts – accounts receivable, inventories, and payables – can be significant sources or uses of cash in any given year. Shrewd management of these accounts is a testament to the operational competence of a company’s management team. Depending on working capital benefits for cash flow, however, is not a particularly good way to support a dividend.

So, what metric would I use to determine “good cash flow”? That is, sustainable cash flow generation abilities of a business? It sounds like finance hocus pocus and is often ridiculed by journalists looking to lambaste people in the finance industry, but EBITDA is a very powerful analytical concept. (More on this to come)

In the mean time, if you’d like to learn more about working capital accounts and why cash flow and earnings do not always intersect, please check out my former posts on the topic:

• Working capital – an important metric during a recession
• Cash conversion cycle case studies

Full Disclosure: Author is long shares of JNJ at the time of writing