Groupon Inc (GRPN) 2013 Q1 法說會逐字稿

Good day, everyone. Welcome to Groupon's first quarter 2013 financial results conference call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the Company's formal remarks.

(Operator Instructions)

Today's conference call is being recorded. For opening remarks, I would now like to turn the call over to Senior Director of Investor Relations, Genny Konz. Please go ahead.

Hello, and welcome to our first quarter 2013 financial results conference call. On the call today are Eric Lefkofsky, Co-CEO; Kal Raman, COO; and Jason Child, CFO. Ted Leonsis, Co-CEO, will join us for part of the Q&A session. The following discussion and responses to your questions reflect Managements views as of today, May 8, 2013 only and will include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results is included in today's press release and our filings with the SEC including our Form 10-Q.

During this call we'll discuss certain non-GAAP financial measures. In our Press Release and our filings with the SEC, each of which is posted on our Investor Relations website, you'll find additional disclosures regarding non-GAAP measures including reconciliations of these measures with US GAAP. Finally, unless otherwise stated, all comparisons in this call will be against our results for the comparable period of 2012. Now I'll turn the call over to Eric.

Thanks, Genny. We're encouraged by our performance in the first quarter 2013. Gross billings growth of 4% year-over-year was driven by 23% growth in North America. Revenue growth of 8% was driven by 42% growth in North America and sequentially, operating income improved by $34 million in the past quarter. We're pleased by these results particularly when considering the tough prior year comparable when our European business was larger, but we have a lot more work to do especially in our international business. At times as an organization we spread ourselves too thin and fail to focus on the things that will have the greatest impact and at times, given the complexity and evolution of our business it's been difficult for you and others to gauge our progress. As we start a new chapter we intend to be more focused and endeavor to provide additional insight along the way.

Before I provide some color on our results, I'd like to take a giant step back to give you some more context at where we've been and where we're headed. I've been involved with Groupon since the very beginning. When Andrew and I couldn't find a business trying to change the world via collective social action, we decided to try and find one by saving people money via collective buying power. And in a flash, Groupon was born. Groupon invented the daily deal space and with it, a means of revolutionizing local commerce for consumers and merchants. By using the power of a deal, we found the tool that hundreds of thousands of merchants could relate to as a way of tapping into the internet and attracting customers.

From 2008 to 2011 we focused on expanding our geographic footprint and increasing our customer base. We grew from 1 city to over 1,000, from a few customers to over 41 million. As we began to push the limits of that expansion, we realized that the global brand we built could support far more than just local deals, so we decided to expand horizontally by adding new categories such as Getaways, our travel business, and Goods, our product business, as well as expanding our local category to include Live, our events business. We were pleased that our customers instantly fell in love with our new categories which grew from zero to about 40% of our business in less than two years. In 2012, we devoted lots of e-mail real estate to these new categories and they flourished and today, because of that, we have a business that is far more diversified than it was in 2011, but by Q4 of 2012, the overall mix shifted toward these new categories impacting our margin and operating income. In Q1 of 2013, that mix rebalanced as our local business experienced solid sequential growth both in terms of billings and take rate which contributed to our improved operating margins for the quarter.

We are a local Company. At our core our mission has always been the same, to bring the power of the internet to local commerce by offering our customers unbeatable deals that they discover when they are out and about. Every day we offer you something great to do, see, eat, or buy, and make it available at the best prices. Everything we do is with local in mind. Our Live business features local concerts and events. Our Getaways business features local hotels, and as we continue to expand our Goods business, we're mindful of our local roots. How can we tap into local inventory? Can our customers get same day delivery or go to a store nearby to try an item on before buying it? Can boutiques use the power of our platform to compete with mass merchants?

We think of local in a broad context. We think of it as a marketplace that has evolved by virtue of the fact that people are increasingly using mobile devices as a means of interacting with their local surroundings. A marketplace in which people travel around carrying the power of a desktop computer in their pocket giving them instant access to information which fosters discovery. And in this marketplace Groupon has inherent advantages. We're highly curated, we cover a wide array of local categories, we're geocentric in nature, buying and using a Groupon is both easy and instant, we're social in that people often use Groupons with friends and loved ones and our customers trust us.

You can use Groupon when you're out to do almost anything from making a spa appointment to buying a TV to replacing your mattress, to booking a hotel, to buying dinner and so on. As a result, our mobile business has skyrocketed from about 20% of our North American transactions two years ago to 45% in March. More than 40 million people worldwide have downloaded our mobile apps so far. Over 7 million downloaded them in Q1 alone, yet mobile is only one facet of our business that's evolving. We're also midstream in building a marketplace which we believe will fundamentally alter the way our consumers interact with Groupon. Just a few years ago, our business was predominantly driven by our daily deal e-mail. In the first quarter, less than 45% of our North American transactions came from e-mail. Mobile and search account for increasing percentages of our total business.

To understand the evolution of Groupon it's important to understand why. The answer lies in the mountain of hard work that was done before I officially joined the team 10 weeks ago. Through a combination of deal bank, our proprietary inventory system, and smart deals, our proprietary relevance engine, we've built the foundation of a marketplace we call Pull. Pull enables customers to search among thousands of categories in our top markets and find relevant deals that they can buy and use instantly. Type in Italian food in Chicago or deep tissue massage in New York or Yoga class in Austin and up pops relevant deals that you can pull-down and use instantly. No other Company has the combination of our breadth of local deals, our expansive customer base, and the necessary data to build a bridge between the two.

At the time of our IPO, we were featuring roughly 1,000 deals worldwide. At the end of the first quarter, we were featuring almost 40,000 in North America alone. As a result over 50% of our local transaction volume in North America comes not from new deals that we feature on any given day, but from our deal bank inventory. When we launched this effort our greatest concern was naturally whether merchants would be willing to participate. It's one thing to ask them to discount their services for one day to attract customers and quite another to ask them to do it every month. As a sign of support for Groupon the merchant community embraced the concept with open arms. In March over 60% of the merchant contracts we signed in North America were for this model. Imagine that.

Groupon's business has evolved across local, mobile, and our new Pull marketplace. As we've evolved, so too have the metrics that we rely to measure our progress. There are eight key metrics we're focused on right now. Four are non-financial, active deals, active customers, spend per customer and units and the other four are financial. Gross billings, gross profit, segment operating income, and free cash flow. One of our biggest challenges today in light of our growth in geographic diversity is to extend the operational advantages we enjoy in North America to all our global markets, an initiative we call One Playbook. As we unify our processes and technology globally, we'll rely on these eight metrics to further guide our efforts and gauge our success. I want to turn it over to Kal Raman, our COO, to talk more about some of the work going on in our international business and then Jason Child, our CFO, will offer more detail on our performance in Q1 and our expectations for the rest of 2013.

Thanks, Eric. As we have said we have a tale of two Groupons. My main focus has been on improving the operational efficiencies across our business globally. Our North American business has seen steady and strong top and bottom line growth while our international business has struggled. Q1 offers the perfect example with North America billings growth of 23% compared to a 9% decline in international and a segment operating margin of about 1% in North America compared to 4% in international. Why are they so different?

To put relevant deals in front of our customers and make Groupon work requires balancing lots of variables, deal density, weighted average price point, category mix, deal quantity, customer demographics, proximity, merchant quality, e-mail and website impressions, purchase flow, redemption, are a few things we need to care about. In North America, we have spent more time and devoted more resources to building the necessary infrastructure to do this efficiently for our customers, our merchants and for Groupon, but our international markets are still behind. Last year, we began a project called One Playbook, which when completed will create a single operating platform for Groupon worldwide. Our goal is to have our largest markets and all of EMEA on one platform by the end of this year.

Some might ask why is this taking so long? The reality is that while we are making strides towards a unification of our back office systems, our internal tool set is far more complicated than many realize. But the good news here is in Q1 of this year, in an effort to catch them up, we made solid progress on the following initiatives as part of One Playbook. Smart deals, our personalization algorithm which has now launched in the UK, Italy, Spain, France, the Netherlands and Brazil, and as a matter of fact we are beginning our rollout in Australia. As we increase the number of deals in our deal bank, the relevancy should raise over time which we believe will improve sales.

Our merchant facing return on investment calculator, we call it Coffee now has been deployed in all 48 countries so our merchants can now understand the return on investment of the deals they are running in a very crystal clear fashion. Through deal factory we are now standardizing the workflows and getting deals on the site faster and more accurately around the world. Ireland migrated to our North American instance in the first quarter and the United Kingdom and other big countries are on their way. Our lead management system is now in 36 countries allowing us to better manage which merchants to contact and when to contact them.

We have also developed a next generation lead management tool in North America called Quantum Lead, which we intend to deploy internationally in 2013. Deal Wizard, our capacity management system, is being deployed in the top European markets as we talk, allowing our reps to automatically estimate deal capacity. As we aim to further improve efficiency and productivity, we will continue to roll out these and other tools, both domestically and abroad. In addition to our platform work, we have made continued progress in elevating our customer and merchant satisfaction scores internationally, so while we are nowhere close to being done, we have certainly made great strides both domestically and abroad in improving our processes and becoming a more efficient global organization, which we call as One Playbook. Now, to discuss the results and our progress I'll turn the call over to Jason.

Thanks, Kal. As we work to provide additional financial details on our business, we've introduced quite a few new disclosures this quarter. In addition to metrics for our direct and third party businesses which shed light on the accounting implications of each, we are now also disclosing financial information for all of our categories for the first time. With the details available in this afternoon's press release, I'm going to run through the highlights of the quarter and then provide our outlook. Note that all comparisons, unless otherwise stated, refer to year-over-year growth.

In summary, gross billings increased by 4% to $1.4 billion. North America growth of 23% was offset in part by an international decline of 9%. Sequentially, gross billings declined by $113 million related entirely to $149 million decline in our Goods category due to the holiday season. This was offset by growth in local and travel. Revenue increased by 8% to $601 million. North America growth of 42% was offset by an 18% decline in International. Sequentially, growth in Local and Travel driven by increased billings as well as higher take rates was more than offset by the Goods decline. Gross profit decreased by 14% to $379 million. Sequentially, gross profit increased $23 million driven predominantly by a mix shift towards Local, particularly given the improved take rates.

Operating income, excluding stock based compensation and acquisition related costs, was $51 million, declining $16 million year-over-year, but improving $37 million quarter-over-quarter with both segments contributing to the increase. It's important to note that for International, Europe drove the sequential improvement and it contributed only a small portion to the year-over-year decline. International profitability continues to be impacted by investment in our emerging markets. Additionally, we're introducing adjusted EBITDA this quarter, a non-GAAP metric commonly viewed by both our peer group and the analyst community as a good proxy for measuring the financial health of a young technology Company. Adjusted EBITDA, defined as operating income excluding stock based compensation and acquisition related costs, further adjusted to exclude depreciation and amortization, was $72 million in the quarter, decreasing year-over-year by $7 million and improving sequentially by $42 million.

GAAP EPS was negative $0.01 and EPS, excluding stock compensation and acquisition related expenses, was positive $0.03. Both included a $6 million negative impact from foreign currency transaction losses. Trailing 12 month free cash flow calculated as trailing 12 month operating cash flow less CapEx and capitalized software was $95 million. For the quarter, free cash flow was negative $6 million due primarily to higher merchant payments related to the seasonally strong fourth quarter. The balance sheet reflects a $51 million reduction in accrued merchant payables quarter-over-quarter. Finally, as of March 31, we had $1.2 billion in cash and cash equivalents.

Turning to the four key non-financial metrics that Eric mentioned. Total units, defined as vouchers and products ordered before cancellations and refunds increased 4% year-over-year to 45 million units. North American units increased 37% and International units decreased 18%. Our net active customers increased in the quarter by about 700,000 to 41.7 million worldwide. Our North America active customer count was 18.2 million. For International it was 23.5 million. Trailing 12 month billings per average active customer was $138. Sequentially, customer spend declined coming off a seasonally strong quarter with North America flat and international declining $9. Active deals increased to nearly 40,000 in North America. Active deals include merchants that are featured in our Pull marketplace. As Eric mentioned, in March over 60% of all merchant contracts in North America opted to feature in our Pull marketplace with a monthly recurring deal which fueled the growth in our active deal count. Given the abundance of new disclosure that we provided for our categories, I'm now going to speak to the highlights.

Local gross billings, which is made up of Local and Live, declined 7% globally year-over-year to $830 million yet increased sequentially for the second quarter in a row by 4%. North America grew 5% both year-over-year and quarter-over-quarter. International decreased 19% year-over-year but increased 3% quarter-over-quarter. As we further roll out the North America playbook, we expect that International performance will improve. Local gross profit decreased 14% year-over-year to $281 million and increased 15% quarter-over-quarter. The sequential increase was due to a 350 basis point improvement in take rates, primarily in North America.

Goods gross billings increased 37% year-over-year to $392 million and decreased 28% quarter-over-quarter as expected due to the holiday season. About 90% of North America Goods billings are recorded on a gross revenue basis, which we refer to as direct, as compared to International where the inverse is true with only 6% of billings recorded direct. As we build out our global supply chain infrastructure, you should expect the mix of direct to increase. Goods gross profit decreased 18% year-over-year to $59 million and decreased 25% quarter-over-quarter due to seasonality. Recall that our presentation of gross profit includes direct costs such as inventory, shipping and warehousing, as well as certain allocated expenses like credit card processing fees and editorial costs that some eCommerce companies classify below the line in SG&A. Because of the relatively high mix of direct revenue, it's helpful to look at Goods gross profit as a percentage of Goods gross billings.

On this basis gross margins were 15% globally, 8% North America and 21% in International. The North America number reflects a higher mix of direct which includes significant shipping, warehousing and other expenses. We expect that margins will improve over time as we begin to scale our shipping and infrastructure costs. When you step back and lack at our pure product margin in Goods in North America, which is defined as sales price less the price we pay our direct suppliers, it was in the low 30%s. This gives you the sense of the healthy margins that our categories can produce, which is one of the reasons we have devoted so much time and energy to expanding them in the past year.

Travel and Other gross billings increased 7% year-over-year to $186 million and increased 3% quarter-over-quarter. In both cases, the growth was driven entirely by increases in North America. Gross profit for Travel and Other decreased 9% year-over-year to $39 million and increased 15% quarter-over-quarter.

Before I provide our outlook I'm going to spend a moment on marketing. Marketing expense for the first quarter was $50 million or 8% of revenues. It's important to keep in mind that we spend marketing dollars in a variety of ways, not all of which hit the marketing expense line item on the P&L. For example, order discounts, free shipping, and take rate reductions assist in our overall marketing efforts yet are recorded as either contra revenue or cost of revenue.

Finally turning to our outlook. We've decided to make incremental investments in the second quarter of approximately $15 million to $30 million between customer incentives and increased marketing spend, which will have a negative impact on both revenue and operating income in Q2 but we believe will benefit us in future periods. As such, for the second quarter of 2013, we expect revenue of between $575 million and $625 million and operating income, excluding stock based compensation and acquisition related expenses, of between $20 million and $40 million. We estimate that stock compensation will be approximately $30 million for Q2 and taxes will be approximately $25 million. For the full year, we reaffirm our guidance that the full year 2013 GAAP operating income will exceed $100 million. As always our results are inherently unpredictable and our actual results may vary materially from guidance. With that, I'll turn the call back to Eric.

Thanks, Jason. It's hard to believe that Groupon is only four years old. We're still a toddler despite our size and scale. What's even harder to believe is that the International business is younger still, just a baby by comparison, without a lot of the infrastructure enhancements that have driven sustained performance in North America. With time, we're confident we'll be able to get them on the same path.

In 2009, our first full year as Groupon, we did just $34 million in gross billings. Last year, that number was $5.4 billion. With unprecedented growth comes unprecedented volatility and Groupon has certainly produced its fair share. At times the focus on our growing pains has overshadowed our achievements. We've built a world class brand that is trusted by over 41 million customers worldwide. We've sold about 400 million Groupons in four years. We've expanded into new categories like Goods, Getaways and Live. We've developed a thriving mobile business that now accounts for nearly half our North American transactions. We've launched payments in POS platforms that serve as the base for a broader operating system for local commerce. We've laid the foundation for our new Pull marketplace that has the potential to fundamentally change how consumers interact with Groupon. And one of our proudest achievements, the economic boost we provided to local merchants. Not only have we funneled billions of dollars into our local merchant community, but based on surveys of nearly 2 million Groupon customers in North America, over 80% of the customers we send to merchants are either new or have not been to that merchant in the prior three months. Groupon can be a powerful force of new customer acquisition and financial returns for small businesses.

With Andrew's vision, Groupon created an entirely new category for local commerce and today, we believe we are better positioned than anyone to redefine one of the last great white spaces on the internet by plugging local commerce into the web. It feels good to once again be able to make the investments necessary to further our long term mission, which we'll do in Q2 by increasing our marketing initiatives to drive future growth. The opportunity in front of us is vast. There are 60 million local merchants in the world and despite our size, we still only do business with about 1% of them. We have the people, the strategy and the rare opportunity to define a space that is emerging before our very eyes. I want to thank my Co-CEO and Vice Chairman, Ted Leonsis, who serves as an invaluable resource and a source of great wisdom to everyone at Groupon. Having just completed my first quarter in this role, I'm energized by what I see and honored and privileged to join Ted and the rest of the Senior Management Team on this part of Groupon's journey. And with that, let's take some questions.

Thank you.

(Operator Instructions)

Ross Sandler from Deutsche Bank.

Great guys. I had two questions and first off thank you for the new segment disclosure, very helpful. The first question is on International, second one is on the take rate trend. So on the International segment, Jason can you give us some color on the decline you're seeing for International Local billings. Are we at a stabilization point for that segment or do you see more downside from these levels? And then the International segment margin increased sequentially in Q1. Do you feel like you've turned the corner on margins in that segment? Is that a function of the increased take rate or is it the automation stuff and then I have one follow-up on the take rates.

Ross, I hope you don't mind if I answer the question. Thanks for asking the question. As you mentioned our operating margin improved by 500 basis points in International segment, which is predominantly driven by the continued acceleration of our Local business for the second quarter in a row, and also are driven by the increased take rate of 300 basis points in International Q over Q. The beauty of our International is as we roll out our One Playbook, it kind of reinforces the fact that the merchants love Groupon. Our active deals are going up, merchant satisfaction score is going up, and the number of merchants who want to do business with us is increasing. Our retention rate is increasing. Those are all the input variables we look at, and they are all in the right direction. But our take rate, the long term variance we have given which is the 30% to 40% we are going to maintain it, but we are going to flex it in such a way that we can continue to attract and retain as many merchants as possible to give greater deals to our customers.

Okay, great. And then on the take rate topic, it looks like take rates are up sequentially in almost every category, so do you think that this is a result of your scale starting to come through or has the competitive intensity in the market been reduced enough to where you think you can sustainably increase take rates and still grow billings? Any color there would be helpful. Thank you.

Ross, we rarely talk about competitors. We focus on controlling the controllables and we focus on our consumer experience and merchant experience and you know in most of the International countries we are number one or number two in market segment share. We invested lots of money in building these 48 countries and we are proud of our investment, proud of the Management team we have built and proud of our market leadership position. And as we continue to execute on our One Playbook, which we have recently started, which I discussed on the call a few minutes back, that is playing a humongous role in improving our efficiencies and improving our ability to pass the savings back to the customers and our ability to attract high quality merchants and retain them on the platform. So this is just not even day one, it's hour one of day one in revolutionizing the local commerce; we still have a long way to go. We are very happy with the progress we have made but we also know very clearly that we have a long way to go.

Great, thanks guys. Nice job this quarter.

Thank you.

Mark Mahaney from RBC.

Great, thanks. I'll ask two questions. One just some updated comments on the CEO search, Eric you did a nice job on the earnings call. Any interest in sticking around and doing that operational role? And then secondly, on the mobile usage, what can you tell about those customers? Are those more likely to be new to Groupon or are they more likely to be people who have already used Groupon in the past as desktop customers, so what you're seeing with mobile usage is just an expanding of spend per active customer? Or is it a draw of new customers or is it a mix of both? Thanks.

Thanks, so if you don't mind I'll actually take the second part first which is the mobile piece and then maybe let Ted weigh in on the CEO search. In terms of mobile, we are thrilled that our mobile business has grown the way it's grown over the past certainly several years and several quarters, it's accelerated. We had 5 million downloads in Q4 and it increased to 7 million downloads in Q1 of 2013. We're now at a point where 45% of our North American transactions are mobile and to us this is part of a very cohesive strategy to try to grow our mobile business, which really serves as a foundation of a larger marketplace opportunity we call Pull.

We see a fundamental consumer shift of consumers who aren't used to being pushed deals every day that hopefully will start more and more to come to Groupon and pull-down deals that they find when they are out and about. And so a cornerstone of this is the fact that you're now carrying the power of a PC in your pocket which is the Smartphone and the adoption curves happen to be fantastic. And so Groupon is ideally situated to I think take advantage of that. And we've also seen that our mobile customers are more active, healthier and they buy more, on average more than 50% more, so this too is a good trend. So you should continue to see us make significant investments in mobile to gain more and more adoption. And we're chartering, we're kind of going in unchartered territory, as we become I think the first Company of scale that will one day be predominantly mobile, that's an exciting new space to be in. In terms of the CEO stuff maybe Ted do you want to weigh in for a moment?

Sure, Eric. Well the search is under way. The Board's formed a committee and we have started the process. The business is complex and we're learning a lot so we don't expect this to be a simple search. The good news is we're not in a hurry, the leadership team is very strong and is gelling very nicely and that's afforded us some flexibility to take our time to find the ideal long term CEO.

Thanks, Ted. Thanks, Eric.

Gene Munster from Piper Jaffrey.

Good afternoon. Is there engagement numbers that you can share, whether it's either on the user side, you talked about the total number of active customers for the engagement as far as the probability that they are repeat customers? You also mentioned the retention rate amongst merchants is going up. Is there any specific trends that the second quarter role that's gone up and any other numbers around that and then a follow-up question.

So let's break that down. So the first question I think the first part was how our customer cohorts holding up and the second part was how are merchant cohorts holding up so maybe I'll take the first part customers and let Kal weigh in on the second. The customer cohorts have been fairly stable. If you look at for example, North America on a quarterly basis over the past four quarters, I think the spend has been $37 in Q2 of last year, and then $36 and then it spiked to $43 in Q4 last year. But that was predominantly due to the holiday season. And then it's at $39. So the long term trend netting out the holiday season is very strong and you actually see a pretty good trend Internationally. We had the big dip from Q1 to Q2 of last year when the business declined in EMEA but its been pretty stable from that point on. It was $33 I think in Q2 of last year and then $29 and then it spiked again to $34 in Q4 also based on the holiday season and it's back at $31. But the good news is that the trends are pretty stable.

And again I think what's important to note is our business today, even though we're highly correlated to mobile, it's still largely a push business where we're either pushing push notifications or we're sending out e-mails and we're sending them in the morning and saying, hey, would you care to buy some pizza or a sky diving deal or go to the spa at 7.00 in the morning. And its been a compelling business but the opportunity to reach people not at 7.00 in the morning when they don't want dinner but at 7.00 at night when they do want dinner, it just opens up a whole new pool of demand, so we're very focused on that. The good news is that our customer cohorts are stable and I think the other good news is that there's huge headway.

Let me take the question on the merchant side. The Pull inventory we call it G2, the adoption of that in March was like 60% of our merchants are putting their inventory to be perpetually available at least for a year or more on Groupon, which is a great progress we have made. And the reason they do this, 80% of the customers we send to every single merchant answered our survey, they are either new to that establishment or they haven't visited the establishment in the last 90 days. So Groupon has proven to be good to our merchants in attracting new customers, not just one-time, month after month after month. And that's already demonstrated in the adoption we are getting, people putting their inventory available all the time. And to combine with that, our ability to retain merchants of greater than 50% and that is the merchants we want to retain. If we really let everybody come with this that number would be a lot higher. We need to care about the deal mix and deal quality so we need to make sure that we get the right merchants retained, and overall the deal count is going up across the globe. So is our merchant satisfaction, which has made tremendous progress both in the US and International.

That's helpful. Thanks for that clarity and just a follow-up to a previous question in terms of the take rate. You'd mentioned the word flex in there. Just want to be clear, is it should we expect some sort of variation in take rate quarter-to-quarter going forward so that it can go down and up or is there going to be more of a linear trend up? Thanks.

So we have given a long term range of 30% to 40% of take rate in Local business. We would definitely be in the range and our take rate flexing, we will predominantly do it just to attract extremely high quality merchants on to our platform. You need to remember our core value proposition is curated deals which are going to be surprising to our customers. But we are also focused on making sure that that is return on investment positive for our merchant partners and that is the only reason we will flex take rates. The take rate range we have given, we are sticking to it. As you saw in the last quarter, we are not only able to increase the take rate globally, we are able to attract more merchants, we are able to retain more merchants, and activate the Local business.

Great, thank you.

Heath Terry from Goldman Sachs. Mr. Terry, your line is open. Please check your mute button. He may have stepped away from his phone. We'll move on. Jordan Rohan from Stifel Nicolaus.

Hi guys. Thanks, it's Nat Brogadir in for Jordan. Just two quick ones if I may. First on the third party, I'm sorry on the first party Groupon Goods, you know North America down 30% sequentially, how much of that is seasonality, do you expect it to pick up? And then secondly, incremental margins have been coming down now inflecting negative in first quarter. How does Groupon plan on adding businesses that have positive incremental margins going forward? What mix needs to happen? Thanks.

Hi, so this is Jason. I'll take the question. So in terms of margins in the Goods business, the way, because you have the mixture of third party which is recorded on a gross basis, I'm sorry, net basis, and revenue on a net revenue recognition basis and then direct to course on a gross, we look at it as a percentage of gross billings, which is the best way to kind of show apples-for-apples. In looking at it in that way, you do see a little bit of movement, which is typically due to product mix, between quarters, especially between Q4 and Q1. However if you look at the overall margins you'll see that the US, which has a very high ratio of direct has a much lower margin, which is down in the 7% to 8% range in total and actually the direct business about 7%. And as I mentioned in the prepared remarks if you want to think about a take rate for the Goods business, it's really what we call pure product margin, which is just the direct cost of the item so we have very healthy take rates in Goods at about 33%, for example, in North America.

Now because we have not really spent a lot of time and really have such a young Goods business, our fulfillment and shipping and infrastructure costs are very high. They are all outsourced and even then the volume has risen quickly. And so you should assume that there just hasn't been a lot of negotiation on using kind of some of the leverage that we should be able to get with that volume. So as a result we're paying significantly more than you'll see anyone else pay. For example, a typical eCommerce company will have usually around a 15% to 25% point, 25 percentage points spread between their pure product margin and their operating margin, and for us, it's obviously quite a bit larger than that. So with I think we're kind of increased focus on shipping costs you'll see those margins improve over time, but I want to make sure it's clear. We're going to continue to optimize for growth since it's such a young business, not even two years old and over time you will see margins improve.

Justin Post from Bank of America Merrill Lynch.

Great, thank you. Over the last many quarters you've been really able to cut your marketing spend. Are you seeing efficiencies there? And any plans to kind of move that forward to start reinvigorating the customer growth? And then when you look at International billings per customer, it looks like it's come down but maybe the rate of decline is a little bit lower. Do you think you can start to see that stabilize and start to grow again and what will it take? Thank you.

Okay, so on -- this is Jason. On the marketing side, let me just cover that. So marketing is down as a percentage of revenue to about 8% in the quarter. However as I mentioned in the prepared remarks we do look at other aspects that we think of as similar to ways to grow customer engagement and overall new customers, which is not recorded in the marketing expense line. So for example, order discounts which would be activation deals, ways to get a customer to make their first purchase or free shipping, which in the Groupon Goods business of course is a significant driver as well. If you were to add those two items and assume they were a marketing cost, it would actually take the percentage of revenue, the total cost as a percentage of revenue up over 400 basis points incremental. So it would take it from about 8% up to about 12% to 13% and so that's still below the long term target that we've given of 20% on a third party basis, or 8% on a direct basis, but certainly closer to those targets. In terms of the specific investments in Q2 that I mentioned in guidance, so $15 million to $30 million of incremental investment to drive new customer growth and overall customer engagement, we'll be doing that through a variety of mechanisms, and at this point we're not ready to say what's going to be marketing versus contra revenue or cost of revenue.

And in terms of the customer stability you mentioned on the International side, we saw a pretty big decline between Q1 of last year and Q2 when we both reduced our marketing spend and also had some of the issues in EMEA where the business shrunk quarter-over-quarter. But its been relatively stable from that point on, especially when you look at the Local business. And as I mentioned earlier if you look at the quarter-over-quarter spend detail, I think it was $33 in Q2 to $29 to $34 to $31 so it's really held up pretty well.

Great, thank you.

Heath Terry from Goldman Sachs.

Great, thanks. Apologies, technical difficulties there. I was hoping you could walk us through a little bit more detail on the free cash flow shift this quarter. Obviously we saw merchant payables come up. To what extent is that sort of part of the underlying strategy and improving merchant relationships? And Jason, if you could sort of give us an idea of where you expect the general free cash flow trend in the business to be over the next few quarters.

Thanks, Heath. So overall in the quarter, the actual merchant payable was actually down about $50 million quarter-over-quarter and so you saw cash flow negative. However if you just take cash minus accrued merchant payable you would actually see that net cash would be up about $7 million or so quarter-on-quarter. And the reason why you saw merchant payables come down quarter-on-quarter is because we were paying all the vendor kind of payables related to the seasonally strong Groupon Goods business in Q4. And so you're basically starting to see a trend that looks more like a typical eCommerce company where you have strong cash flow in Q4 and then you'll effectively have a lower cash flow in Q1 because of the timing difference.

Now, I think in terms of overall AP days you'd actually see that AP days were very consistent they're actually up very slightly from the last quarter. It used to be a year ago that we had a big difference between the US and International, and in the last year you've seen International come down and the US go up a little bit and now we're between 50 and 60 between the two segments. And we think that's a good place to be. So while you seen, you'll see some -- you've seen cash flow come down a little bit over the last couple quarters because of the working capital pieces, we feel like it's in a pretty good range now and going forward. In the long term I would encourage you to look at CSOI as really the number that will approximate what cash flow is going forward.

Great, thanks and Kal, if you could give us a sense, behind the operating system strategy what you see sort of being the key product component issue -- areas that you plan on investing in. It would be great if you could sort of rank order payments, fulfillment, the areas that you sort of see being the main focus behind this operating system strategy.

Yes, so if you look at our core business about curating the deals and then in a scientific way targeting the right merchant in a very systematic way, determining the deal structure because pricing is nothing but a statistical equation of supply and demand, and then sending the right deal to the right customer so you look at them in terms of two big areas. One is the tools related to supply, everything from quantum lead to sales workbench to Coffee to deal wizard. As I said in the recorded script you listened to a few minutes back, we are making significant progress in International, as a matter of fact between now and the second half of the year we would have all these tools rolled out in the majority of all International countries this year. And that will give us leverage in deal productivity, deal quality, and cost efficiencies.

And on the demand side, the most important thing is smart deals. Smart deals is our proprietary IP we are building targeting the right deals to the right customer at the right time of the day. We are rolling this out to all of the major countries like UK, France, Italy, Spain, Netherlands and we are in the process of rolling it out in Brazil and Australia. We are making phenomenal progress, that team is doing a fabulous job. We are lucky to have the team and they are so dedicated and focused. So we will make significant progress on that this year too, and those are the core business areas that I'm focused on. When it comes to the local operating system, which is related to payments and point of sale, I will ask Eric to give you an update on that.

Yes, so we began -- as you know we began making some investments about a year ago into what we call the operating system for local commerce, and essentially it's a bundle of investments around point of sale systems, payment systems, loyalty and reward systems. And all of which we view is kind of critical to the long term mission of making it seamless for our customers to come in and be able to redeem their Groupons and interact with the merchant and have that entire process be frictionless. We also, because we are for many merchants, hundreds of thousands of merchants, their largest source of new customers, we also at times can be a pain point in that we're sending all these customers and we want to help merchants manage that process and we want to help them determine how best to target these customers so that they come back on a repeated basis. So we realized that we needed tools inside the merchants' shop to help them do that and hence the investments we've made. These are longer term investments. I think you shouldn't expect them to have an impact on our performance next quarter, but these are still things we very much believe in and we think long term they will be great businesses for us. And they are all on track, all doing well.

Sounds great, thanks guys.

Brian Pitz from Jefferies.

Thanks. I may have missed this but what were the drivers behind the Q1 18% decline in International unit growth? And just a follow-up on your payments comment. Any specific merchant feedback so far in terms of using the product, enhancements you might be thinking about going forward, et cetera? Any commentary or additional color? Thanks.

Well let me take the first question. The 18% decline is driven by tough comps we had from last year. Last Q1 was the highest point of our European business in our very short operating history, so we have tough comps to start with. And also you need to remember, the Goods business, which is seasonal, from Q4 to Q1 had degradation in units, but the thing which is very encouraging for us is the acceleration of our Local business in International, which is now happening for the second quarter in a row, I know two quarters is not a trend but it is a good beginning of a trend.

So I am focused on controlling the controllables, which is all of our input variables, of getting high quality merchants, retain them, great deal structures, continue to accrue more customers, and provide them with great deals, provide great customer service which could be measured in output variables like merchant satisfaction and customer satisfaction scores, deal count, and merchant retention and customer retention. Which will all be done through the One Playbook implementation and we are making progress. Like I told in the script as well as in one of the questions I answered, we are in the right direction, but we still have a long way to go, but we are very positive and upbeat with the progress we have made so far. The second part of the question, I will let Eric answer that on payments.

Can you just repeat the question because we got kind of a muffled at the end.

Yes, sorry. Just in terms of merchant feedback in terms of using the product, any enhancements, people requesting, just general thoughts or commentary on the payments product.

Yes, I mean, I would say the feedback has been quite positive. I mean I would encourage you to actually try the product. It's pretty remarkable how good our payments product is. And there's actually some new enhancements coming out this month that I think we even make it stronger, but it's a great product. And we have a very interesting strategic foothold in that as I mentioned a second ago, we are such a large source of revenue for so many merchants and so we could be able to offer them a payments product and help them save money and help them improve their operations is just a great position to be in, especially when we're -- we have one of the lowest rates in the market and one of the best technology sets So I'd say try the product and you'll have a great view of them.

Great, thanks.

Arvind Bhatia from Sterne, Agee.

Yes, thanks for taking the question. Congratulations on the quarter. I wanted to see if I could ask two quick ones. One, as we think about Groupon say two to three years out and we imagine your International business at that point is running well, profitable, where do you think the Company's EBITDA margins can be or EBIT margins can be two to three years out? And then my second question is more near term. We've talked a lot about the International trends and you've put some good numbers in the profitability side Internationally. Should we think of the first quarter margin Internationally as sort of the trough, with some improvements throughout the year, or is that going to fluctuate as well?

I'll go ahead and I'll take the first question. So on the long term targets, you said two to three years out, unfortunately I'm not going to answer your question as to what two or three years will be. I will tell you that our long term targets are for the third party business to be at roughly 25% to 30%, CSOI margin, so that would actually be a little lower than adjusted EBITDA, which of course excludes depreciation and amortization in addition to stock based compensation and amortization related expenses. And the third party, I'm sorry the first party or direct business has a long term margin assumption of high single digits. And keep in mind on third party when I say 25% to 30%, that's on -- if you were to convert that to a billings basis to make it apples-to-apples to the Goods business or the direct business, it would be somewhere in the 8% to 12% range. So overall, we're certainly, in North America we're progressing towards that target where we're actually at about a 13% or 12.7% margin in the most recent quarter. International, we're a ways away because of the investments that we're making, certainly in One Playbook, and also just the investments we're making in growth. But those are our long term targets but again I can't time down those to be two to three years at this time.

Yes, on the second question, I'd just like to add a statement here. So as I said in the script, our operating margin for North America is around 12% this quarter compared to 4% in International. As we continue to roll out One Playbook, as we continue to work on delighting our customers and making the relationship profitable, and furnishing our merchant partners, the operating margin in long term in International should be very much like the United States. Because it is the same business, same playbook, same customers, because it doesn't matter where you live, customers want great deals at great prices and merchants want them in profitably.

Great. That's very helpful, thank you.

Thank you. That concludes our question-and-answer session for today. We thank you for your participation and you may now disconnect.