Issue XXIV - Groupon

Dear Readers,

The increased scrutiny that Groupon has faced recently is not limited to debate over what the company is worth. Other major challenges lie ahead for Groupon as it prepares for its IPO this year (no, the Tibet-themed Super Bowl ad is not one of them, although I must admit I liked the commercial but can see how others could view it as being in bad taste). First, it is debatable whether its business model is beneficial for its customers, particularly the small businesses. Second, Groupon is facing challenges from LivingSocial, Google and a host of other deal-of-the-day websites. In such an environment, will Groupon be able to effectively evolve as a business and maintain its competitive advantage? These challenges and how the company handles them will ultimately determine its long-term course. While it may not be the next Google or Facebook, decisions made today and in the near future will go a long way toward Groupon remaining a viable internet business that provides a crucial discount retail service.

First, a brief overview of Groupon’s business model might be helpful. The customer/merchant either contacts a Groupon sales associate or is solicited by one. The sales associate and Groupon then structure an offer. For example, a product that would normally cost $20 for $10; a 50% off deal that is sure to increase traffic on the day(s) the deal is offered. Then the merchant is featured on the website, and a cap is placed on the number of these deals that can be sold (the merchant can opt for packages ranging in number from about a dozen to many thousands). As these deals are sold on the website for $10, Groupon takes 50% of the revenue generated, in this case $5. The merchant then gets a $5 x 500 coupon redemption to be paid out over 90 days. A 500-coupon package at this price (assuming that the merchant could potentially be selling 500 items for $20 and adding in Groupon’s cut) will cost the merchant $7500. Compared to traditional methods of promotion via discounts, such as print ads or television, this is expensive, especially for small businesses.
In an economy like the present, Groupon is a haven for consumers who are looking for deals, not necessarily a merchant whom they can go back to on a regular basis. Thus, the subscribers that Groupon connects to the merchants inherently have a smaller chance of re-patronizing the businesses that are featured. For the merchant, it is up to them to entice the consumers to come back at full price, a task much easier said than done. Of course, some might come back, but coupon-clippers are a notoriously frugal demographic (just ask any seasoned consultant who is worth his or her billable hour). In this respect, Groupon is a beneficiary of fortuitous timing, launching at a time (late 2008) when even upper-middle class individuals began penny pinching and looking for deals. However, that doesn’t mean the situation is a win-win for all merchants.

The issue is not that a sizable percentage of merchants lose money on these deals (and close to 33% do, according to a 2010 Rice University study). A merchant who offers a Groupon deal, or for that matter any discount situation with the expectation to make a lot of money, is either naïve or missing the point of a deep discount. Discounts of any kind form the classic economic concept of a loss leader, intended to facilitate a sale that otherwise might not take place. The intention is not to make money, but to bring in new customers who otherwise would not have patronized that business. That said, many merchants are not only losing money on the deals, but are complaining that it didn’t result in a sustainable uptick in business. This is amplified within sectors where consumers have many choices as well as in sectors that are lower-margin businesses by nature. For example, there many deals for personal care services being offered among the deal-of-the-day websites. Many consumers in a big city will go across town for 50% off an expensive spa treatment or other such deal but would never be willing to pay full price (especially if doing so means going back across town). Of course, some do, but that is the exception. For smaller deals, i.e. 50% off a $20 men’s haircut, not as many are interested.

Even less interested are the merchants who shell out a bunch of half-price services and then don’t reap the benefits of repeat business. In the case of many small businesses, they usually are not using Groupon to clear out inventory. They are attempting to offer a discount, utilizing the marketing power of social media, to create awareness of their business. When that awareness doesn’t translate to higher profits and/or retained customers, they aren’t satisfied.
The aforementioned Rice University study surveyed 150 random businesses that ran Groupon deals between June 2009 and August 2010. Of those businesses, 42% said they would not offer another Groupon-type promotion again. The most commonly cited reason was that the customers were “extremely price sensitive, barely spending beyond a discounted product’s face value.” Repeat-purchase rates were found to be around 13%. It should be noted that spending beyond the coupon’s value was markedly higher in a few sectors, particularly restaurants, underscoring the fact that Groupon is more effective for certain business segments than others.

The study’s findings are consistent with decades of academic and corporate research that have found that price promotions do not produce many long-term benefits for businesses. Even worse, when promotions are repeated on a regular basis they chip away at brand value over time, and lead to customers who aren’t willing to buy without a deal. One of the first and most famous examples of these findings occurred back in the 1980s, when Sears had a revelation regarding discounts for its vaunted Craftsman tool line. Sears found that buyers of the tools waited for the weekly sale flyer, and then, would only buy what was on sale. If what they needed wasn’t on sale, then they would wait until it was before buying it. Effectively, Sears found that it was teaching its customers to wait for the sale. Businesses that run Groupon deals are faced with the same dilemma. Assuming the study is correct, even if all of the coupon users become repeat customers, only 13% would on their own volition and pay full price, while the rest would only be returning because they received yet another discount incentive. Over time, this effectively lowers the price for everything at a loss to the retailers.

Many of those who have defended Groupon in the business press and in the blogosphere tout the incredible amount of publicity that a merchant can get, especially a small business. That is definitely true. When selling deals, Groupon salesmen walk into various stores armed with spreadsheets containing hard numbers of the exposure that a business can expect to receive. But, as stated earlier, the fact is that this exposure is to consumers who are looking for deals, a group that is already preconditioned to not be willing to pay full value.

Groupon, LivingSocial and the other websites that have popped up since 2007 deserve credit for advancing yet another retail sector into the digital age: coupons. Realizing that discounts are just as effective, if not more effective, when distributed via the internet as opposed to newspaper clip-outs or television, many have jumped at the opportunity to provide merchants with such services. With more and more offers available as the sector has proliferated, the market can only get saturated more quickly, i.e. the number of viable, small-to-midsize merchants that are willing to run promotions can only be exhausted at an accelerated pace. But that is not to say that there will not be interested merchants. After all, over 60% of the merchants featured in the study made money off of their Groupon deal (other academic studies on Groupon will be published in the coming months; as of now the Rice study is the only empirical study available). The point is that it works for some merchants, and doesn’t seem to work for others. Eventually, the website’s customers could primarily be small and midsize businesses that find the promotions to be effective as well as large businesses. Indeed, deal-of-the-day websites are already increasingly offering deals from larger merchants, and are finding these deals to be very profitable.

Recent developments within the sector indicate that the momentum is shifting from small businesses to larger retailers. Some of the largest retailers in the country are now working with the deal-of-the-day websites. This trend first came to the forefront back last summer with Groupon’s August 20 deal with Gap (pay $25 and buy $50 of merchandise, nearly 500,000 of these deals were sold), and more recently, LivingSocial set sales records by offering gift cards worth $20 of goods at their partner Amazon.com for $10 (over 1,000,000 of these deals were sold in a 24-hour period).

Working with larger retailers may be where the sector’s ultimate destiny may lie. Small businesses will always be looking for exposure, but the fact is that larger companies have a greater wherewithal to absorb a few of these one-day discount deals once in awhile. Furthermore, although financials are not disclosed, I have a hard time believing that Groupon would take 50% from deal with such a large customer, as a large profit is virtually ensured even with lower margins. Within the small business sector, many of the upstart deal-of-the-day websites are charging less than the 50% that Groupon typically takes (LivingSocial is one of these), and thus the margins in the small-business deals are falling. As small businesses discover better deals offered by other websites, Groupon will eventually be forced to lower their margins. If the deals with large retailers/merchants prove to be more profitable and reliable for repeat business, then you can expect that this is where the sector will focus on in the coming years.

With so many questions that have yet to be answered about the sector, the biggest looming question is whether it will still be viable once the sheen of novelty has worn off. The answer is yes, as long as these websites can evolve and adjust. So far, they appear to be doing so. As stated previously, the dozens of deal-of-the-day websites that have popped up can only shrink the pool of interested merchants more quickly, continually forcing margins down. However, that may be a trend that keeps both parties coming back for more. As the merchants sense that there are better deals, they will go with those, and the more expensive players will be forced to adjust. In a few years, I could see local websites, perhaps sponsored by local newspapers that have seen their ad revenue eroded by Craigslist and other listing websites, launch deal-of-the-day sections to reconnect with local merchants who they are already familiar with, and who in turn could use them to reach their target local audience. If the margins are low enough, this could be a mutually beneficial venture. Additionally, there are new startups popping up within the sector that offer deals which are contingent on either repeat business from customers, or purchasing a certain amount beyond the deal’s value. If this catches on, expect merchants to favor that approach and for Groupon and the larger players to adapt.
On the other hand, even before their IPOs, Groupon and LivingSocial have begun buying up other deal-of-the-day websites not just in the US but all over the world. When these companies go public, expect them to attempt to purchase many of their competitors in order to obtain certain innovations their competitors may have pioneered, and thus maintain their competitive advantage. Thus, while the current social aspect/novelty of these websites may prove to be a temporary social fad, they aren’t going away. With adjustments that they will make either by choice or by necessity, you can expect deal-of-the-day websites to be an influence on the retail sector for years into the future.

Respectfully Yours,
Matthew R. Green
February 11, 2011