Wednesday, February 23, 2011

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 na├»ve 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

Thursday, February 3, 2011

Issue XXVIII - Tech 2.0

“Past may be prelude, but which past?” - Henry Hu

In the first week of December 2010, one of the major business stories involved Google’s (GOOG) $6 billion offer to purchase Groupon. Founded in 2008, Groupon has expanded at an extraordinary pace to become the largest deal-of-the-day website. Every day, Groupon e-mails subscribers an offer for heavily discounted items or services from a particular merchant in the subscribers’ local market. In the economic climate of the past few years, it has proven to be very popular. To the shock of many, Groupon CEO Andrew Mason turned down GOOG’s offer. Early in January 2011 GOOG announced it is launching a similar service, dubbed Google Offers, while Groupon is planning an IPO. Reports have put the anticipated size of Groupon’s IPO around a staggering $15 billion. The rapidly increasing valuations of websites such as Facebook and LinkedIn, as well as deal-of-the-day websites – reminiscent of the first wave of technology overvaluation – have raised concerns of another tech bubble in the making.

Despite the bad memories elicited by “tech bubble,” websites today such as Groupon are probably not going to be the next crop of high-profile flameouts like Pets.com or Webvan ten years ago. For one, Facebook is already so large that its position could be similar to that of GOOG in 2004, in which it can go public and subsequently use its IPO cash to acquire other companies, increasing its market share and gradually building value for investors. Therefore, the unfolding situation could have characteristics of the tech bubble and successes such as GOOG. Parallels to the past will inevitably exist, but the question is which scenario will be more closely mirrored, and for which startups. Ultimately, a lot of these websites may not be worth as much in a few years as they are today. At the same time, lessons learned from the first tech bust have resulted in today’s websites being in better financial shape as they prepare to go public. This is Part 1 of what will be a 2-issue topic. This week, the focus will be on the present valuations within the sector, and next week the focus will be on what the future may hold and what Groupon in particular will need to do to stay competitive as the sector evolves.

One of the factors in the high valuations within the tech sector is simple supply and demand. Assisted by SecondMarket and other facilitators of private-stock transactions, accredited investors are able to invest in startups such as Facebook and LinkedIn with relative ease. In such transactions, the selling party is often the startup’s employees cashing out their private shares in the company. Since these shares are relatively hard to come by and the market is not as liquid as it would be on an exchange, investors have bid up the prices relatively quickly. However, the valuations may be entering a territory in which legitimate arguments can be made that they are overvalued. SecondMarket’s latest share auction values Facebook at approximately $70 billion. This is half of what GOOG is valued at, despite GOOG having $25 billion in revenue, $10 billion in earnings, and, most importantly, higher operating margins than Facebook. I am not flat-out suggesting that those who have invested in Facebook via private transactions will not make money. It is entirely possible that Facebook’s valuation could surpass $100 billion before its IPO, which is expected to come before 2013. However, the higher the valuation climbs, the more likely it becomes that there could be a rapid exodus as lots of individual investors seek to get out once the lockup on their shares expires.

For those who doubt that this is a possibility, look no further than Yahoo! (YHOO) circa 1999. YHOO was the character of the first tech bubble that was most synonymous with the internet as a whole, not confined to a retail sector like Amazon or EBay. Adjusted for inflation, YHOO’s market cap at the end of 1999 was approaching $150 billion. Today, stripping away YHOO’s tangible book value, the market currently values the company at close to $0. That’s right, net of its cash position and other tangibles, such as investments, the market values YHOO at $0. I am talking about a business that generates $1 billion in cash flow on $5 billion of revenue. Needless to say, a decade later YHOO is no longer the gorgeous new girl on campus. While Facebook, LinkedIn, and Groupon are in great shape right now, if something better comes along, unless these websites evolve accordingly, then they will be on track to become as old as, well, YHOO.

With current valuations high, the time is ripe for these companies to go public. Wall Street is currently gearing up for what will undoubtedly be two of the hottest IPO’s in 2011, Groupon and the just-announced IPO of LinkedIn. While Groupon has not yet filed for an IPO, bankers are aggressively (and smartly) vying for the assignment. Although the valuation may be frothy, bankers know that in order to get the most successful IPO for a client in the rapidly-growing deal-of-the-day sector, now is the time to move forward. Even if the valuations do eventually deflate, Facebook and Groupon are more than likely here to stay and will be major clients for Wall Street in the future, just as YHOO, AMZN, EBAY, etc. were viable businesses that thrived and were active clients for Wall Street throughout the 2000s despite the tech crash early in the decade. Amidst the excitement about the pending IPO, many on Wall Street are concerned that Groupon is overvalued, even more so than Facebook. Concerns about the viability of Groupon’s business model compound these concerns.

To compare the two companies, Facebook has over 600 million users and a scalable business model with very low fixed costs. Most importantly, it is by far the most widely-used social network. Groupon, on the other hand, is finding itself in competition with a plethora of other deal-of-the-day websites. Thanks to the low barriers to entry provided by the internet and an easily replicable business model, many of these new players are undercutting Groupon’s margins to provide better deals for the featured merchants. As is the case with most industries/sectors that proliferate, as new participants enter the market profit margins will become thinner, profits will decline, and eventually revenue will stop growing and perhaps even fall. Additionally, with GOOG launching its own service and Amazon teaming up with DC-based LivingSocial, two large players with deep pockets will increasingly be nipping at Groupon’s heels. While Groupon has indeed achieved tremendous growth in a short amount of time (in fact, in August 2010 Forbes named Groupon the fastest-growing startup in history), to maintain growth it has had to add thousands of local salespeople and has to continue doing so to find new local and national merchants to feature. That is not as scalable of a business model as Facebook and many other websites. Yet, a $15 billion IPO is being planned in the midst of an increasingly saturated market.

Another challenge to Groupon’s valuation is the fact that the business sector led by Groupon is inherently lower-growth than many others on the internet. When GOOG’s offer for Groupon was announced, a few commentators compared it favorably to GOOG’s October 2006 acquisition of YouTube. However, significant differences between Groupon and YouTube would not have made Groupon as good of an acquisition as it may have seemed. A few analysts noted that GOOG bought YouTube for $1.65 billion when the latter’s revenue was a mere $11 million per year. On the surface this makes Groupon seem like a steal, as it is projected to earn somewhere between $1.3 and $1.5 billion in 2011. However, despite the meteoric growth rates of Groupon, it should be noted that YouTube’s customer base is simply any internet user who wants to watch or upload videos. For Groupon’s 40 million online subscribers, the service is very popular and growing. But those people are not the customers. Groupon’s customer base consists of the merchants who utilize it as a loss leader to bring the public into their stores, hopefully stimulating future business and/or purchases of other products at full price. Thus, Groupon’s customer base is inherently more fickle, especially those for whom the deal doesn’t work. Eventually, there will be a core group of merchants in any given local market who will be regular customers of Groupon and other such websites, and the rest won’t use it. That puts a lid on growth for the company in its current form. For YouTube, on the other hand, the user base and revenue-generating ad clicks are constrained only by the overall number of internet users, which is continually growing worldwide. Facebook is the same way, as it is constantly entering new countries around the world. Eventually there will be limits to its growth, but that is further off for Facebook than Groupon.

With a number of copycat websites eroding market share, even if Groupon does remain the sector’s leader, it may not be worth $15 billion in a few years. Although it incorporates the easy distribution and powerful marketing characteristics of social networking, Groupon is neither an all-encompassing hub for the world’s information like GOOG nor is it a social network like Facebook. It is more akin to a discount service provider while borrowing a few characteristics of a social network. Businesses in the discount service sector are typically not worth $15 billion. For example, Overstock.com has $1.2 billion of revenue and is valued at about $370 million. Just five years ago, that valuation was nearly $2 billion. In the brick-and-mortar discount retail sector, Dollar General has $14 billion of revenue and is valued at approximately $10 billion. Currently, a large part of Groupon’s valuation derives from, like GOOG and Facebook before, the prospects of exponential growth. However, the valuations of businesses like Overstock.com and Dollar General that are more similar to Groupon may give a better indication of what its true valuation should be, especially if Groupon’s growth prospects are increasingly limited.

Despite the increasing valuations for tech startups, this is not simply a repeat of the first tech bubble. If this were the late 1990s, Facebook, Groupon, LinkedIn, etc. likely would have gone public several years ago. After the successful Netscape IPO in August 1995, historically pointed to as the beginning of the tech bubble, tech startups were increasingly geared toward fast-track IPOs. Entrepreneurs, venture capitalists, and bankers alike all contributed to this against the backdrop of the soaring NASDAQ, which helped to mask the fact that not all of these startups could possibly be successful. YHOO was founded by Jerry Yang and David Filo in 1994 and went public two years later. Similarly, Jeff Bezos founded AMZN in 1994 and it went public in the spring of 1997. Yet, many others were taken public with little to no earnings of which to speak. Still others burnt through their venture capital even before going public. This isn’t the case today with Groupon, LinkedIn and Facebook. They are highly profitable and growing. Yet despite an improving IPO climate since 2008, they are waiting for the right moment to go public. Groupon would be the exception in this case, as it is two years old. Facebook and LinkedIn are seven and eight years old, respectively. Even GOOG did not go public until it was nearly six years old, in 2004. So there is definitely a prudence that may have been lacking in the late 1990s when the internet sector temporarily seemed to be invincible. Yet, a better managed process of growth doesn’t mean that these startups aren’t overvalued at present and could still be when they go public.

The verdict about whether these soon-to-be-public startups are overvalued is still out. While my opinion leans toward yes, it should be noted that in the case of Groupon there have been several well-respected parties, Google and Goldman Sachs among them, who have taken a peek at the numbers and clearly didn’t pick those $6 billion and $15 billion respective valuations out of a hat. Obviously, the valuations take into consideration the company’s rapid growth and potential to do so in the future. Thus, two main questions need to be answered to more accurately gauge the sector’s prospects.

First, will the deal-of-the-day sector become so crowded that it will become significantly harder for Groupon to compete in the future? The sector is evolving as quickly as it is growing (indeed, one of the main reasons an IPO would be helpful to Groupon is so it can have cash to evolve via acquisitions). The robust activity within the sector in December was furthered by Amazon’s $175 million investment into LivingSocial, the second-largest deal-of-the-day website. LivingSocial’s deal with Amazon has enabled it to quickly diversify its offerings beyond its subscribers’ local markets and perhaps represents a more intelligent route toward growth. Not surprisingly, Groupon is increasingly offering national retail deals as well.

Second, deal-of-the-day websites could prove to be a fad that fades away because the economy improves or because consumers/merchants tire of the concept. Will Groupon still be worth $15 billion in that case? Most likely not. However, as stated before Groupon is not going away. After all, consumers are always looking for deals in good economies and bad. If the sector fades it will be the weaker players who will vanish, leaving only Groupon and a few of the stronger competitors. An improving economy may reduce traffic to the deals, however. Additionally, there are serious questions about the viability of Groupon’s current business model above and beyond the aforementioned issues. Such will be explored further next week.

Respectfully Yours,
Matthew R. Green

February 3, 2011