Underestimating the Groupon Model

As widely reported, Groupon filed their first S-1 today in preparation for an IPO. They’re raising $750 million on top of the $160 million they have already raised from angel & venture capital investors so far. The likely valuation range will be $20-25 billion (or possibly more after what happened with the LinkedIn IPO).

The hefty valuation, along with the youth of the company (2.5 years) and the reported operating loss may lead observers and the media to cry “bubble.” While I think that $25 billion is a very rich valuation and wouldn’t pay that amount if it went public today, I think people in general underestimate the potential of Groupon’s business model. In other words, they were probably right to turn down Google’s offer of $6 billion (even if they don’t cash out during the offering).

Before going into Groupon’s business model and competitive advantages, here’s a quick run down of some of their customer statistics from the S-1:

In the above equation, those 5 metrics are multiplied to arrive at Groupon’s net revenue amount (the amount Groupon gets to keep after giving merchants their cut). So in the first quarter they made $270 million before expenses.

First the market, then the moat

Before Groupon and all the other deal sites began, local businesses had many lackluster options for advertising their product. They could send coupons in the mail; pay for ads in a local newspaper; pay for outdoor advertising; or pay for online advertising via Google, local news sites, etc. Most of these options (Google less so) are what Seth Godin calls interruption marketing. They are made to interrupt what you are normally trying to do. And because of that, people usually don’t like them, and they have a very low hit-rate in acquiring customers.

Groupon sells what Godin calls permission marketing. People want Groupon to send them daily emails, even if they don’t bother with 95% of them. This “permission” asset that Groupon owns is very valuable. It is not only the huge email list alone that is valuable, but the fact that the people on the other end look forward to Groupon offers (even if they don’t come in the form of daily deals in the future).

Felix Salmon has a good article going into more detail on the value of the “collective buying” model to consumers.

The absence of a well-run permission marketer in the local advertising space (a HUGE market) was an enormous opportunity. It was a form of entrepreneurial arbitrage — find the gap, and close the spread before everyone else catches on. But filling an unmet market opportunity, even if you’re the first mover, doesn’t necessarily mean your profits are protected from assault by competitors.

No company, outside of one with government contracts, has a competitive moat right off the bat. But as Groupon grew to fill-in the market opportunity, it grew its barriers to entry along the way:

  • Trust & habit — similar, though not as strong, is why people continue to use Google despite many low-barrier alternatives. This is the initial, fundamental reason for Groupon’s success. As long as they keep their customers happy (and don’t screw anything up), people will keep using what their familiar with and trust. That will also be the one they tell their friends about.
  • Initial network effects — the more people that use the service, the better discounts Groupon can get because they can better guarantee a certain amount of people will buy. The group buying aspect provides a kind of mini-economies-of-scale for local businesses. If they have a certain amount of fixed costs, the more customers they can bring in the door (even at little or no variable profit) the better.
  • Long-run network effects — local businesses want to sell/advertise their product with the company with the biggest customer base (email distribution, popularity, trust). This is the key advantage. Because Groupon already has a dominant market share, local businesses will seek them more than anyone else. This also leads to a feedback loop—the bigger and better quality Groupon’s “deal” base is, the better they can serve their customers. Combined with trust/habit, these network effects allow Groupon to capture a significant amount of consumer’s attention and time. That attention is obviously very valuable to local businesses around the world. It is much more valuable than say an ad in the newspaper, yellow pages, or on the side of the road.

Groupon also has a funding source in the form of float. It receives the cash from selling a Groupon in an average of 8 days, but waits an average of 79 days to pay merchants their share. This is mainly due to a policy of paying merchants 1/3 five days after their debut, 1/3 thirty after, and the remainder in 60 days. As of March, this amounted to total float of $268mm (payables – receivables). This float has funded most of their recent cash needs in excess of non-growth profit.

All the above also applies to LivingSocial, Groupon’s largest competitor. Past a certain point, customers will get “deal fatigue”. No one wants to receive and sort through 20 daily email offers, or to browse 20 different deal sites. People have a limited amount of “mindshare” to devote to things like this. But at the same time, despite the above competitive advantages, people will still subscribe and solicit other deal sites. This business model is well designed for an oligopoly between Groupon, LivingSocial, and maybe a few other smaller players (Gilt, Travelzoo, etc.).

Not all growth is free

Here is a quote from a blog post today on Forbes: “…investors would be wise to mind the gap between dazzling revenues what it costs to get them.” These are probably the thoughts, at first glance, of many observers.

But if Groupon cut its advertising to nothing, there wouldn’t be a mass customer exodus. In fact, I would guess that growth wouldn’t even slow that much — at this point, it seems that a good portion of obtaining new subscribers would be organic (spread by word-of-mouth). It was certainly smart to spend as much on marketing as possible at first in order to grow market share, for the reasons stated in the above section.

So a certain percentage of marketing spend could be classified as “maintenance expenditures”, which would be the amount they would have to spend to maintain the current customer base. I have no guess as to what that number is, but it’s a lot smaller than their total marketing spend in the 1st quarter of $208mm. To arrive at an adjusted figure (they call it “Adjusted CSOI”) Groupon adds back $180mm of that amount. This would mean it costs them $28mm a quarter to maintain the current customer base. Seems reasonable to me.

Using $28mm in maintenance marketing, Groupon’s first quarter steady-state operating income was $63mm.

There’s always a “but”…

Groupon’s model and growth story aren’t a perfect fairy tale. There is certainly a “fad” element to Groupon (but the same could be said for Facebook, and Facebook has a more difficult job of converting attention to money). As Andrew Mason mentioned is his S-1 letter to investors, there will be bumps along the way. That’s inevitable for a company only 30 months old, no matter what its size.

Groupon is not unassailable. Although they have a moat, it’s definitely not as big as the moat around Google, Apple, or Facebook. In going back to the “oligopoly” argument — even if this is the case, LivingSocial has similar advantages and could potentially outdo Groupon in terms of service and efficiently acquiring customers. I’ve been a customer of both for a while now and recently it seems LivingSocial has done an excellent job. Regardless of whether it’s Groupon or LivingSocial on top — and LivingSocial has a long way to go at 10% market share vs. 70-80% for Groupon — the business model is a powerful one that will continue to produce large amounts of profit for years to come (until it is inevitably disrupted at some point in time by another business model).

4 thoughts on “Underestimating the Groupon Model”

  1. I believe that you are going to find Groupon’s moat, built from:nn- being firstn- permission marketingn- a good record with customersnnis of abysmal quality as fortification from competition as their business model is entirely replicable.nnMore times than not “getting there first” just means getting crushed sooner, and the effort and and expense Groupon puts into getting and maintaining permission-to-solicit and maintaining product credibility actually benefits it competitors as much as itself through a halo effect (most people really don’t differentiate between it and LivingSocial, with some even believing them to be the same company). Moreover, Groupon’s propensity to NEED float just to survive to the next funding cycle is highly remeniscent of the dot coms which made bubbles famous. nnAlso, where I would agree that the concept to arbitrage the gap in the local market is an effective strategy – the fact is that Groupon was not the first to enter that space; the incumbent player in that space was and still is Entertainment Publications, LLC (long-time publisher of the 2-for-1 Entertainment coupon book), which has been unambitiously sitting back and quietly enjoying consistent (although relatively meager) returns on this concept for decades.nnI will admit that Groupon and Entertainment use different business models, but unfortunately (for justification of a Groupon valuation) is that the business model used by Entertainment is more favorable to the customer – e.g. no money other than the cost of the coupon book needs to be put up front and there is a single, long-term expiration date for all of the offers, whereas with Groupon the customer pays the full cost up front and the expirations and terms vary with each offer. You can rest assured that people WILL evetually figure this out.nnNow I’ll also be the first to admit that Entertainment has really been a slug through all of this; they clearly do understand that the competitive world has come to their niche and from their response (establishing their own e-mail-based Daily Deal) they clearly do not have a clue as to why people buy Groupons. So although I’d like to see Entertainment get this figured out (and it’s not that hard to figure out if you’re a customer of both, is it?), since they haven’t yet, I think its clear that the future of local deep-discount introduction lies more in the Entertainment model (with some modifications) rather than the Groupon model, but with someone other than Entertainment Publications at the helm.nnTo sum up:n- Any valuation on Groupon is too much as they won’t lastn- If you like the Groupon model, buy LivingSocialn- If you believe what I do about the inherent advantages of the Entertainment model over the Groupon model, wait for the replacement for Entertainment that properly counters the very minor advantages of Groupon over Entertainment and consider buying thatnnnnnn

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  2. Rick,nThanks for the comment. nnFor any company or business model still under 3 years old, nothing is set in stone and things could certainly be completely different than they are now a few years out (for good or bad). In other words, I realize my thoughts on Groupon could be proven wrong very easily. Also, any numbers or financials for a company this young probably shouldnu2019t be given much weight in a decision about the future of the business. Thatu2019s why I think any analysis of a startup or early-stage company like this should be light on numbers and heavy on mental models/concepts. [Sorry, this isnu2019t really a response to your comment but just something I wanted to get across that I didnu2019t mention in the post.]nnRE: u201cgetting there firstu201d: I agree that being first mover does not necessarily mean you have the advantage. Grouponu2019s efforts to increase quality and credibility probably do rub off on other deal sites, but I still think the Groupon brand is a factor (with trust, word of mouth, etc.). In terms of the float, I donu2019t think they need it to *survive* but just to grow. And in that case, float is cheaper than raising equity. nnRE: Groupon vs. Entertainment: Had not heard of Entertainment before — like you said, they are both in local advertising (using coupons) but the business models are different. It doesnu2019t seem to me that Entertainmentu2019s method is necessarily u201cbetteru201d than Groupon/LivingSocialu2019s for customers — just different. I think most customers of the deal sites understand what they are getting and still believe itu2019s a good service. Average u201cuseu201d per customer will probably go down after a while once hype/novelty wears down (as pointed out elsewhere this has already happened in older markets), but overall itu2019s still a good service and people will use it in one form or another in the foreseeable future.nnRE: LivingSocial — Iu2019ll agree with you here. If they both traded publicly and I had to choose one to buy regardless of price, it would be LivingSocial. They have more room to grow and I think will take market share from Groupon as the concept u201csettlesu201d over the next few years. But in reality, price makes all the difference and I probably wouldnu2019t buy either if they were both public today (once again, not because of any belief the business is bad, but because of the high valuations & low return to equity holders even if they model works out well).

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  3. I have a web site where I give advise on penny stocks and stocks under five dollars. I have many years of experience with these type of stocks. If their is anyone that is interested in these type of stocks you can check out my web site by just clicking my name. I would like to comment about the linkedin public offering . New issues are generally almost always bad investments the vast majority of these stocks are way over priced on purpose. I always recommend that investors stay away from these stocks.

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