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).