By James Kwak
Groupon plans to go public later this week. According to the latest leaks, things are going well: the IPO valuation, scaled back from $30 billion to about $12 billion, may be raised because of a successful road show. Apparently even after the company conceded that the amount they pay to a merchant does not count as revenue, investors have decided they like what they see.
But there is still something fishy about Groupon’s business model.
The company’s basic story goes like this: We have been losing money (more than $300 million so far this year) because we are investing in building our customer base. In essence, we are paying for customers. But once we have a customer, we can harvest a long-term revenue stream from her, and the value of that revenue stream is greater than the amount we pay to acquire her in the first place. In an effort to show that this model eventually results in profitability, the company severely cut back on marketing expenses in the third quarter. That’s how its operating loss fell by $101 million while revenues only increased by $38 million. (See the quarterly results, p. 60.)
This is the most compelling evidence that their business model will work (p. 81):
“The Q2 2010 cohort is illustrative of trends we have seen among our North American subscriber base. The Q2 2010 cohort included 3.7 million subscribers that we initially spent $18.0 million in online marketing to acquire in the second quarter of 2010. In that quarter, we generated $12.8 million in revenue from the sale of approximately 1.2 million Groupons to these subscribers. Through September 30, 2011, we generated an aggregate of $92.8 million in revenue from the sale of approximately 9.4 million Groupons to the Q2 2010 cohort. In summary, we spent $18.0 million in online marketing expense to acquire subscribers in the Q2 2010 cohort and generated $92.8 million in revenue from this group of subscribers over six quarters.”
In other words, they spent $5 to get each subscriber, and have since earned $25 in revenue from that subscriber. Sounds good.
But there are still a couple of problems with this story. First, out of every dollar in revenue, Groupon incurs 64 cents in non-marketing costs (cost of revenue and SGA). So from that $25 in revenue you have to subtract not only $5 in marketing costs, but another $16 in other costs, leaving only $4 in profit (plus 36 percent of any future sales to those subscribers).
Second, Groupon’s long-term profitability depends on its ability to harvest revenue from existing customers. The problem is that, on average, sales to a given customer will follow a decay function. In the quarter in which you become a customer, by definition, you will buy at least one Groupon and quite possibly more. For example, Groupon entered Boston in Q2 2009 and sold 26,032 Groupons to 8,545 customers, or 3 per customer. On average, that number will fall over time as people lose interest, unsubscribe, switch to competitors, etc. The big question is how fast and how far it will fall.
I don’t have enough data points (and Groupon hasn’t been around long enough) to estimate that function. But I can do a quick-and-dirty estimate of sales to old customers by making an assumption about how many Groupons the typical new customer buys. This chart shows how many Groupons were bought by the average old customer in Boston, with different assumptions about how many were bought by the average new customer.
What you end up with is a number that is below 0.8 and falling. This means that when Groupon has saturated Boston (and it’s pretty close, with more than a million subscribers and almost 400,000 people who have bought at some point in the past) it can expect to bring in about 0.8 sales per quarter from its customer base. That’s not bad: with the current customer base, that would mean 360,000 Groupons per quarter. But what’s worrying is that that number has been falling for more than a year, meaning that the productivity of the existing customer base is decreasing. How far that will fall is anyone’s guess. That fall could be part of the decay function, in which case it will level off as the business matures. Or it could be something else, which might not level off.
Another big question mark is that Groupon’s business model depends on its ability to make money off existing customers without spending a lot on marketing. In theory, this makes sense, since email is cheap. But is it true?
We know that Groupon slashed its marketing expenses in Q3 in order to pretty up its financials. That should have had no impact on its existing customers, if you believe the company’s line. (“Once acquired, subscribers have been relatively inexpensive to maintain because our interaction is largely limited to daily emails and our mobile applications,” p. 80.) But in both Chicago and Boston (the two North American cities that Groupon breaks out numbers for), the total number of Groupon sales fell—by 11 percent and 5 percent, respectively. Since Groupon added new subscribers and customers in both cities (though not as many as in previous quarters), that means that sales to the existing customer base did particularly badly. This implies that sales to the current customer base are affected by marketing spending. So we really don’t know how Groupon will do without a continuing blizzard of marketing spending. The only data point we have to go by is Q3—when the company was getting plenty of free publicity because of the run-up to the IPO—and that isn’t encouraging.
Then there’s the fact that revenues as a share of billings (that is, the share of what customers pay that they keep) have been falling steadily, which could be an indication of increasing price competition.
Now I can’t prove that Groupon won’t be profitable in the long run. It’s quite possible that as they saturate markets, they can find a level of marketing that generates enough sales to old customers (since there won’t be many new ones) to cover their expenses, and that they’ll be able to keep prices high enough despite competition. In fact, my guess is that they probably can. But there’s nothing in the S-1 that proves that that is likely, either, because we can’t see the numbers that matter.
The Baseline Scenario 
Groupon is a sales force and a mail list.
Some months ago, Goupon said that there were 5,000 people in the sales force — and growing. The sales force pounds the phones to come up with deals the same way newspapers, direct mail bundlers and coupon books have been doing it for decades. These are not premium jobs and turnover is high.
When Goupon says that they spent $5 to acquire a customer, they should say that they spent $5 to acquire a friendly e-mail address. The famous GAP deal was an example of losing money on a deal in order to get a lot of new e-mail addresses and some of those will respond to deals on yoga classes, massage treatments, bowling and chiropractic evaluations.
But the “new” kids on the block are Amazon and Google. Both have lots of e-mail addresses already and Amazon for sure has some idea of what kinds of stuff those e-mail owners buy. Amazon already has long term relationships with manufacturers (Amazon already owns Woot! which does pretty much the same thing as Groupon). Google is, well, Google.
There’s no magic here. Just hard work and average margins.
I’d have to believe that I’m a fairly typical Groupon customer. I joined when they had a deal I couldn’t refuse for something I would have bought anyway. Since that time, I think we’ve (my wife and I) bought 2 more total. That probably spans almost 2 years. Here’s our problem with it.
A significant percentage of the offers are things I don’t want at all, at any price. Another percentage are offers I’d take but the businesses aren’t local enough or it’s something I don’t need/won’t use in the time provided.
In other words, there are 1-2 offers per year that meet my criteria of being good enough, close enough and needed enough to buy. Reading this post, it really does look like that’s fairly typical of what’s going on. Unfortunately, fixing that means making broader based offers, and as you and others have already covered, broader based companies don’t have a need to buy their customers with Groupons – hence, their broader base.
Yeah, are we all missing something w/ Groupon? How is it worth more than just an e-mail list? What’s an e-mail address worth? And these are very generic e-mail address, right? Not particularly affluent or particularly targetted (they can’t be since the list is so big).
My gut tells me that Groupon is very selective about the cohort. I really wonder if other cohorts are all that profitable, particularly as advertising expense for any given quarter is not necessarily attributable to new Groupon membership for that particular quarter. There are of course lagging effects from the advertising in previous quarters, and significant but non-sustainable customer referrals that you’d expect in a popular (perhaps faddish) startup.
There’s also the ruptured balance sheet. Marketing burn has been extremely high, to the point where liquid assets do not come close to covering liabilities owed to merchants (the merchant unearned revenue). The IPO should give them breathing room, but I’m not sure this model is sustainable.
Hey Mr. Kwak,
I’ve always found it amazing how our minds seem to work in parallel somehow (although I’m sure that thought frightens the hell out of you and you would vociferously deny that). Parallel at least in terms of your posting topics and my recent thoughts. It’s weird, I rarely visit Damodaran’s website, but I had recently purchased one of his books (basically because it was like over 20 years old and I could get it cheap). So I was meandering on his blog and I found this. I wonder if it might answer your question on Groupon’s fishy business model (at least in part).
http://aswathdamodaran.blogspot.com/2011/10/growth-part-4-growth-and-management.html
Here is the abbreviated version of Damodaran’s take:
“By giving the founders/insiders 150 voting rights per share, Groupon effectively is issuing common shares with no voting rights. They are telling me that they want my money but not my input on how the company is run. That is their prerogative but I will exercise mine and not play this one sided game.”
I for one, would stay the hell away from Groupon as a stock investment.
Talk about bad corporate governance….. Groupon looks like the poster child.
Aside form the numbers crunching, Groupon is advertising flim flam for non-neccesities that works better in a bloated economy than it’s likely to in times when the American economy adjusts to its diminished prospects. Raise prices for some junk, then slash the inflated figure to give Groupon dolts a “savings”?
Pet rocks anyone?
What I wonder about (and haven’t seen as much research on) isn’t buyer customer burnout but merchant customer burnout. I signed up for Groupon very late, for Chicago at least, mostly to give a matched donation to a charity. Since then I’ve seen one offer that would actually be useful to me ($15 off $30 in bike stuff), one that would be a nice indulgence (25% off a hotel room downtown in the pretty Aqua building), and other than that a lot of restaurants I have no interest in and a lot of places out in the burbs.
If I’m eating out, I’d rather just go to a restaurant I’m interested in than save ultimately not that much money on whatever Groupon turns up. From my admittedly personal, anecdotal experience, Groupon’s competition seems to have a better grasp of the Chicago market, or is at least having better luck finding appealing deals, perhaps because they don’t take as big a cut.
Yeah, we’ve tried Groupon and one of its competitors (Buy With Me) and it’s true: we got one or two marginally useful offers, and many of no interest at all. The small savings are not worth the daily spam, so we dropped them. I think it will be hard for them to keep customers long term. Costs to get new users will increase with market saturation, and returns will diminish.
Here in Boston, I joined because one of a 50% off deal for a restaurant I go to anyhow. The other was a deal on ferry tickets to get to the Cape where I have a summer place. So I bought both to save money on things I’d do anyhow. The rest seem to either be things I have no interest in (woman’s gym memberships? You can’t even figure out what gender I am?) or they are not in my close geographic area. Everyone I talk to pretty much says the same thing, which brings me to…
I’m also a small business owner. When I was opening up, I talked to another couple of merchants in the area who are pretty successful and asked if they used any of the coupon sites. Both had a good merchant view of this…if I could be sure of landing a new customer because of this, and not someone just coming in for a discount, I would. But I can’t so I don’t, because if most people behave like me, they’ll just come in and buy something at discount and never come back. Also there is a big delay in getting paid by Groupon. So what they do is just advertise and get people to “like”them on Facebook and then make offers to those customers who tend to be more loyal. It makes complete sense to me. I think given this, the best deal could be for restaurants, because people will try somewhere new for a good deal. Perhaps some services like massage too. But for merchandise, it’s pretty shaky. And from a merchant perspective, think of the ferry company or my local restaurant. They just lost more than 1/2 of what I would have paid anyhow. Is that a good deal for them? Is there anyway to account for that when you do a deal with them?
I can tell you that I’ve acquired far more customers by using Facebook efficiently, leaving cards in local shops and businesses (reciprocating for people), and offering targeted local discounts than by any other means I’ve ever used. And Facebook creates a sort of “community” around what we’re doing and we get great commentary and involvement from the customers. So I can’t imagine why anyone would spend the money with Groupon, honestly, as a merchant. And as an investor also, I find that as troubling as their accounting methods.
Groupon not taking the buyout offer made earlier will go down as one of the stupidest business decisions of all time.
It is nothing but a big negative for retailers because it exclusively drives one time shoppers to you, and they are looking for something for nothing. Which Groupon, at the expense of you the retailer, readily supplies. Tomorrow the customers are back out looking for the next something for nothing deal. Rarely can a retailer count on obtaining a repeat customer.
What kind of business model is it where the retailer pays to give his stuff away? It’s not sustainable. Not to mention completely stupid.
Only fools buy IPOs. Everyone knows this. Read your Benjamin Graham.
Groupon seems to have mainly offers for girls (waxing, tanning, etc.) or for boring people (candlelight dinners), but almost never anything for a cool guy like me.
http://www.truth-out.org/occupy-colleges-now-students-new-public-intellectuals/1321891418
Published on Truthout (http://www.truth-out.org)
Occupy Colleges Now: Students as the New Public Intellectuals
Monday 21 November 2011
by: Henry A. Giroux, Truthout | News Analysis
(excerpt)
“The police violence that has taken place at the University of California campuses at Berkeley and Davis does more than border on pure thuggery; it also reveals a display of force that is as unnecessary as it is brutal, and it is impossible to justify. These young people are being beaten on their campuses for simply displaying the courage to protest a system that has robbed them of both a quality education and a viable future.
Finding our way to a more humane future demands a new politics, a new set of values, and a renewed sense of the fragile nature of democracy. In part, this means educating a new generation of intellectuals who not only defend higher education as a democratic public sphere, but also frame their own agency as intellectuals willing to connect their research, teaching, knowledge, and service with broader democratic concerns over equality, justice, and an alternative vision of what the university might be and what society could become.”
(Read it ALL)
http://www.truth-out.org/occupy-colleges-now-students-new-public-intellectuals/1321891418
Published on Truthout (http://www.truth-out.org)