The market for daily deals continues to heat up, as technology heavy-weights such as Amazon.com (AMZN) and Google Inc (GOOG) enter the fray. Groupon filing for an IPO last week did not really come as a surprise, since there has been a lot of hype surrounding it and analysts have been providing lofty valuations.
Understanding the revenue model was truly difficult, however, since the heavy discounts being offered were obviously being borne by either the vendor, or the intermediary selling the coupon (in this case Groupon), or by the two parties together.
Typically, the coupon seller would be buying discount coupons from the vendor and sell them to the buyer, for example, a $10 discount coupon enabling a purchase of up to $20. Therefore, the acquisition price by the coupon seller would be of utmost importance.
If the face value of the coupon ($10 in the above example), is paid to the vendor, this would mean that although the discount was shared by the two, there was no cash inflow to the coupon seller. So the coupon seller’s only gain would be the increase in its prospective customers, while its cash outflow would be the amount paid to the vendor.
On the other hand, if the coupon seller pays less for the coupon than its face value, it would be able to keep the difference thus generated from the sale of the coupon. With this in mind, if we take a look at the coupon sellers, it looks like a difficult operating model, where they would not under normal circumstances be able to generate very high margins.
On the face of it, the arrangement is also not very attractive for the vendor, since it naturally generates very low margins or even a small loss. But there is also another side to the story.
First, vendors may need to generate sales in off seasons, for which they would need an agency to direct traffic to them. Second, if the coupons are cleverly denominated, buyers would be forced to buy higher-value items, paying for the difference in cash. Therefore, vendors have an incentive to pay the coupon sellers a good margin just for directing traffic to their stores.
For the coupon-selling model to be effective, the coupon sellers need active customers and customer loyalty. An active customer means a person who has made a recent purchase.
Constantly attracting new customers would be possible only by offering deals on a large number of regular-use or low-value items, such as batteries, toiletries, fast food, mobile recharging and so on. These would have to serve as the loss leaders.
To generate customer loyalty, the company would also need to ensure that customers make repeat purchases. The standard practice by retailers is to offer some sort of reward points that could ensure this.
Another way of doing it would be to study customer behavior and location and based on this information, provide search results of items that the customers would be most tempted or likely to buy. This is the area where we are likely to see some innovation and progress.
This is also the area where the discount business will very soon see extremely strong competition from Google. Google has recently announced Google Offers, which is a daily discount service, similar to Groupon Now.
Groupon’s advantage is its early start (the company already distributes coupons from merchants in 500 markets across 44 countries, according to PCWorld).
Google on the other hand has access to customer behavioral patterns, meta search technology that it acquired from ITA Software, a mobile OS that is the fastest-growing the country and a digital wallet that could enable a cool, hassle-free purchase.
The other big player is Amazon, which although toying with the idea of a group buying system (as the coupon selling model is also called), had kept things limited to its ties with prime Groupon competitor LivingSocial, in which it had invested around $175 million last year. However, a couple of days ago, Amazon announced its own daily deals program, which it is calling AmazonLocal.
The coupon selling/group buying model will inevitably be a low-margin business given the number of clones springing up all over the world. Moreover, companies will find it extremely difficult to retain customers who will in most cases deviate to the cheapest alternative.
We think Groupon is a good short-term investment, but we are skeptical about its long-term prospects, given the crowded market, extremely low barriers to entry, and presence of cash rich tech behemoths such as Google and Amazon.
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