Why Groupon May Fizzle

| About: Groupon, Inc. (GRPN)

The animal spirits have welcomed Groupon (NASDAQ:GRPN) to the public markets, with a successful initial public offering that values the company at a hefty $16 billion or so. That's a much frothier start than other recent IPOs such as LinkedIn (NYSE:LNKD) or Pandora (NYSE:P).

Once the initial buzz wears off, however, Groupon will have to prove that its business model is sustainable in a convulsive retail environment that's being transformed by technology and a Darwinian economy. It may also have to face down some of the giants of retail, such as online powerhouse Amazon and perhaps even Google. Many investors, in fact, believe that Groupon's soaring stock-market opening—with a share price that started at $20 and spiked above $30 for a while—will be the high-water mark for the company, with a quick fade inevitable.

Groupon and its founder and CEO, Andrew Mason, certainly deserve credit for devising a new retail wrinkle and for rapidly turning the idea into an international business. Millions of Americans have already purchased the kind of daily-deal coupon that Groupon originated, saving 50 percent or more on goods or services once they redeem the voucher at a local merchant. Since Mason started Groupon in Chicago just three years ago, it has swelled to a company with 7,000 employees, operating in more than 40 countries. That's the kind of "job creator" the U.S. economy desperately needs.

Whether Groupon can sustain those jobs is another question. The company's business depends on merchants who are willing to offer deep discounts on food, clothing, spa services, dental work, and everything else local businesses offer, as way of getting new customers in the door. So far, the scheme has worked, even though some businesses lose money on the deals and aren't sure they'll ever make up the difference by turning deal-seekers into return customers willing to pay regular prices. There are clearly some factors in Groupon's favor. A recent study by consulting firm Accenture found that fewer than half of all U.S. consumers have used daily-deal sites so far, so there's still a large untapped market. Groupon also has a head start on competitors, with a bigger list of existing customers (and their E-mail addresses) and better brand recognition than other deal sites.

But there are several reasons that Groupon's early success might be a temporary phenomenon. Here are four:

Low barriers to entry. Groupon's success has spawned many other deal sites, such as Living Social, LevelUp, Mogl, and hundreds of smaller outfits. By one estimate, in fact, more than 500 daily-deal sites have sprung up over the last couple of years, some of them already out of business. Groupon is the biggest so far, and it has first-mover advantage. The question is whether that will count for much in the longer term.

In some businesses, being first to market establishes a huge edge that can last for years, especially if the business relies on a new design or idea backed by proprietary technology, such as the iPad or the Mini Cooper. It's also hard to copy physical infrastructure that takes time and money to build. Netflix, for example, milked its first-mover advantage for a decade before competitors caught up to its DVD distribution system and came up with better ideas, such as renting movies out of vending machines at retail stores.

It's a lot easier for competitors to copy Groupon's model, since all it really takes is a sales force canvassing local businesses and a promotional campaign that will attract customers to the deals. Competition will cut into Groupon's market share and force it to offer better terms to merchants, lowering profitability. It may also exhaust merchants, who tire of the onslaught of deal chasers and dial back, at some point leaving less business to be split among more deal purveyors. To succeed, Groupon will have to keep outsmarting competitors and finding new ways to reach customers. "If they rest on their laurels or try to rely on the sizzle of the idea," says Tom Jacobson of Accenture, "they'll probably end up in the same place as anybody else who doesn't innovate." In other words, think Borders or Blockbuster.

Middlemen. Businesses who offer deals through Groupon or a competitor are paying a fairly high price. Most of them are willing to lose money on the deal itself, because they're paying for a promotional campaign they don't have the staff, budget, or expertise to handle in-house. But businesses might be able to get a better deal themselves. New companies such as Stampede offer to act as an agent helping merchants negotiate better terms with the deal sites—another trend that will lower profitability for Groupon, et al.

On the consumer side, sites such as Yipit monitor dozens of deal sites and send consumers the offers that are likely to be most appealing, based on their personal interests. That seems likely to further erode Groupon's first-mover advantage. While Groupon may have brand recognition, there's no evidence that its customers are loyal to the brand, especially since they tend to be price-sensitive by nature. So consumers seem likely to chase the best deals, from any site, rather than stick with one deal merchant.

The "decay function." Blogger James Kwak argues that Groupon's existing customer base—which the company touts as one of its most valuable assets—could end up being worth far less than the company claims. By analyzing Groupon's own data, Kwak estimates that customers who have purchased a coupon in the past and are already in the fold may end up spending less money on Groupon in the future, as they try out competing deals or simply lose interest. This "decay function" might level off at a point that allows Groupon to remain profitable. But it could also keep falling, which would force Groupon to spend a lot more on marketing to continually bring in new customers. That would be a costly and perhaps devastating blow to Groupon's business model, which relies on existing customers to keep spending.

Another big, unanswered question is whether the novelty of daily deals will wear off. The Accenture study shows that daily deals remain popular, but it also highlights some weaknesses of the whole concept. Significant numbers of people who belong to a deal site feel they get too many E-mails, and too many offers for things they're not interested in. That problem could get worse as deal sites proliferate. And participants on average redeem barely half of the deals they've paid for, which means many people may not be saving anything at all, on the whole. If enough consumers do the math and decide such deals aren't worth it, the entire trend could suddenly stagnate.

Overdependence on physical stores. For now, Groupon-style deals are targeted at the most vulnerable part of the retail establishment: local stores. Groupon is aggressively pursuing a mobile strategy—known as Groupon Now—which allows shoppers to download coupons onto a mobile device and find real-time deals wherever they happen to be shopping. That's a smart play meant to capitalize on what looks like the next big trend in shopping. But guess who else plans to capitalize on that trend: Google, which has its own smartphone platform, a near-monopoly on Web advertising and more money than all daily-deal sites combined will probably earn over the next decade.

Since brick-and-mortar stores are consistently losing ground to online shopping sites, Groupon's long-term profitability depends heavily on its ability to find a niche among the biggest names in E-commerce. That includes Amazon, which just rolled out a low-priced tablet device meant to steer shoppers to its website for many of the things they once traveled to stores to purchase. Then there are huge hybrid retailers like Target and Wal-Mart, which have a strong presence in both the physical and digital marketplace and seem to have no need for deal-packagers like Groupon.

Maybe Groupon's startup mentality will keep it a step or two ahead of the lumbering giants, and even help local merchants find a way to expand their business online. But there have been hundreds of scrappy businesses that buzzed triumphantly under the nose of the Goliaths for a while—before getting squashed. Groupon has a long way to go to prove it's not one of them.

Disclosure: No positions