Groupon's Business Model Doomed To Fail

Dec. 5.11 | About: Groupon, Inc. (GRPN)

Groupon (NASDAQ:GRPN) has incurred a net loss annually since the company’s inception. As of the end of the first quarter of 2011, the local online advertiser faced an accumulated deficit of $522.1 million dollars. Groupon makes their money by keeping 50% of what the customer pays for the coupons it advertises on its website and mobile applications. While that sounds financially lucrative at first glance, a closer look at its business model exposes serious viability issues.

Groupon’s success is for the most part dependent upon two critical operating metrics: (1) Growth of subscribers who actually purchase vouchers, and (2) attracting new merchants to its already expansive list. As of March 31 this year, Groupon had more than 83 million subscribers while advertising the products and services of 56,781 merchants (the number of merchants featured in the first quarter 2011).

While Groupon has seen incredible growth since its infant days in 2008, it is highly unlikely to keep pace in the years to come. The primary reason for this is competition. When current CEO Andrew Mason thought of the idea for Groupon, there was little to no business entities in the arena. Now, there are more than 500 sites worldwide, with over 100 in the United States. Yes, Groupon has penetrated markets in South America, Europe, and the Middle East, but what have they done to distinguish themselves? What is unique about the service they provide? What do they offer that no other company can? The answer is - nothing.

The only way for Groupon to succeed in subscriber and merchant growth in the long term is to separate itself from the competition. High growth companies like Apple (NASDAQ:AAPL) have been able to thrive because of their ability to innovate. There is nothing in Groupon’s business model that ensures it stays one step ahead of the competition. Big companies like Amazon (NASDAQ:AMZN), through its investment backing of LivingSocial, have seized opportunities and enjoyed success. Google (NASDAQ:GOOG), which once tried to acquire Groupon for approximately 6 billion dollars, has ventured into the field with its new Google Offers program. With close to a billion subscribers, Facebook will also inevitably become a dominant player in the game. Without that “it” factor, Groupon cannot continue to add subscribers anywhere near its historical rate.

The presence of other companies also provides plenty of options to merchants. Merchants may find better voucher percentage sharing programs with other companies or a faster reimbursement system (Groupon pays its merchants 60 days after the coupon has been redeemed). With more than one company providing a nearly identical advertising service, and the possibility of better financial arrangements, it will be difficult for Groupon to maintain growth in its merchant index.

Interestingly, the 2 components vital to Groupon’s success were also the two critical driving forces behind another popular company that has recently come under intense pressure – Netflix. Netflix (NASDAQ:NFLX) was dependent on not only growing its subscriber base for its DVD and online streaming service, but also to retain and add to its content providers. Netflix succeeded in both areas for some time and saw it’s stock skyrocket as a result. However, the moment it suffered a retraction in the number of subscribers this past quarter, it’s stock took a swan dive (it is currently trading at just over 20% of its year-to-date high). The subscriber loss was largely attributed to an increase in monthly fees. Presumably, executives felt it necessary to raise fees to grow profits as opposed to concentrating on subscriber growth. If that is the case, it cannot bode well for Groupon, which already operates at a loss while reaping a hefty percentage (50%) of the profits with its merchants.

Coincidentally, Netflix shares a common enemy with Groupon, namely Amazon. Amazon has built a formidable library of streaming titles in its Amazon Prime service by striking deals with CBS and NBC Universal. In addition, Time Warner has expanded its streaming video service and Apple has slowly been adding video streaming to its iTunes service. Netflix’s loss in subscribers is one factor in their recent troubles. They have also struggled in maintaining content. It lost its contract with Starz and will not be able to have access to big name movies from the likes of Sony (NYSE:SNE) and Disney (NYSE:DIS) after February 2012. Ultimately, Netflix was a "growth stock" that stopped growing.

Groupon seems destined to follow the same path as Netflix. While it may have some success in the short term like Netflix, competition with deeper pockets will eventually catch up harming subscriber and merchant growth. As this happens, the current deficit will spiral out of control, quarterly losses will continue, and its stock will take a significant hit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.