The future of Groupon’s business model

By Felix Salmon
August 27, 2011

Has Groupon created an inherently profitable industry? Or is it one of the most effective means ever invented of taking investors’ money and setting fire to it? Since I wrote my big post on Grouponomics in May, the optics surrounding Groupon have changed considerably. Jeff Bercovici, for one, is convinced there’s nothing there:

Could the fastest growing company in history sputter out just as quickly? At this point, the better question may be: How could it not?

Jeff quotes Rob Wheeler, who’s equally adamant:

Groupon’s fundamental problem is that it has not yet discovered a viable business model. The company asserts that it will be profitable once it reaches scale but there is little reason to believe this…

Groupon’s venture investors and executives need a way to cash out before everyone realizes that the emperor has no clothes. I will probably buy a Groupon every now and again — I have no problem letting investors finance my cheap consumption. But as far as an investment goes, Groupon is looking about as profitable as giving away your merchandise for 90% off.

But the problem here is that neither Bercovici nor Wheeler seems to understand what Groupon is doing. I have my own doubts about whether Groupon will be able to achieve long-term success without running into a short-term liquidity crunch, but there’s nothing inherently illogical about Groupon’s cash-burning drive for growth.

For smart analysis of Groupon, you’re much better off reading Vinicius Vacanti and especially Henry Blodget — but be sure to read them carefully. Both of them are being quoted by the likes of Bercovici and Wheeler, who are drawing broad and simply false conclusions from what they’re reading.

At heart, what Groupon is doing makes sense. Its core business, I’m pretty sure, is profitable — although no one knows just how profitable it’s likely to prove over the long term. If you give Groupon a large number of subscribers in some given city, and a team of sales people in that city, those sales people will be able to sell deals to local merchants in such a way as to more than cover their own costs. That’s the model at the heart of Groupon’s business, and historically it has worked spectacularly well. It’s worked so well, in fact, that Groupon has found it incredibly easy to raise new equity capital and to grow faster than any other company in the history of the known universe.

Groupon has used all of its profits from selling deals to expand aggressively — to sign up new customers and launch in new cities and countries. This costs money, but it makes sense, given the substantial first-mover advantages available in the space. Groupon wants to be first to any given market, and it aspires to become a kind of corporate shorthand, like Hoover or Kleenex or Xerox, where the company name is used to refer to the whole class. Growing as fast as Groupon has done is expensive, but Groupon is convinced that the more money it spends up front, the more money it’ll ultimately end up making in any given market.

All this makes a lot of sense, and nothing we’ve seen with respect to Groupon’s losses invalidates any of it: there is no reason to believe that Groupon is in an inherently unprofitable business. Contra Wheeler, Groupon did discover a viable business model. And it’s just silly to think that when you buy a Groupon, that in some way Groupon’s investors are financing your cheap consumption: the cost of your cheap consumption is borne wholly by the merchant in question.

In fact, one of the two problems with Groupon is that its investors aren’t financing Groupon’s growth. As Blodget points out, of the $1.1 billion that Groupon has raised from equity investors, fully $942 million has been used to cash out its early investors and executives. If Groupon had held onto that cash and used it to finance its growth, it wouldn’t be facing a cash crunch right now. Groupon should be able to use the proceeds from its IPO to cover any potential cashflow crunch — but it’s nice to have the option not to IPO, if the market’s looking weak. Groupon should be able to tap its current private investors in the event that its IPO gets postponed or canceled — but right now they’re looking to make money on their investment, rather than throw more cash at it.

The other problem with Groupon is that its fundamental business model is looking less profitable than we might have once thought. This is Vacanti’s point: in mature markets, Groupon is making less money per subscriber, and less money per merchant, than it has ever done in the past. The latter decline is particularly precipitous:

boston-merchant.png

Now this isn’t necessarily as bad as it looks. The number of merchants that Groupon has in a town like Boston is a cumulative number: we’re looking at quarterly revenues, here — a flow — divided by a steadily-growing stock of merchants. Even if you haven’t done a Groupon offer in years, you’re still part of the denominator; my guess is that even merchants which have closed down entirely are included.

What really matters, in Boston and elsewhere, is whether Groupon can stay substantially profitable in such mature markets. And that’s why it’s a little sad and indeed a little worrying that Groupon is getting rid of its ACSOI profitability measure — something which is at heart, as Groupon CEO Andrew Mason explains, was always an attempt to try to work out the steady-state underlying profitability of the company’s operations. Maybe Groupon got rid of it because of all the criticism — but it’s also possible that Groupon jettisoned ACSOI because it was worried that it was falling sharply and maybe even headed into negative territory.

Over the long term, I suspect that Groupon will succeed or fail based on the perceived quality of its offers. It has grown fast based on the simple tactic of offering great deals to consumers — giving them things for much less than they would normally pay. But at some point, it would do well to start concentrating more on quality rather than just price. Here’s Ryan Sutton:

Have you ever heard of Amber on the Upper East Side or Mambo in the West Village? Nope. Yeah, well neither have I. They’re just two random sushi joints. But Groupon ran a special on both last week, and they sold over $85,000 in California rolls, tuna rolls and other fake forms of sushi. That in itself is a travesty…

What’s going on here with Groupon, a national brand is giving national attention to a local joint that doesn’t deserve it, and as a result, a lot of people’s money is being misallocated. It’s anti-economic. Groupon is the invisible hand of capitalism sucker punching good restaurants that deserve to succeed and helping out mediocre venues that deserve to fail.

The thing to pay attention to here is the perception of Groupon: that it’s a desperation move for mediocre merchants. If that reputation spreads, then Groupon will find it increasingly difficult to move its product, no matter how wittily-written its emails are. So if I were thinking of investing in Groupon, one thing I’d be looking out for would be the quality of the merchants being featured. If it’s high or rising, that’s good news; if it’s low or falling, that’s bad news.

Qualitative judgments, of course, aren’t particularly tractable, or easy to chart; analysts hate them. But ultimately the success of great companies like Apple comes down to precisely the quality of their products. And that’s something that might well end up determining the long-term fate of Groupon, too.

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