The flaw in Groupon’s business model is a big one–loyalty. The daily deals juggernaut has made a few changes to amend its issues, but who knows whether those changes will suffice.
I needed sunglasses, the prescription kind. I hadn’t owned a pair in years, but this past summer I finally became fed up with squinting and wincing while daytime driving. Lo and behold, a few days after I decided to invest in some new shades, a Groupon for a local optical shop appeared. Pay $75 now for $175 off frames and lenses later. Serendipity.
That was in July, and a couple of weeks ago, I finally found some free time to head downtown and cash in my coupon. I found some nice frames, haggled a little on the price ($312 was hard to justify for sunglasses when I spend half my time in front of a computer screen), then I pulled out my Groupon. “Ugh,” groaned the sales clerk, eying the piece of paper in my hand. “You have one of those.” And a little twinge of guilt set in.
It turned out that the Groupon promotion had been much more popular than the tiny shop had anticipated. They’d been inundated with Groupon wielding customers and had a hard time keeping up. More salesperson hours plus deep discounts for a luxury item that most people only buy once every couple of years. Was it worth it? The clerk shrugged his shoulders noncommittally. Maybe. Would you use Groupon again? A blank stare that seemed to ask, “Are you daft?”
Sometimes Good, Sometimes Bad
That’s long been a popular refrain from small businesses who have tried Groupon. On the one hand, it’s a virtually guaranteed way to reach large numbers of new customers. On the other, unless you can turn those customers into repeat business or up-sell them, the deep 40-60% discounts Groupon demands can be damaging. Plus, if you can’t keep up with demand or the influx of new customers annoys regulars, your business could suffer a hit on reputation.
Yet, Groupon reports in its IPO prospectus that it featured on its site over 45,000 merchants in North America in the first two quarters of 2011 compared to just over 27,000 in 2010 — small businesses keep signing up. Why, in spite of well-publicized horror stories, would businesses jump into such a risky marketing strategy?
For some businesses, Groupon makes sense. For large corporations, like Gap, which ran an extremely popular promotion on the site last year, Groupon provides a great way to reach millions of potential customers. A business that large can eat the cost out of their already sizable advertising budget. For businesses that provide oft-repeated or critical services, such as auto mechanics or hair salons, a Groupon might be able to convert more repeat business, and thus be beneficial (note: that’s idle, but logical, speculation on my part).
But why did a boutique optical shop run a promotion? I suspect they thought they had to, and I suspect many other small businesses feel the same.
A down economy and low consumer spending numbers that refuse to rise out of the doldrums have forced business owners to do whatever they can to get people in the front door. Groupon’s millions of potential customers are just too attractive to pass up, even at a high-risk. In other words, small business owners feel compelled to gamble because the economy has forced their hands. When the economy turns back around — whether that’s in a few months or a few years — business owners won’t need sites like Groupon, and certainly not on Groupon’s terms.
A June study from Rice University that looked at deals across five major daily deal sites found that 48.1% of businesses would run another deal — a number that closely mirrors Groupon’s own internal data, as well as that of another recent study. Almost one in five say they would not run another deal and just about a third are on the fence. Half isn’t a terrible merchant retention number. According to the study’s author, Professor Utpal Dholakia, however, it is indicative of flaws in the daily deal model.
“Over the next few years,” writes Dholakia, “it is likely that daily deal sites will have to settle for lower shares of revenues from businesses compared to their current levels, and it will be harder and more expensive for them to find viable candidates to fill their pipelines of daily deals.”
Businesses Won’t Always Need Groupon
In an online presentation about the upcoming IPO, Groupon CEO Andrew Mason runs through what he says is a typical deal on the service. His example is Seviche Restaurant in Louisville, KY, a seafood restaurant that is, according to Mason, already very successful. Seviche wasn’t happy with traditional advertising, and ran a Groupon as a way to attract new customers. The details of the deal are as follows: $25 for $60 worth of food. Groupon keeps $12.50 of that price. Mason says that Seviche’s average bill is $100 and its cost of goods is 33%, which means that each Groupon customer should be worth, on average, $19.50 to the restaurant. His point was the prove that, when properly structured, Groupons are indeed profitable for the businesses that run them.
But let’s take that math a bit further. We’re getting into the land of hypotheticals here, but bear with me. Let’s say that the Groupon brings in 100 new customers. 100 x $19.50 = $1,950 in profit. Let’s also say that a traditional ad would perform only 40% as effectively at bringing in new customers, so it brings in just 40. Those 40 customers are paying full price, so they’re worth $67 in profit. 40 x $67 = $2,680 in profit.
How many of each become repeat diners? The Rice University study found that only about 1 in 5 daily deal users become repeat customers. If 20 customers from the original 100 that bought the Seviche Groupon come back, say, twice in the next year and spend the full $100, that’s worth another $2,680 in profit. I’d argue that the traditional ad customers probably convert to repeat visitors at a higher rate simply because they spent $100 on a dinner from the get-go (that is, they were all definitely customers willing to fork over full price), unlike the Groupon-wielding customers, who are getting a big discount . But for simplicity, let’s use the same metric as the daily deals for repeat customers. That’s another $1,072 over a year.
So who wins? In our hypothetical situation, the Groupon nets the restaurant $4,630 over the year while the traditional ad gets us just $3,752 — and there were probably some upfront costs that still need to be deducted. So Groupon is the clear winner, right? It’s actually trickier than that. According to the Rice study, just 35.9% of daily deal customers spend beyond the face value of the deal. Or, in other words, a large chunk of those initial Groupon users might get to the $100 average bill, so the profits from the Groupon might be much lower. (In our example, Groupon customers would be worth negative $7.30 if they only spend the Groupon price. That means they’re worth about $235 the first time through, assuming 64 of them only spent the coupon amount and the rest spend the full $100 average, and about $2,915 over the year.)
Of course, I can make the numbers say whatever I want — it’s all hypothetical (changing the numbers this way can make Groupon look great or look terrible) and I’ve made plenty of assumptions about customer value. The point is this: Other forms of advertising don’t have to be that much more effective (and can still be less effective from a pure purchaser standpoint) to create similar revenue and offer similar customer acquisition costs.
When consumer spending is low, it makes sense that fewer people are spending on things like expensive dinners out. A discount Groupon is an attractive incentive to get them out to the restaurant, and it is more effective at driving new business, even for successful restaurants like Seviche. But that likely won’t always be the case. If and when the economy rebounds, businesses might have an easier time getting customers in the door to spend at full price. They may no longer require the high-cost marketing that Groupon offers.
Can Groupon Keep Growing?
Groupon’s growth relies heavily on marketing. When the company cuts its marketing expenditures, revenue growth slows dramatically. That’s in a poor economy that is friendly to Groupon. What happens to that growth when businesses with desirable products and services can afford to refuse offering such attractive discounts? What if merchants refuse to play at all? Just 29.5 million of its nearly 143 million subscribers have ever purchased a Groupon (again, according to the company’s IPO prospectus). What will that conversion ratio look like if deals cease being as attractive to buyers as they are now?
As the company nears its IPO, investor confidence appears to be waning. In a piece in VentureBeat Monday, analyst Rocky Agrawal, who thinks Groupon is bound to fail unless it significantly reinvents itself, painted a bleak picture of who loses if the company goes under. Spoiler alert: it’s not just Groupon’s executive team and investors who would feel the pain.
Customer Retention Over Acquisition
So is Groupon destined for collapse? I’m not ready to say that just yet. Any economic turnaround in the U.S. won’t happen overnight — and could take years — and Groupon has aggressively expanded into international markets over the past year, whose economic climates I can’t and won’t comment on. They’ve also launched some new programs in an attempt to diversify their offerings, such as Groupon Now, which allows businesses to target deals to specific times and sell excess inventory during slow periods (though some reports indicate that Now is not gaining Groupon-like traction), as well as a travel deals service.
However, I do believe that Groupon will be forced to significantly alter its existing business model to survive long-term.
More than decreasing customer acquisition costs, Groupon needs to find new ways to add value for merchants to keep them offering deals. I predict that once the economy rebounds, small businesses will need to risk less to get potential buyers in the door and will be more interested in ways to retain and reward customers. This is something that Groupon only just recently began to address with Groupon Rewards, a clever program that allows merchants to reward customers for repeat business with exclusive deals. Groupon isn’t alone in this space — they’ll face stiff competition from companies like Swipely and Google’s yet-to-launch Punchd, which incentivize full-price purchasing through discount rewards, and Foursquare, which drives repeat foot traffic at a low cost.
This is the future. Customers will always buy deep discount deals, but fewer merchants will need them. What they’ll need are ways to turn existing business into repeat business.