Is the Groupon Business Model Failing?

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With its IPO looming and its financial reports open for public dissection, Groupon – and the entire daily deals market – is facing increased scrutiny about the strength of its underlying business model. So does the daily deals business model have potential past this initial round of potentially over-excited investors, or is it more likely that Groupon's meteoric rise will be paralleled by an equally spectacular crash?

To determine whether or not the Groupon business model is failing, we first need to understand what exactly the business model is. Most consumers are familiar with it from the retail point of view (consumers receive daily emails promising coupons for 50% or more off of deals at local businesses), but how are things running behind the scenes?

When a Groupon approaches a new merchant to set up a deal, a number of factors are negotiated, including the value of the Groupon ($10 of merchandise for $5 versus a $70 dinner for $35) and the percentage of the sales that Groupon retains (typically 50%, though sometimes more or less). Groupon then balances its expected revenue generation with the seasonality of different offers and the types of offers it's recently run in any given city.

Once the merchants Groupon has run, Groupon immediately takes its cut of the sales and then pays out the merchant's earnings in three separate payments over a 60-day period – the first payment within 5 days, the next in 30 days and the final check 60 days after the Groupon has run. At first glance, this seems like an ideal solution for Groupon – after all, they don't have to pay out merchant payments until they've received payments themselves, potentially eliminating negative cash flow.

At least, that would be the case if Groupon's only expenses were related to deploying merchant coupons…

Part of the problem the company is currently facing are the costs it incurred growing as large as it has, as quickly as it has. It isn't easy to be one of the fastest growing companies in recent history, as this rapid expansion brings with it some significant overhead expenses. According to Henry Blodget, writing for Business Insider:

“As of June 30, Groupon had $680 million in current liabilities–bills the company has to pay. Meanwhile, Groupon only had $376 million of current assets with which to pay them (composed mainly of cash and receivables).”

Not that all of these liabilities need to be paid off at once – clearly, this disparity would only be an issue if the company were to be liquidated tomorrow. As long as Groupon continues to bring in more from coupon sales that it spends expanding to new cities, this shortfall shouldn't be a problem.

Unfortunately, there's some debate as to whether or not the daily deals business model is as profitable as initially estimated. Based on an analysis by daily deals aggregator Yipit, fewer Groupons are being sold per subscriber and average merchant revenues per Groupon are falling in some of the company's older markets.

Specifically, while studying the Boston market, Yipit found that although the number of subscribers to the site grew nearly 21% and the revenue generated grew by 17% over the last few months, the number of Groupons sold actually declined slightly.

On its face, this trend isn't too alarming – after all, does it really matter if the number of Groupons sold declines if the overall revenue is increasing? In fact, it does matter when considered in conjunction with data on the falling revenue generated by each Groupon merchant.

Here's why these factors together could represent a big problem for Groupon:

“Groupon is spending considerable money to acquire subscribers but those subscribers are buying less Groupons. Groupon is also spending considerable money to acquire merchants but are making less revenue per merchant.”

While the number of merchants placing Groupons hasn't yet declined, there has been increasing talk in the marketplace about whether or not this type of advertising actually benefits the merchant at all.

First, there are the obvious concerns. While offering substantially discounted products can be a great way to get new visitors in the door, there's no way for a merchant to ensure that these new customers will either a) become repeat customers or b) spend any more than the face value of their Groupon. If they spend no more than their Groupons allow and never return, they've effectively stiffed the merchant out of half the retail value of his merchandise – an unsustainable situation for many merchants, given the unexpectedly large volume of Groupons sold for most deals.

For a merchant to determine whether or not a Groupon is successful, he'll need to know whether his Groupon attracts primarily new or existing customers, as well as whether the coupon leads to repeat visits in the future.

Unfortunately, Groupon doesn't make this information available, claiming that sharing the names and contact information of its buyers violates the company's privacy policy. As Rocky Agrawal of Tech Crunch says:

“Groupon touts a win-win proposition. But the reality is that Groupon usually wins and merchants usually lose.”

There's also the problem of increased competition from companies like LivingSocial and Daily Deals (as well as city-specific competitors), which create an environment of information overload for consumers whose inboxes are already packed full of daily deal emails. And while it remains to be seen if Groupon's new “Now” feature, which alerts users to nearby Groupon opportunities via smartphone app – is enough to differentiate Groupon in this atmosphere, its biggest threat will likely come from another major company that starts with a G…

Although Google's “Google Offers” program hasn't yet reached the popularity with consumers that Groupon currently enjoys, it's likely to become more widely used due to a major difference in its merchant payout terms. While merchants running Groupons must wait nearly two months to receive their full payouts, advertisers on Google's Offers network receive 80% of their profits within four days of running a deal.

If you were a local business owner struggling to make ends meet in a tough economy, which of these options would you choose?

The obvious ramification of this is that if merchants defect from Groupon to the new Google Offers platform, Groupon runs the very real risk of not bringing in enough cash from its offers to pay its existing bills. It's also worth mentioning that Groupon is facing these challenges after having paid out $942 million to cash out its early investors – an unprecedented move that leaves the company on even shakier financial terms.

So is Groupon failing? Maybe – the company certainly is in a tenuous position considering its advertising costs, cash flow concerns and dwindling market share.

But does this mean that the daily deals business model as a whole isn't inherently profitable? Of course not! It may not be the wunderkind business model that initial investors believed it to be, but there's obviously room for companies that can attract more subscribers with fewer overhead resources and create more sustainable agreements with merchants.

Image: Groupon

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