Posted by: hdemott | December 5, 2010

Is Groupon Crazy? Has Groupon Solved Local? I Don’t Think So X2!

Over the past week we have seen a ton of the “will they, won’t they” reports on Groupon and its potential nuptials to Google.

Rumors of price have been as high as $6B for the company – a price so high that most assumed that it would be irresistible to turn down – and yet Google has seemingly been left at the alter by a runaway bride – who, as it turns out had a larger dowry than expected (courtesy of about $135M of secondary stock sales.)

So is Groupon and its investors crazy to turn down this sort of money?

I don’t think so.

Here’s why:

It is rumored that Groupon has about $1B in revenue. Now there model is simplicity itself. They pay out 50% of that to their partners who offer the discounts – and the remainder of the company cost is in sales. If you look at a typical media company at scale – they tend to run about 20% of sales as costs (incremental margins on the extra $ of revenue is over 80% often) – so on $1B of revenue you have $200M of costs. Since most of the Groupon employees are either sellers or administrative people writing copy for the deals and there is not a ton of hard technology nor is there a ton of database necessities or server needs – one can assume that the cost structure is not going to get too far beyond the SGA line.

My guess is that Groupon is doing $1B in revenue – $500M in Cost of Good Sold, $200M in SGA and perhaps another $50M in miscellaneous costs (real estate – exec salaries, the cost of ramping up ahead of revenue etc…) – for a total of $250M in EBITDA.

So Google offers $6B for $250M in EBITDA – 24X which seems like a large number – but if EBITDA is scalable and growing extremely fast (over 100% per year right now) – then the 24X becomes 12X in a year and 6X in 2 years – which seems like a pretty good deal for Google – and is probably one of the reasons why Groupon decided to remain private.

So is Groupon Crazy? I don’t think so.

Now in order to reach that conclusion, you also have to believe that Groupon will continue to take an increasing share of the local advertising market – particularly the promotional budgets and marketing budgets of the local advertisers.

It has been written that Groupon has cracked the local problem – and that all of the $100B per year or more that is spent locally is open to them. Perhaps, but I think it is instructive to disaggregate that market a little bit and see just who is using Groupon.

As a store owner – if I choose to use Groupon, I am offering a 50% discount generally – and Groupon is taking 50% of the offer price – so in essence, my net is 25% of the retail price. The question is, who can afford to offer 75% off on a regular basis?

The answer falls into two buckets:

1. Companies with extremely fixed costs, high marginal profit levels, perishable inventory and incremental capacity. Say you own a spa. The overhead is completely fixed and you are paying the workers to be there – so incremental margins are high. You can imagine that the margins on cupcakes are very high. If you own a school or provide a service where you already have staff being paid for who are sitting around part of the day. I live in Fairfield County – and today’s deal is $10 for $20 of Michelle’s Pies. Now Michelle makes some fantastic pies – my family had an apple crumb pie last night from there – so I can attest to the quality, but this is a perfect example of an ideal Groupon deal. Baked goods have tremendously high margins – it is a volume buiness. Michelle has a storefront (paid for), bakers on staff (salaried employees), very high margins (cost of goods on a $20 pie can’t be more than $3), a perishable inventory (how long is that pie going to keep before you have to replace it?), and slack capacity (when’s the last time you went to the baker only to find all the pies sold out?)

2. Companies looking to lose money in order to convert customers into regular paying customers. Businesses willing to spend money to acquire users. In most media businesses this is called SAC (subscriber acquisition costs) or CPGA (cost per gross add). The issue with these costs are that you have to know very well what the lifetime value of the customer is in order to price these properly. If I go to a store on a Groupon deal and never return – it was a terrible idea for the store to offer me the discount. If my regulars use the coupon, it is also a terrible idea. My guess is that most local businesses couldn’t even begin to think about understanding the concept of lifetime value at the customer level.

Now let’s look at the local advertising market. If you take a look at the revenues of typical local advertisers it consists of car dealers, chain restaurants, bars and grills, retail stores, electronics chains, supermarkets, etc… What you realize looking at the list is that most of these businesses operate in extremely competitive environments with margins that are razor thin at best. Car dealers are in no position to use Groupon – nor are clothing stores, electronics chains, supermarkets etc… The margins for these businesses are too low – and they already spend a lot of marketing dollars branding themselves. You think Best Buy is really going to offer 75% off some product to drive traffic? Which coimputer savvy shopper has never heard of Best Buy – or hasn’t shopped there recently? There’s just no reason for them to become customers.

And that’s why I don’t think Groupon has solved local. Because it’s appeal is to a small subset of local businesses.

Now that is still an enormous and wonderful business and I’m in awe of the job they have done building the business – but it doesn’t obviate the need for local marketing the way that Craigslist obviated the need for newspaper classifieds. And it isn’t necessarily useful to everyone.

Whether it develops a nation of coupon clippers who only show up for deals and never shop full retail is yet another question – and one that is beyond my scope – but if those cupcake offers drove a ton of business the first time around – I hope that the bakers were smart enough to track the buyers and see if they became repeat customers – or just deal junkies looking for their next cheap sugar high.

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Responses

  1. great piece Harry. Now can you weigh in on what we ought to be doing with NFLX at $185 or wherever it is these days? Some chatterbox on CNBC suggested the other day it would lose 3/4 of its value as they deal with new (as of yet unnamed) competition. Obviously we ought to be concerned with escalating content costs; is renegotiating the new Starz deal the seminal event here? Or has their first mover advantage given them scale enough to have the upper hand in these negotiations? Thoughts??

  2. Does Groupon really do a good job of matching excess capacity to demand in high margin businesses?

    A local business using groupon has to 1) have substantial excess capacity to deal with the onslaught of dealhunters and 2) be able to plan in advance to utilize that capacity. As for the SAC, conditioning customers for substantial discounts is a tricky way to build a business.

    Obviously nothing new in what I’ve written, but I’m not in the bullish camp. I think Groupon will need to start dropping their take once all the first-time “try the fad” businesses have been exhausted. I told a friend a few days ago that I think $6B will be something of a watermark for Groupon’s valuation and I’m not backing off it now. We’ll see though.

  3. Good analysis as usual Harry.

    I don’t think Groupon has solved local – their model works beautifully for them, but there is a lot to be desired for most types of businesses as you mentioned.

    I think the nature of small business is that for the most part, they aren’t super-organized or analytical with regard to sales and marketing.

    There are so many variables to track (season, weather, competition, local economic climate, in addition to the regular product/price/place/promotion) and most business owners are already time-starved, that it’s unlikely many will really break it all down (as you also mentioned).

    To me, the magic of Groupon is that they convinced local businesses to slash their prices and margins in the first place… Their business really came to life because of the general economic malaise, and now that the genie is out of the bottle, I’m not sure where things will wind up.

    In essence, Groupon pushes forward demand just like the other ‘stimulus’ programs out there. Seems great in the short run, but not really sustainable in the long run.

    The $6b purchase price makes sense for Google – maybe not for other acquirers – but with all of that cash in the bank and the opportunity to own the category defining brand, I think buying Groupon would have been a smart move even if they were only doing $500m… It’s obvious that the model can scale, so with Google’s backing, it would probably have grown even more quickly.

    It’ll be interesting to see what Groupon looks like in another 18-24 months.

  4. Thoughtful post. I found it while searching to see if anyone has yet to concoct a conspiracy theory suggesting the $6B offer was a manipulative guerrilla tactic employed by a shrewd Google/Obama collaborative to stimulate consumer spending by getting Groupon immediate, ubiquitous exposure. If they did, it should go down as an ingenious move on their part, at least to cover the short term. What do you think?


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