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Is Groupon Bad for Business?

Halina is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Imagine you are a small business owner who doesn't want to invest a lot of time and effort into building an Internet presence. Imagine also that your business is just starting out and so you're quite willing to discount your products in order to get customers through the door. This sounds like a job for Groupon (NASDAQ: GRPN), a company that comes complete with a well-known online reputation, imaginative (if sometimes ludicrous) ad copy and a business template that simply cannot fail. 

Groupon's Business Model: Failsafe?

In a nutshell, you offer Groupon's customers online coupons that provide a discount of 50% or more to your business. Groupon takes half of that discounted price, leaving your business with just 25% of the revenue on the advertised good or service. In return, Groupon lists your business on its site and sends customers to your store. Hopefully, the new customers like your products well enough to return and buy them at regular prices. This business model works beautifully if everything goes according to plan.

However, it doesn't always go as planned. Stories abound about businesses that lost money on Groupon deals due to overinflated coupons, such as in the case of Posies Bakery & Cafe, which offered a $13 Groupon to customers when average store sales were just $5. The business ended up losing about $10,000 on its Groupon promotion. Then there is the well-known story of Need a Cake Bakery, which was forced to make 102,000 cupcakes because its Groupon deal was oversold. The bakery lost the equivalent of $19,500 on its Groupon order, wiping out its profits for the entire year.

Part of the reason merchants get burned by Groupon deals is that they often make no profit off of them and have little say in how or when the promotion is actually launched. There is also very little transparency in just how Groupon generates its revenues; while the basic idea is for Groupon to take 50% of the merchant's revenues, in some cases the merchant receives no revenues whatsoever on his/her already discounted products. Online customers are often allowed to buy up to three like coupons to the same business, which is a no-no if the business hopes to gain new customers by offering loss leader coupons. Obviously, Groupon's merchant agreement is lopsided to favor Groupon, not the merchant.

Repeat Customers: Good for Local Businesses, Not so Good for Groupon

That's not to say that some businesses have not been successful with Groupon in their corner; The Gap, which planned for a huge turnout after it launched a $50-for-$25 coupon, attracted 445,000 customers and brought in much new business. Some critics also point to the fact that Groupon has seen an increase in repeat business from its merchants, indicating that its business model works. The graph below illustrates how repeat merchants have increased from 33% to 56% in just half a year:

 

<img src="/media/images/user_12999/chart-of-the-day-groupon-new-and-repeat-merchants-june-2012_large.jpg" />

 

However, there is another explanation for this rise in repeat business: According to Rakesh Agrawal of Tech Crunch, merchants sign up for a new Groupon campaign in much the same way that financially struggling families sign up for a new credit card once their old credit card is maxed out. In other words, past Groupon merchants come back to Groupon because it provides them with up-front cash to keep the business afloat. Groupon's merchant agreement states that merchants receive 1/3 of the money on their deeply discounted products in 5 days, another 1/3 in 30 days, and the final 1/3 in 60 days. Thus, for at least two months, a struggling business is flush with cash. However, once customers start showing up with their coupons, the bottom line of that business quickly erodes. After too many months of losses, the business again looks to Groupon to receive its much needed "hit" of quick cash.

Is Groupon Investing in Used Car Salesmen?

The idea that more and more struggling businesses are generating a good percentage of Groupon's revenue is noted in a study released by Yale University postdoctoral fellow Giorgos Zervas. The Zervas study reports that Groupon merchant ratings are declining with time, suggesting that Groupon is backing more and more uncertain businesses. The study also shows that a business's Yelp rating drops after that business runs a Groupon deal and that Groupon customers habitually give lower Yelp ratings than their peers. Lower ratings again hint at the possibility that Groupon may overwhelm businesses with more customers and/or discounts than they can reasonably afford and adequately take care of.

Competition on the Horizon

Back when Groupon was still on the rise, Google (NASDAQ: GOOG) offered to buy out the company for $5.75 billion. Groupon refused Google's offer and was later valued at $12 billion during its IPO in November of 2011. However, Google didn't take rejection lightly and launched Google Offers last June. These Offers provide much more generous merchant payment terms; the merchant receives 80% of his/her money in just 4 days. Groupon, meanwhile, can't match that kind of turnaround because much of its cash flow is based on future revenue. Even though the company makes a good chunk of change, its money management style leaves much to be desired: In the fourth quarter of 2011, Groupon made nearly $507 million in revenue- yet still posted a $42.7 million loss. Such fiscal carelessness could become an issue if Groupon's merchants start demanding that it match Google's (or another daily deals site)- payment terms.

Google also has a higher number of platforms on which it can advertise its Offers, such as Gmail, AdSense and AdWords. Groupon, for the most part, uses subscriber emails to advertise. A merchant hoping to gain a diverse population of new customers in a short amount of time would be better off choosing Google Offers as opposed to relying on the same base of Groupon subscribers.

Summary

Groupon has been a pioneer and is still the leader in the daily deals business. However, its lopsided merchant terms may lead many a merchant to competitors such as Google Offers or Living Social. Likewise, the slow decline in Groupon merchant quality could turn customers away from buying its coupons. Groupon needs to become less money-hungry and more money-savvy when it comes to attracting merchants as well as customers. For Groupon, saving money must become more than just a corporate slogan.

 


halina23 owns shares of Groupon. The Motley Fool owns shares of Google. Motley Fool newsletter services recommend Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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