Why Groupon’s Margins will Hold Up

LaunchTime (the business I am a partner of) is very bullish on the daily deal space.  For full disclosure we are investors and are incubating businesses in this space including Yipit, Coupang.com and DoodleDeals.com.  We were told about Groupon in the middle of 2009 about 7 or 8 months after they launched.  Our initial reaction was that this business was a great idea but the low barriers of entry would force margins of the business to shrink dramatically.  This is what happens in markets with tons of competition.  Competitors compete for business and when there is not enough of a differentiation, they are forced to drop their price in order to compete to try to win the business.  Bidding wars ensue and margins are compressed.  This is what happened in Search Engine Marketing agencies.  They started off with 30 to 40% margins but tons of them both big and small sprouted up and margins got compressed to less than 10%.  So our initial hypothesis is that this would happen to Groupon.  Groupon clones would sprout up like weeds and they would start going to the same merchants and ask for much lower revenue shares and margins would be compressed.  However, it is now 2 years in the business and Groupon’s margins have been firm at 40% to 50% revenue share on the deals they run.  So how have margins remained strong as hundreds of daily deals sites have entered the market?

The reason why the margins of Groupon have held up is because of scale.  When I refer to scale, I mean the size of both their audience (consumers) and merchant network.  Groupon has over 25 million email subscribers giving them the power of being one of the few “rainmakers”.  For businesses that have the capacity and desire to add a lot of new customer, if you are featured on Groupon, they usually deliver enough new customers to completely fill that need.  At this time, very few daily deals site can do that. I would argue that LivingSocial may be the only competitor in the same ball park.  So when people think that Groupon has a lot of competition, in reality, they don’t.  They are working primarily with businesses that want a lot of new customers and the capacity to handle the “firehose” – being featured and getting a ton of new customers.  They are not interested in working with the business that wants a handful of new customers such as the popular restaurant that has a little excess capacity on a Monday night at 5pm.  They want to work with the large new restaurant that needs a lot of new customers right away so their business can quickly have a loyal regular customer base.  If you want the trickle of new customers, you can go to their competitors or just use Groupon StoresGroupon Stores doesn’t even to plan to make money from a revenue share just on breakage of non-redeemed vouchers.  The market for the trickle of customers is competitive and will have low margins.  The market for the firehose will not have low margins because it won’t be nearly as competitive.

Will Groupon be the only player with scale?  No, there are plenty of companies with very large audiences and customer bases that will tap into this model.  However, there are not going to be thousands.  There is just not enough consumer attention to have that many at scale.  People will go to a small handful of very large general market plays – like having a few major prime time major tv networks.  And then there will be a good number of middle tier players that are focused on a certain vertical or niche – like having a bunch of pretty popular cable networks.  And then there will be a ton of very small scale players – like having tons of people handing out paper fliers.  So the small handful of very big players and the good number of middle tier players will be a more competitive market than what we have now but there are millions of merchants to choose from on who to partner with to be their “firehose”.  The most coveted merchants will see more generous revenue shares.  However, there are plenty of good merchants to choose from for these larger scale players to choose from who will play ball at these higher revenue shares.  So if you want to pick the winners in this market – pick those who can get to scale as the very big players or the middle tier players.

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4 Comments

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4 responses to “Why Groupon’s Margins will Hold Up

  1. Joe Berkowitz

    All good points Ben. Time will tell. Exciting time in the business especially with the looming Google acquisition news.

    I actually think the big margin deal business will struggle keeping those high margins, over time. Even for the top tier “scale” folks as merchants that can handle the firehouse evolve with their use of deals (and technology) to drive profitable customers.

    There is a good argument and empirical evidence in the marketplace that a number of decent sized merchants get crushed in this high Groupon deal model. The smart ones will either move on or figure out ways to adjust with technology or service providers to consumer buying patterns. I actually believe in the growing popularity of Facebook deals or the Google meets eBay self-service model. Net net – given the popularity and demand from both sides there is lots of development activity going after the margins and consumer dollars.

    Don’t get me wrong – the business remains exciting with opportunity, yet i believe the landscape, merchant value proposition, and consumer deal purchase experience will evolve rapidly.

  2. Sergey Nazarov

    Ben,

    Thanks for sharing your perspective, it is clearly very insightful. When I first saw the Group Buying craze while working as a junior VC i thought the same thing as yourself; since the barriers to entry are so low, competition will make these current economics unsustainable in the long-term.

    I do agree that you are right in that competition hasn’t yet hits its stride in this space, but I am still sincerely wondering why the above wouldn’t happen when it does. Once group buying offers become a common source of revenue on portals like Yelp, AOL and niche content sites eg: Daily Candy, there will be more than enough traffic to service multiple daily deals on each site, increasing the competition for sellers and then depressing the margins of group buying sites as you mentioned earlier. After looking back over the numbers there seems to be more than enough traffic at conservative conversion rates to fulfill very large inventory demands, assuming that group buying becomes a commonplace source of revenue for content providers and other high traffic sites.

    It also seems clear that competition for sellers will increase as some sellers step away from the “firehose” because they have come to learn that it doesn’t fit their economic model, even when they have few customers due to tough economic times. A process that only seems to be beginning now (would be very interested to know if you think this is true for particular sellers).

    In addition to the above two factors, wouldn’t you expect that improving macro-economic conditions would cause many of the highest quality sellers to step away from group buying as a source of customers. In theory, as the economy improves the most common best sellers (dining and spas) wont need group buying as much as they do now.

    Your point is well made but i am still wondering if the above three dynamics combined aren’t enough to make high quality sellers scarce and depress margins as you mentioned earlier.

    If you have a moment or are considering writing another post soon I would be thrilled to hear your thoughts on starting a vertically focused group buying site in today’s competitive landscape. Specifically, what are he factors for success and where you think those sites can effectively compete with giants such as Groupon.

    Looking forward to more great posts.

    Best regards,
    Sergey

    • Ben Sun

      Sergey – all great points.

      On increased competition from verticals and portals – completely agree. Verticals like DailyCandy or what we are doing with moms with DoodleDeals will offer deeper relevancy for specific categories. I also think that other local ad/commerce services will converge to support a vertical like Opentable also getting in the deal space. Portals will also throw their hat in the ring. However, I believe that there will only be a small handful of dominant large scale players and a good mount of middle tier players in verticals. The main reason have limited capacity of even being notified of deals. Email is right now the vehicle of choice and consumers won’t subscribe to more than 2 or 3 at most. So the ones that get scale and are relevant should stay there b/c consumers won’t continue to sign up for too many of these emails. It is just too much. Probably also the need for Yipit which we are investor in. 🙂

      As for the improving economy, I think we will have a good decade with 9 to 10% unemployment and in Internet years that is an eternity. 🙂

  3. Pingback: Working Cpaital Deficit – Example Groupon

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