Asymmetrical Information - Megan McArdle

11.30.12

Trouble in Coupon Land

Groupon and Living Social hit the skids. Why did we ever think this was going to work?

So Groupon and Living Social are in trouble.  Color me unsurprised; I never got the Groupon business model.  Well, I guess I got the business model--it's not that complicated--but I never got why people thought that eventually this model was going to be worth a zillion dollars.  

Coupons basically serve two functions for businesses--advertising, and price discrimination.  Advertising means it brings in new customers by making them aware of your service, or giving them an incentive to try it.  Price discrimination, on the other hand, is what food processors do with grocery store coupons: it lets them sell their products to customers who are very price sensitive, without lowering the price paid by people who are too busy or embarassed to clip coupons.

As far as I can tell, small businesses viewed Groupons largely as the former: you give away your product near cost, and gain new customers from Groupon's huge mailing list.  Anecdotally, Groupon's salespeople in fact encouraged businesses to give their product away at a loss in order to attract new consumers.  By lowering the cost of trying your restaurant or salon, the theory ran, you could win new business that you wouldn't otherwise have gotten.

The problem is that for consumers, it seems mostly to have been about price discrimination; people used Groupons to buy something that they wouldn't buy at full price.  So while your Groupon deal brought in a huge stampede of new customers, those customers were either too cheap, or too poor to spend a bunch of money at your business.  Restaurants, who were supposed to be one of the core businesses for daily deals, complained that Groupon customers were disproportionately poor tippers who took up tables while carefully not spending any more than the face value of the Groupon--no drinks, no dessert.  Then they never came back.  

No slam on the Groupon users--they have a perfect right to use their Groupons for a meal they couldn't otherwise afford.  But from the business perspective, why would you pay good money to attract those sorts of customers to your business, where they will anger your workers, and alienate your existing customer base with huge crowds?  

Businesses seem to have figured this out, too; early deals on Groupon were often fantastic, while now they're mostly a big yawn.  Unfortunately, users have also figured out that the deals are not as good as they used to be; Groupon's stellar revenue growth has slowed considerably.

But even if the deals had been better, it was hard for me to see how Groupon was creating a ton of value.  A service that helps you price discriminate is super useful for hotels and airline seats, where the marginal cost of providing the product is trivial; the additional cost of putting a body in a hotel room or a butt in an airline seat is a couple of dollars worth of sundries. If a hotel room or airline seat would otherwise go unoccupied, then finding a way to sell it off for a nominal sum without affecting your existing full-price customers, this is a huge gain for everyone: bargain hunters, hotels, the firm selling the discounts.  That's why Priceline is a great business: it actually adds new users to the market, people who are profitable for Priceline's customers without cannibalizing much existing business.  

But Groupon's core businesses, like restaurants and spas, have a relatively high marginal cost of providing their service: food, labor, laundry.  That means there's much less room to create a new market with deep, deep discounting.  Groupon, it always seemed to me, was mostly going to redistribute customers between existing businesses, while lowering their revenue-per-customer.  So it was hard for me to see where their fantastic valuations were coming from, especially when you consider that the business has pretty low barriers to entry, and competition was getting fierce even before the market was profitable.   Essentially, consumers liked Groupon because it was helping businesses get into price wars.  But businesses do not want or need to pay someone to get them into a price war.    

There were other things you could point to that were troublesome, like their high cost of customer acquisition.  But that sort of thing can be fixed.  The core weakness--that they were not creating new revenue for the industries they targeted--seemed insurmountable.  I heard a lot of talk about Groupon's amazing mailing list, but mailing lists decay--and even if they didn't, who wants a huge database of customers who will only buy your product if you sell it at cost?

My concerns seem to have been borne out: Felix Salmon, one of Groupon's big boosters, just lost a bet that Groupon's valuation would not fall precipitously.  And Living Social announced yesterday that they were laying off 10% of their staff, after Amazon took a massive writedown on their ownership stake. This despite the fact that Living Social has been one of the more innovative firms in the space--here in DC, there's an increased focus on travel and events like cooking classes at their new headquarters.  Groupon's board, meanwhile, just met to decide whether or not to fire the CEO. (They didn't, but still.)  

If one of these companies survive, my money's on Living Social; at least from my customer perspective, they've done the best job of pushing into markets that actually have some potential, sustainable revenue.  But it's quite possible that none of them will.  They may just be this generation's Kozmo.com, a service that was hugely popular with venture capitalists, and New Yorkers--but only as long as it was selling its product at a loss.