Can Groupon's Dominance Continue?

Coming on the heels of the successful  LinkedIn  IPO, Groupon GRPN will now head to the public markets with a planned offering that will likely top the billion-dollar mark. We'll have a lot to say on both the company and the deal in the coming months, but here is our initial take on Thursday's filing:

Investors now have the ability to see what all of the fuss is about. Groupon filed its S1 last week announcing its presence as a force in the world of local advertising. The company has changed the face of local advertising through its daily deals offerings. However, we believe the limits to the scalability of the business model and increased competition will inevitably end its early dominance.

Groupon makes money by selling what is essentially a discounted gift certificate to local merchants. For example, it could sell a coupon (called a "groupon") for $20, entitling the customer to $40 of food at a local restaurant. Groupon collects the $20 immediately, and the restaurant collects $10 from Groupon when the customer uses the coupon or it expires. While giving away $40 worth of food for $10 seems like an aggressive promotion, the restaurant is marketing for an upsell and attempting to drive repeat business.

Growth has been nothing short of remarkable. In 2010, revenues grew 22 fold reaching more than $713 million. Even more astounding, revenues in the first quarter of 2011 alone are approximately $644 million. Customers are also increasing the number of groupons they are purchasing, demonstrating repeat usage. Clearly, Groupon is providing exactly what consumers want--cheap prices.

Revenues alone don't prove a business case, and the cost structure gives us pause. First of all, marketing cost is substantial, although management considers that full amount to represent the cost of customer acquisition. This optimistic view would represent a cost of about $30 per customer addition, by our estimate. However, we expect some of this cost to represent a recurring marketing expense over time, ultimately lowering the lifetime value of each customer. We believe that the firm will have to invest in marketing the deals to instill loyalty and drive transactions, even from existing customers.

Another way to analyze the business model is to look at profitability of each offer. We believe gross profits averaged around $5,000 on a per-deal basis, before marketing and sales expenses. Even if the company is correct in asserting its marketing expenses are non-recurring, the sales and editorial expense may eat up half of all gross profits per deal. Of course, these are our initial thoughts, and we'll be following up with a more detailed analysis.

Lastly, we do not believe Groupon has an economic moat. Now that Groupon has proved the demand from merchants and subscribers, we expect Facebook Deals, Google Offers, and LivingSocial to have success in this market. Switching costs are reasonably low both for customers and for merchants. Ultimately, we expect the revenue share to become more favorable to merchants, lowering Groupon's long-term profitability. Furthermore, Facebook has much more information about its users, potentially offering a more targeted approach for merchants to acquire new customers and build relationships. Luckily for the competition, Groupon has drawn the map.

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