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June 03, 2011

Groupon S-1: Mind The Ratios

When evaluating company documents and filings, a hedge fund manager friend of mine has a simple mantra: "read the footnotes".  So when the Groupon S-1 was posted last night, I was eager to pour over it and find a few hidden nuggets that might explain the company's success and provide some indication of what the future might hold.

I think I found it on pages 74 (not the footnotes, I grant you, but buried quite deeply in the 110 page document).  The company presents two case studies for its two oldest cities, Chicago and Boston, and provides a few datapoints that allows one to infer two of the most important metrics for the business - customer churn and customers per merchant.

Let's look at the longest-tenure city - their hometown of Chicago.  Here's the chart they provide in the S-1 for performance over time:


All the numbers are growing, which is terrific.  But what matters in these situations is the ratios of growth, not just the absolute growth.  So let's do some simple calculations.  First, subscriber (defined as someone who receives an email from them) growth per quarter and percentage growth:

Groupon-Chicago 2

As you can see, quarter over quarter subscriber growth is slowing considerably in Chicago.  In Q1'10 it was 81%.  In Q1'11 subscriber growth was only 37%.  This is incredibly important because there are going to be inactive subscribers - also known as attrition or churn - and that number will likely grow over time.  Groupon needs to fill this leaky bucket with new subscribers every quarter.  If not, growth will slow, flatten or decline.

Now, let's look at customer growth.  Typically, I would expect the definition of a customer to be someone who purchases a Groupon in that period.  But a footnote on page 8 provides a different definition.  A customer is defined as anyone who has purchased a Groupon since January 1, 2009.  That is, it is a cumulative figure representing anyone who has purchased in Groupon's history.  Thus, the change in customers is far more important than the absolute number.  Here's what that looks like:

Groupon-Chicago 3

As with the subscriber numbers, this figure is slowing in quarter-over-quarter growth.  In Q1'10, the change in cumulative customers (that is, new customers) was 69%. In Q1'11, it was 35%.

Now let's look at things from the merchant's view.  The number of Groupons sold per merchant and the number of Groupons sold per customer per merchant are two important ratios of merchant success and customer activity.  Here's what that looks like:

Groupon-Chicago 4

As you can see, these ratios are also in decline, with Groupons per merchant per 1000 customers dropping 10x from Q3'09 (21.3) to Q1'11 (2.3).  This ratio is a good proxy for how active the cumulative customer base is.  The lower the ratio, the more likely there are large pools of inactive customers.  Again, if customer engagement attrits over time, then there is a leaky bucket that can only be filled with new customer acquisition. In saturated markets, it is typical for new customer acquisition to slow down and become more expensive over time.

To be clear, I'm incredibly impressed with this company and what it has achieved.  But a careful read of the rations is instructive when thinking about persistence and durability of the model.  Groupon has so many assets at their disposal and is so early in their innovation cycle, that I'm sure we haven't seen anything yet in terms of targeting, loyalty and other techniques to provide sticky customer relationships.  But the ratio data above suggests that the basic model they're executing on right now has some weaknesses that will become more acute over time.


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Great analysis. Looking forward to see what LivingSocial does next.



This feels like a 105 minute HBS case study (in a good way) that Professor Sahlman would be proud of!

Set me up with all the growth, get me all animated, and then tell me the truth at the end.....and sheepishly and silently, i acknowledge you as the master teacher =)

On a more serious note: Feels like they are stealing a page from Google, Facebook, Flipboard, et. al.

Continue raising an insane amount of capital from private and now public markets as the "new, new thing" and then plan to "innovate" your way into new market verticals once your core business demonstrates what appear to be inevitable weaknesses (or in Flipboard/Facebook's cases--figure out the ORIGINAL core business model.

Problem for them, no business is as cash-generating as Google AdWords and even with their unprecedented human and capital resource, it is unclear they will ever deliver another innovation as profound as Google Search.

This is a true Innovator's Dilemma.

Very refreshing analysis, thanks! This together with their already rising cost of customer acquisition shows it is about time they leverage these "assets at their disposal" and start innovating - also to accomplish sticky merchant relationships. But who knows what they are already doing behind the scenes...

Indeed. I wouldn't underestimate them. They're clearly a brilliant bunch. 

Thank you, brother bussgang. Very very helpful and insightful

When we also factor in the inevitable pricing war (as Groupon's competitors lower and lower their take (price to merchants), plus the awesomely fast rise of competitors, and copycats, it certainly gives one pause...

Indeed. Competition is good for merchants and consumers, not for margins. Just ask the airline industry. 

"Groupon has so many assets at their disposal and is so early in their innovation cycle".

I once learnt at school (UMBC - Prof. Charles Nicholas) that looking at numbers and ratios too early is like trying to gauge if your 2 year old is going to be a grand slam champion because she flings her sipper further than other kids her age.

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Well said! There is much still to play out

Why does the merchant care about groupons sold per customer per merchant? They only care about the ability to attract the right kinds of new customers, and would rather a smaller deal hitting a higher quality set of customers than a deal broadcasted to everyone.

From a merchant perspective, they want groupon to have a massive number of customers, and groupon to target them wisely. From groupon's perspective they want a massive number of merchants that they can repeat offers with. In both cases, the fundamentals you highlighted will look "bad", but the health of the business would be increasing.

Very good analysis. So how does Groupon know they are attracting the right customers? IMO they are attracting the very customers that most merchants don't want. Those who are hard to maintain when the promotion runs out. Are there any independent studies that show the post promotion retention ratio?

Great look at the #s. It's just not a sustainable model -- they've captured the market as is, but they'll blow a lot of money to keep the position they have.

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Good question. I'm not familiar with any.

Great perspective, Jeffrey. I must be missing something because looking at ratios can be misleading when the base for the calculations becomes a certain size - which Groupon has clearly reached. On a separate note, your finding about the definition of subscribers was brilliant!!)

Are they in the Margin game or market share game? That could color the interpretation of the data. They made $24k per merchant in Q1'09 vs. $28k in Q1'11.

Thanks For this -

They have no moat. they have nothing of mine that would give me pause to not use them - save for the deals they get - which are now being highly competed for.

They will need to innovate in ways that cause me to build some kind of interest graph on top of their platform. this type of construct will create a switching dilemma for users.

I've heard they are trying to solve for this. But its an extremely big ask to gather users around another burning man event when you are so well known for a coachella. (If you get my drift).

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It's an interesting thought exercise vis a vis LinkedIn - how would your life change if LinkedIn disappeared? How would your life change if Groupon disappeared? Every valuable company needs to be able to answer this question in a compelling fashion.

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Thanks, Michael!  Their balance sheet is a
huge weapon, for sure.  But I did feel that the current business model has many
flaws that are worthy of a skeptical eye.

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Groupons sold per merchant is a measure of
revenue impact on the merchant and Groupons per merchant per customer is a
measure of customer activity (or inactivity).

Jeff - thought you might enjoy this analysis of 8 troubling things about Groupon:



Excellent analysis. It is always fun to poke at a high flyer, and I am also skeptical of their long term business model. I have recently spoken to many merchants and almost all of them do not like Groupon. It does not build the loyal, return customers that they want. They get cheap, bargain hunters who will go to the competition for the next deal.

i think its chalk and cheese. Linked in leverages connections to establish high switching costs. Groupon has no switching costs. Secondly they have no diversified value capture. at least not yet. Lets see how they try and monetize the merchants.

But as you point out - they've done something right. Its the greatest value transfer from local merchants to consumers in american history.

Well said, they are brilliant.

Thanks for this.

Paul Azous
CEO, PPM.net

I still don't see churn from this. Nor do i see any recognizing that the % don't mean alot as compared to the actual net new figures. In a fast growing business once you hit scale your conversion ratios decline but actual values are enormous. Example above 68% was 25k and the 35% was 400k net new. Did you all not notice thatcommits slowing but in a big way. Decent analysis but really was hoping to get some trajectory on churn!

Brilliant idea when it came out, but their numbers aren't yet reflecting the shift in the local merchant community. Over the last few months, there has been a noticeable shift in the deals being presented by Groupon and Living Social both. For example, the most popular merchants, restaurants, are no longer doing $20 for $40 worth of food, or $40 for $80. Instead, they're doing $7 for $14 or $10 for $20. Local merchants figured out that they were losing big on Groupons and the customers weren't repeating. So now they're offering deals that are almost guaranteed to produce an add-on sale, in which they keep all the cash. Net result to Groupon is that they're selling deals that produce smaller revenue streams. This will get more and more common, putting downward pressure on their revenue.

This is good analysis of the demand curve. But the supply curve is where Groupon is really in trouble. Overall, Groupon is no longer anywhere near the 50-50 split with merchants that they once demanded. How do we know? When they adjusted revenue by eliminating the money passed through to merchants, they adjusted it downwards by significantly more than half. Number two, in their "mature" Chicago market, they also just broke their firm rule against deals that offered customers less than half off.

The problem for Groupon is that the types of things they are offering get worse and worse in a mature market. There were only so many businesses who had priced themselves at 4 times what they could get by with. And Chicago businesses now know there is very little "marketing" behind Groupon. Groupon holders do not become loyal customers. They just wait for the next deal. So it only makes sense to do a deal whose terms are narrowly constricted so as to make it profitable based on the revenue derived from the sale. There are several ways this is possible, but all involve a sort of bait and switch that ultimately leads Groupons customers to be more wary of buying.

a) creation of a new "item" which you've never offered before. You can set a ridiculously high price for it and then offer a 50% "discount" while still getting your margins;
b) time or seasonal constraints; (this is the essence of Groupon travel - great deals based on high-season prices timed so that it's most likely people will use them (or they'll be required to use them) at down times.
c) counting on a large number of voucher holders not to use them. This may be more important to Groupon merchants than anyone realizes, partly because Groupon can't publicize it, because it would crystallize that nagging feeling in the back of every customer's head - crap, I bought that Groupon and never used it, maybe I better not buy another one.

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