Does Groupon Realize Its Supermarket Deal Could Start a Ruinous Price War?

Depending on your point of view, Groupon (GRPN)'s new deal with Big Y, moving it into supermarkets for the first time, will either help it steal share from the overpriced cartel of companies that currently dominate grocery coupons or it's a strategic disaster that will unleash a ruinous, margin-eroding price war for both Groupon and the incumbents.

The fight will be mouthwatering: A modern tech company, with a business model featuring no barriers to entry for competitors and terrible profit margins, goes to war with an entrenched, print-based empire struggling to digitize that has client relationships and exclusivity contracts stretching back decades. It will provide a classic business case study that will be examined for years to come.

Until now, Groupon has done something extremely smart: concentrated on small businesses that do not usually use coupons in their marketing mix. Before Groupon, it was not obvious that pizza parlors and yoga studios, when aggregated, could generate $644.7 million per quarter in coupon revenues. The national supermarket business is another beast entirely.

A cartel controls grocery coupons
The traditional coupon business has revolved around large, national supermarket brands such as Procter & Gamble (PG) and General Mills (GIS). That business is controlled by a cartel, consisting of Valassis (VCI), News Corp. (NWS)'s News America Marketing unit, and a smaller company named Insignia Systems (ISIG). After years of litigation, the three companies settled all their competitive disputes with each over the last few months, and all have signed agreements to work together. The agreements will last for the next 10 years.

Between them, the three companies deliver almost all newspaper coupons and in-store coupon offers to U.S. supermarkets. Valassis has about $547 million in revenues per quarter, News -- which doesn't break out its numbers -- probably has about the same, and tiny Insignia takes in just $5 million.

They are entrenched, and not just because they've been dealing with grocery clients for decades. They have printing presses, distribution teams, signage operations, junk mail systems and online coupons all working together. Those are significant barrier to entry: As the litigation between the companies revealed, the companies can leverage cheap pricing in one channel to entice clients to buy their other channels, also. They also sign their clients up to exclusive deals which forbid rivals -- such as Groupon -- from posting ads on supermarket shelves.

The appearance of Groupon will be welcomed by clients, who are always eager to find new, cheaper ways to reach customers. If Groupon wants to make any progress into grocery coupons, it must start a price war.

In many ways, Valassis/NAM/Insignia will rub their hands with glee at such a prospect. They know how price wars work -- they've been fighting each other since the 1990s -- and the damage they do. They know Groupon does not have the luxury of high margins it can sacrifice in the short-term to gain long-term share. And both Valassis ad Insignia are sitting on cash war chests gained in settlements from News that they can deploy to keep clients happy.

Further, Groupon has warned that when it deals with national clients its margins suffer. It is also inexperienced in the cutthroat world of packaged goods: a Sara Lee executive once complained that dealing with News "Feels like they are raping us and they enjoy it"; a NAM executive was once accused of bribing Winn-Dixie official for business. One wonders whether Groupon may be overreaching.

It's the margins, stupid
That's the case for the defense. From Groupon's point of view, it seems only logical that it should move into the heart of coupon-land. On paper, its delivery system (email) is a lot cheaper than those operated by Valassis et al. It is not burdened by their legacy analog costs. And it's a reasonable notion that online companies like Groupon could do to supermarkets what online news sites did to newspapers. Groupon is extremely easy to use, and there are low switching costs for customers who want to stop clipping coupons and start using Groupon offers.

The central problem, therefore, are the margins. Before the Big Y deal, Groupon had a fabulous, massive business: It delivered coupons to 83 million users and made more in revenues per quarter than the entrenched players by serving a client base they were not interested in. One of the advantages of structuring a category like that is that as long as all the players tacitly agree to stay within their boxes, they don't have to compete against each other. They can build virtual, legal monopolies -- and raise prices and margins. In fact, the legal agreements between Valassis, NAM and Insignia all indicate they understood this thoroughly.

Whether Groupon understands, though, is an open question. Its IPO will raise a big cash warchest that can help it compete, but imagine how much more profitable Groupon might become if it decided not to compete -- and to use its dominance in the small business category to crush Livingsocial instead.

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