Groupon and LivingSocial: The Next Bubble Waiting to Pop [Update]

Daily deal company Groupon has become the latest darling of investors and expects to take in up to $25 billion in an IPO after the $1.14 billion in venture investment it has already garnered, according to Bloomberg. Maybe that has to do with the $760 million it grossed last year.

Now, rival LivingSocial, with $232 million in funding, says that by next year its sales will pass those of Groupon, at least in the U.S., as Sarah Kessler writes in Mashable.

With those levels of success and investment interest, there is a steady stream of competitors, whether start-ups trying to grab a piece of the pie, aggregators that pull together the deals from everyone, and such large operations as Microsoft Bing and the New York Times. But some early signs and a little historic perspective suggest that the category is in a huge bubble that will pop within the next few years.

Groupon U.S. sales trend down
During the Super Bowl, Groupon had an outrageously ill-considered ad that tried for humor but instead screamed bad taste. That seemed to have a big impact on U.S. sales, according to data from Erick Schonfeld at TechCrunch (click to enlarge):

As Schonfeld points out, there are several ways in which the data could be flawed, but as it comes from scraping deals from Groupon sites, if the method hasn't changed, then any systemic bias should be fairly consistent and there has likely been some kind of drop.

He pulled comScore data on unique visitors to Groupon to check, and they seemed to agree. Groupon CEO Andrew Mason replied with a graph from Google Analytics that seemed contradictory. However, that graph is labeled visits, which means "individual sessions initiated by all the visitors to your site." If someone is inactive for half an hour, any new activity counts as another session. Furthermore, if the person comes by multiple times that month, it counts as multiple visits.

In other words, Mason compared apples to oranges. There are also multiple reasons why sales could be down, even with traffic, whether unique visitors or visits, going up:

competition increasing supply faster than demand
local merchants negotiating better
merchants doing smaller deals
customer fatigue

All of them suggest that the rampant growth in the segment will soon be checked. Let's split the factors into two groups: competition and customers, with the latter including both local merchants and consumers.

[Update: In a new post, Schonfeld notes that he has new data that would indicate a far more successful February for Groupon. That said, the essential problems of competition and pressure from both business and consumer customers remain. In the long run, it will be difficult to get high margins out of this business, because there are too many downward pressures on sales and margins.]

Competition gets tough
The number of would-be competitors is growing, and some are increasingly successful. Mashable's Kessler also has data taken from sales comparing Groupon and LivingSocial. She has a graph showing the relative percentage of U.S. sales each has (click to enlarge):

Already LivingSocial is putting pressure on Groupon. In addition, the competitive field keeps expanding. That means price pressure. Up until now, the deal companies have commanded a 50 percent cut of whatever consumers spent, and there have often been transaction fees in addition.

That can go nowhere but down with increased competition. The arrival of large players like Microsoft, the New York Times, or even Google (GOOG) means the existence of companies that already have access to many consumers and, thus, have smaller costs of end user acquisition. There is still the cost of finding and selling local businesses on doing deals, but the bigger companies already sell to local businesses through their existing media holdings. Daily deals would require expansion, but not a start from scratch.

Such an advantage combined with the focus on additional, not primary, revenue means the big competitors could take significantly smaller shares of deal revenue. That will further press Groupon, LivingSocial, and other deal-specific companies to come down in price, which will reduce revenue per deal and seriously slow their growth.

Cranky customers
What ultimately feeds off the competition and drives lowered prices are unhappy customers. Remember, there are two types of customers: the businesses that offer the deals and consumers that buy them.

Businesses are already getting smarter in how they work with deal sites, as Elizabeth Holmes at the Wall Street Journal notes. When a small company heavily discounts goods or services -- say by half -- and then splits the proceeds with the deal site, what is left is usually a loss per consumer.

But company owners that are dumb don't stay in business long. Many are already getting smarter about the deals they'll do. Groupon has said that 95 percent of business customers would use the site again, but that gets tough when a university study found that for a third of businesses that tried a Groupon promotion, the experience was unprofitable.

Businesses going back will push for better terms -- lower income for the deal company -- especially as an increasing number of deal companies try to get them to sign up. Either deals will have to be profitable, or the consumers who use them will have to prove themselves of long term value to the businesses. Again, it's downward pressure on deal companies' revenue.

Finally, we suggestions that consumers are experiencing deal fatigue. Not only are there too many companies sending too many offers, but consumers who buy into the deals are motivated by savings and not necessarily tied to a deal site's brand. They will prove a fickle lot.

That brings us to historical perspective. Deal coupons are nothing new. Newspapers and direct mail companies have offered them for years. The immediacy and instant gratification aspects of online deals are novelty that will wear off. Then you're left with what in the past has proven to be a commodity industry.

Pull together all the evidence, and it suggests that even if daily deals are ramp up in total volume, the industry will soon hit maturity and find a cap on what it can collectively do. Big tech investors expect constant high growth. When that begins to stall, the unhappy investors will find other places to put their money, and suddenly making money off daily deals will become grinding work, not a quick way to become rich.

Related:

Image: morgueFile user jzlomek.

Erik Sherman

Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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