Live

Watch CBSN Live

New York Times To Clone Groupon -- to Its Likely Regret

The New York Times (NYT) plans a Groupon-style daily deal business and will launch it at the end of March, according to Peter Kafka at All Things Digital. You can certainly see why, given that outfits like Groupon and LivingSocial are pioneering what might be a $3.9 billion industry by 2015, according to analyst firm BIA/Kelsey (source of the graph below, click to enlarge).


But it's a phenomenally bad idea. The daily-deal business is clearly another bubble in the making -- one with such inherent weaknesses that, absent some quickcourse corrections, it's very likely to burst. Soon.

Vacuum effect
Daily deal sites can pull in money like crazy for two reasons. They offer ridiculously good buys for consumers, who then sign up and make use of the bargains. The resulting flash crowds are a compelling draw for the businesses who advertise the deals -- especially for small local companies that aren't sophisticated in their marketing.

All that excitement comes at a stiff price -- the huge discounts that draw the crowds in the first place. Unlike older forms of local promotion -- coupon mailers, for example -- a site like Groupon wants half of the resulting revenue.

So a 50 percent discount is actually a 75 percent discount from the business's view, and that's not counting an additional transaction fee that the deal company might impose. Suddenly, the cost of marketing skyrockets. The deal company makes its money not from adding value, but by subtracting it.

When promotions go bad
There are times that a high discount strategy actually works, but only when the company directly offering the discount is sophisticated enough to understand the lifetime value of customers. It's actually a very old direct response marketing concept:

  1. Determine the cost of undertaking the marketing.
  2. Count the number of new customers.
  3. Multiply the number of customers by the average margin per new sale.
  4. Subtract the total margin from the marketing cost (or add for an average loss).
  5. Divide that total by the number of customers.
You now have an acquisition cost per customer. To make the promotion work, the margin you make from a customer over the time the customer does business with you must be greater than the acquisition cost.

If you've got a once-in-a-blue-moon type of business -- painting houses, for example -- then making a very steep discount promotion pay can be tough. If your business has the potential for having regular customers -- a clothing store or coffee shop, as an example -- then you need to keep the customer coming back without continued discounts.

Unfortunately, many of the customers motivated by high discounts won't convert into steady revenue streams.

Pain of success
As my BNET colleague Donna Fenn has noted, experience with using Groupon can vary widely. She gave examples of two companies that used the service. One, ScanDigital, lost money with each sale, but thought it was a good customer acquisition tool. As the company's CEO said, "We know that our customers will place repeat orders and generate word of mouth business for us."

It's true that getting a new customer on a breakeven basis can make sense -- if you track your business well enough to know the lifetime value of the customers that come in through the promotion. But most companies, especially small local businesses, don't. Fenn's example of an LA photo studio shows the downside of discounting a $275 photo shoot for $59.

Groupon sold 859 of the deals, which initially made studio co-owner Natalie Novoa very happy. But the numbers just didn't add up. "Groupon took 50% and $2 an order for transaction fee," she says. "That left us with $27.50 per shoot." Moreover, she had to extend the redemption deadline for customers who purchased the coupon because the studio could not accommodate the large influx of new customers, many of whom waited until the summer to schedule photo shoots. "We haven't had one regular paying customer in six months," says Novoa.
Would she try Groupon again? Sure -- if she could talk them into a price closer to $100. That shows a fundamental problem with the daily deal model. The salespeople are motivated to make money, which means closing deals, whether they're good for the advertiser or not.

Things fall apart
The overall result for a daily deal site promotion is dicey. Although Groupon claims that 95 percent of its business customers would use the service again, and CEO Andrew Mason claims to have surveyed 3,000 businesses that used Groupon, you have to wonder whether these responses were offered in the heat of the promotion or after someone did a final tally.

According to a Rice University study, a third of the businesses that used a Groupon promotion found it unprofitable, and more than 40 percent said that they wouldn't run such a promotion again. That would mean a satisfaction rating of under 60 percent, which is pretty bad. Furthermore, return rates to purchase at full price even in the profitable promotions were only 31 percent. In the unprofitable ones, the return rate was 13 percent.

This is a problem for daily deal companies because in any local market, there are only so many companies that will be willing to try a promotion. Burn more than 40 percent of them, and even with new businesses opening, the deal company must constantly acquire new prospects. That's expensive.

With more entrepreneurs and established corporations trying to jump into the space, at best there will be a big shake-out, with most of the ventures falling to the wayside. Bad buyer feelings about one deal company will transfer to others. All this limits potential growth. And if you're an investor in Groupon, which wants to hit $1 billion in sales this year, that should be a little scary. (And having customers sue over deals gone bad is just mud icing on the cake.)

Related:

View CBS News In