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Daily Deals: The Future in Retail - Analyst Blog

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What has become commonplace for tech companies and others aiming to lower costs is now seeping into the retail segment as well. The idea is the same: outsource routine functions to a specialized party, making them responsible for volumes that could generate higher profits than those shared with them.

This is what the tech companies had been doing previously, although they outsourced the manufacturing function, which is easier to understand given the tangible nature of goods produced. Also, the outsourcing of manufacturing was to lower-cost regions, so the cost advantage was significant. Naturally, the impact on profits was also greater, enabling them to pour funds into R&D and thereby increase product differentiation.

Background

Things are different in retail, however, especially for the small retailers that have been more willing to experiment. Here, store location is of paramount importance, since adequate space is required to stock and display wares, and also attract customers. Therefore, the primary concern for the small retailer is real estate that suits his or her needs.

After selecting the location, there are only a handful of things that the retailer could do to differentiate his or her store from the one next door. This lack of differentiation makes it impossible for retailers to generate high margins, forcing them to compete on price instead.

The retailer's next focus is the generation of traffic. Here, he or she is limited by the physical location of the store. As a result, there is reason for retailers to be interested in companies that send customers to their stores directly. And this is what the specialized companies like recently public Groupon Inc. ( GRPN ) and LivingSocial have been doing. Google ( GOOG ) Offers and Amazon ( AMZN ) Local are other similar services.

Business Model of the "Specialized" Players

The concept started pretty crudely, with the daily deals companies offering coupons that promised huge discounts. The coupon was priced in a manner that could induce the buyer to spend more. However, the system didn't really work, because many customers did not spend the full coupon value and the initiative failed to generate repeat customers.

While the basic concept remains the same, most companies are now changing the rules of the game. They are tracking customer preferences through their registered credit cards to determine the kinds of products that induce a particular customer to repeat the purchase. This information is then being used to create customer profiles.

Customer profile data is perhaps the most valuable asset that these companies possess -- this is their bread and butter. Therefore, companies with a larger customer base (people purchasing coupons) and number of partners (retailers signing up for the service) stand a greater chance of creating valuable information. This clearly makes Groupon the leader in the space since its user and partner bases are both significantly higher than other players.

Moreover, the selection is also broader these days, with electronic goods, events, services and travel joining retail and restaurants. The inclusion of electronic goods is a big positive because this is an area that is expected to attract the largest percentage of consumer discretionary dollars in the next few years.

Building Loyalty

However, customer profiling and targeted sales pitches have their limitations. Retail customers by their very nature do not always buy the same things or from the same parties because they want to try new things. Therefore, it often helps to partner with competing retailers to ensure that at least some coupons are sold. On the other hand, retailers would not be interested in partnering with daily deals companies that are unable to generate repeat purchases. It is also practically impossible to enter into exclusive deals with them.

These problems are driving daily deals companies to try new strategies. For instance, startup daily deals company LevelUp offers a small discount on the first purchase and rewards repeat purchases with instant credit. This reportedly encourages coupon-holders to spend 5.8X the deal value and bringing back customers 45% of the time (according to Nate C. Hindman of The Huffington Post).

More recently, Groupon modified Groupon Rewards (first launched in early 2010), which makes customers eligible for additional deals when their total purchases at a retailer over a period of time reaches the limit fixed by the retailer (for instance, $500-$1000 spent over 6 months could be rewarded with a $200 deal for just $40). This system automatically takes care of the retailer's concerns, ensuring that they part with only as much profit and only during such times (could be the slack season) that they see fit.

Even better, customers are not hassled, since they can purchase the items they need at their own discretion for some additional benefit. Groupon can also provide reminders when they are approaching the reward. Establishing this connection between the buyer and seller is the essence of the daily deals business that Groupon appears to have down.

The Next Consideration: Cost

The main problem that daily deals companies (including Groupon) are facing is customer attrition. Attrition rates are likely to remain high until loyal customers are identified. Even then, there will always be a good amount of attrition, as the companies go after new customers.

This calls into question the cost factor. How much should the companies spend for building their most valuable asset? Groupon's marketing costs in 2010 were around 37% of its revenues, while its selling and administrative costs accounted for another 33%. Cost of sales was as high as 61%. Although the company raised $950 million in its November 4 IPO, it remains to be seen if the amount was enough to justify continued spending at these levels.

Rising Competition

Most of Groupon's success is on account of its first-mover advantage, as the company started in 2008 and grew very rapidly to take the leading share. Its coupons (referred to as groupons) are the most well-recognized discount coupons available. After shunning Google's $6 billion offer, the company has proved that it could grow on its own merit.

However, things are beginning to get more difficult. Google moved on to introduce Google Offers, Amazon gave money to LivingSocial and a host of new companies entered the marketplace. Therefore, despite Groupon's brand awareness, the company could be under pressure to maintain customer interest in its discounting scheme.

To Summarize

For investors looking to capitalize on the daily deals business, Groupon seems like a good bet. Google Offers could be something one day, given that Google already knows about customer behavior and preferences (through search), and also about their whereabouts (through maps). We think Google will take a little more time to operate on the scale that Groupon has, although we expect some big agreements -- and possibly acquisitions -- that could jumpstart the business for Google. The smaller players (and we think LivingSocial, too) will take even more time to catch up with Groupon.

That said, we cannot discount the fact that the company still has some investing left to do (and we don't know how much). This would mean continued losses in the near-to-medium term. Add to this the fact that the business model is still evolving, so we have inadequate knowledge about the legal and competitive concerns.

We therefore have a neutral stand on the shares and would like to caution investors about them, especially because we expect some holiday-driven hype.

AMAZON.COM INC ( AMZN ): Free Stock Analysis Report

GOOGLE INC-CL A ( GOOG ): Free Stock Analysis Report

GROUPON INC ( GRPN ): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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