Why Google Buying Groupon Is a Bad Idea

Garage Sale; Yard sale

So the latest rumor is that tomorrow Google will buy Groupon for $5 billion. You’re not alone if you think that’s crazy. Here’s why:

»  $5 billion is an absurd valuation for a company that is in a business with virtually no barriers to entry and is younger than my toddler.

»  That’s more than what they paid for YouTube (NSDQ: GOOG) which had a heck of a lot more traffic when it was acquired than Groupon has now.

»  It’s a huge chunk of the cash that Google has on hand. That’s a lot of money.

Now if the price was something more believable, like $1 billion, that would be a little less shocking. There are after all a few attractive pieces to the Groupon story-it’s theoretically a very lucrative business model (though not sure in actuality it’s as profitable as it should be given how many sales people they need to get the deals they have; they have more employees than Facebook supposedly has and it’s a much smaller business). It’s on a roll. It is a really different approach to local advertising where the merchant is guaranteed foot traffic and some upfront revenue. I personally love Groupon.

But I have a lot of doubts about what is happening with the business, and I’m not sure I see how Google can successfully amplify their business, or how Groupon can help Google crack the elusive “local search” nut.

Some Groupon obstacles:

They have a million competitors. Everyone and their grandmother, from well-heeled competitors like Living Social to the Yellow Pages to Facebook are now in this space. There is very little barrier to signing up to receive alerts to another deal site. So I’m not sure what first-mover advantage really means in this market.

This business model fundamentally attracts the wrong customer. “Half off” is not a hard idea to sell to customers. The challenge for merchants is to find those customers who like the concept of “half off” but spend much more than the deal minimum.

Merchants still aren’t fully sold. While Groupon will have you believe that their sales force can barely keep up with the inbound volume of merchants dying to be featured on Groupon, my hunch is that getting the great quality deals that have made Groupon successful is no easy task. There’s adverse selection at play here-the local merchants that we are most likely to want on Groupon are the least likely to need or to want to promote their products at half off. This is why even though this idea of “half off deals” (which has been around for years on sites like <a href="http://www.halfoffdeals.comHalfOffDeals.com or Restaurants.com) hasn’t been as successful in the past-because the deals frankly just haven’t been as compelling.

The real trick with this business is list quality. Groupon likes to say that their list size is enormous-30MM last I heard. That’s huge. But let me say this, the winner in this space will win not because they have the largest list but because they have the best list. By that I mean, knowing who are the customers who will spend more than the value of the deal and who will come back to frequent a business. The company that can identify those people, even if it’s just 100k customers will win. And the player that presents the best customers and gives better margins than Groupon to merchants stands a better chance of getting the best merchants. That is who the “winner” (to the degree that there is only one) will be.

The market size of this space is smaller than it looks. The challenge with this business isn’t just to take any local business and offer its goods for half off. You have to find the really good merchants that people want to do business with. And many of these merchants have a capacity limit. Many of them, because they are local merchants, can’t service more than a few thousand customers in a year-at most. That’s why Groupon is tackling larger national deals (e.g. buy at your local Gap for 50% off)-because they don’t have the scale problem (though ironically the Groupon site crashed that day and there have been many customers grumbling that they had problems redeeming the coupons). To grow, Groupon is also going to have to start putting more restrictions around deals-say, you can only redeem a restaurant voucher on a weekday-to attract some of the better deals. But let’s cut to the chase here: the universe of great deals doesn’t go on forever-there just aren’t that many great merchants, and they don’t have unlimited capacity.

None of these sites has any track record. Groupon (and its clones) are so young, and many of the markets they’ve launched in don’t even have a year of history. One merchant I talked to who was happy with the response to a recent Groupon also told me, “I was glad I did it, but it’s going to be a long, long time before I do one again.” Groupon may be hot now, but the fad will fade in 24 months. And margins in this business will be compressed over time.

Groupon probably won’t transform local search. “Local” has been a VC buzzword for some time now. How that will play out on Google is unclear. When you Google a local business, will you be offered a Groupon? Doesn’t seem likely because that wouldn’t be relevant; there are far fewer Groupons at any given time than local searches happening. When you do any Google search, will you receive notification of the local Groupon going on in your area? Possibly but unlikely-you know how Google hates clutter on its search results pages. Will we start going to Groupon to find local businesses? Doubtful; most people still don’t even use Yelp to do that yet. Will Google serve up Groupon offers on mobile search results pages? Maybe, but Google has always been schizophrenic about whether or not to let competitors advertise on the trade names of others (most customers use mobile to find the address of retail establishments they already intend to use). Will Google sales reps now bug Groupon merchants to buy some Google search words? Hmmm, maybe there are some synergies after all.

$5 billion is a pretty big bet to place on something that could be a one-trick pony. But then again, this would be a way to get a huge infusion of talent when you’ve got such a big brain drain you have to give your employees an across-the-board 10% pay raise. And from Groupon’s perspective, they should be itching to close this deal as quickly as possible lest their suitors get cold feet. A year from now, Groupon will receive a report card and when growth and margins go down as the laws of gravity and economics dictate they do, so will their valuation.

Sucharita Mulpuru is a vice president and principal analyst at Forrester Research, where she serves eBusiness and Channel Strategy professionals. She blogs here.

This article originally appeared in Forrester Research.

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