Much has to be said about the viability of Groupon’s (GRPN) business model. Commentators across the board have accurately identified significant obstacles to Groupon’s continued growth and aspirations of becoming a profitable enterprise. From low barriers to competition to questionable accounting tactics, Groupon certainly has its fair share of naysayers. However, the biggest threat to Groupon’s future may be its own source of income – the merchant.

In a nutshell, Groupon’s business model focuses on monetizing the personal information of potential consumers across a broad spectrum of markets. It utilizes the email addresses of its subscribers as a communicative channel to advertise the discounted deals of local merchants (it also uses a mobile application as part of its marketing strategy). It is this direct and personalized communication to the masses that attracts Groupon to merchants. Merchants, in particular small businesses who have just started their operation or seek to broaden their customer base, see Groupon as a viable alternative to traditional advertising despite the hefty cost that comes along with it (merchants often split the gross revenues with Groupon).

Simply put, merchants are the lifeblood of Groupon’s business model. They produce the product that Groupon markets. Acquiring more merchants diversifies the list of products they can market, which allows them to attract more paying subscribers and increase revenues. As a result, the rate at which Groupon adds new featured merchants can be a quite the barometer for future subscriber and revenue growth. However, what is more important than the acquisition of featured merchants is the retention thereof. Groupon boasts of increasing the number of merchants featured in its marketplace from 212 in the second quarter of 2009 to 78,466 in the second quarter of 2011. However, this acquisition growth will undoubtedly slow, as there can only be a finite number of merchants willing to use the service. Consequently, the majority of revenues must come from repeat merchants.

In its S-1 filing, Groupon acknowledged that merchant retention was integral to revenue growth and achieving profitability:

 

If our efforts to market, advertise and promote products and services from our existing merchants are not successful, or if our existing merchants do not believe that utilizing our services provides them with a long-term increase in customers, revenue or profit, we may not be able to retain or attract merchants in sufficient numbers to grow our business or we may be required to incur significantly higher marketing expenses or accept lower margins in order to attract new merchants. A significant increase in merchant attrition or decrease in merchant growth would have an adverse effect on our business, financial condition and results of operation.

What is Groupon’s plan to ensure merchant retention? In the same filing, Groupon stated:

Our merchant retention efforts are focused on providing merchants with a positive experience by offering targeted placement of their deals to our subscriber base, high quality customer service and tools to manage deals more effectively.

Is there strategy effective? Unfortunately, Groupon doesn’t say. In a previous article, I identified a key measurable that Groupon fails to inform its shareholders. Groupon reports how many groupons are purchased in a given period but fails to disclose how many subscribers are actually purchasing them. Along the same vein, Groupon informs us how many merchants were featured in a given period, but they refuse to inform us how many of them were repeat merchants (those who use Groupon more than once). In a letter to CEO Andrew Mason dated June 29, 2011, the SEC made it a point to highlight this omission in Groupon’s S-1 filing and requested it disclose this key information to shareholders. Groupon failed to do so in its amended September S-1 filing, which can only raise negative implications as the following case study may illustrate.

On September 10, 2011, Groupon published its deal of the day for a Houston seafood restaurant called Ragin Cajun. The well-known local restaurant gave customers $40 worth of its tasty cuisine for just $20. The deal ended quickly and successfully, with over 5,000 groupons purchased. I was fortunate enough to get in on the receiving end of this great bargain. The following weekend, I went to the restaurant and used my groupon for $40 worth of shrimp and oyster platters. The restaurant was packed, and it seemed everyone in line had a printed groupon voucher in hand. Interestingly, before we could redeem our groupon, the cashier made each and everyone of us fill out a brief questionnaire. The slip asked for some personal information, one of which was our email address. Not long thereafter, I received an email from Ragin Cajun (see below):

As you can see, Ragin Cajun essentially decided to cut Groupon out of the equation. Essentially, the restaurant asked itself this question: What does Groupon do that warrants a 50/50 split in proceeds? The answer: they have the email addresses of people who might be interested in our kind of food — and nothing more. Instead of using Groupon again and splitting the proceeds down the middle, Ragin Cajun just decided to duplicate Groupon’s service. It took the email addresses of all those who redeemed the groupon and sent a mass email to those customers offering another discount (now only 25%), only this time, they stand to pocket all the money. I have yet to see another Ragin Cajun groupon offering, and I highly doubt I will see one again.

What the Ragin Cajun example proves is the unlikelihood of merchants using Groupon more than once. Many businesses may not view the Groupon service as a long-term strategy to increasing profitability. Rather, they view it as a potent promotional tool to get customers they once could not access in the door. Once that is accomplished, they will cut ties with Groupon and use their own resources at a notably lesser expense to market their product. This is especially the case when it comes to the merchants in the food and beverage industry where the deals just aren’t economically feasible. The mark-up in your traditional dine-in local restaurant is 300%, give or take. Taking this figure, Ragin Cajun’s break-even price point for its deal of the day was about $13.33. Because the restaurant only received $10 per voucher (the other $10 went to Groupon), it took a $3.33 loss per voucher redeemed. Clearly, the restaurant took the one-time loss for purposes of expanding its customer base. For those who may be skeptical of the numbers, the proof is in the pudding. The restaurant didn’t use Groupon again, and it marketed the same kind of deal but with just a 25% (as opposed to 50%) discount on the meal the second go-around.

Groupon must figure out a strategy to incentivize their merchants to repeatedly offer their products/services without affecting its profit share. It does not have the luxury of continuing to sustain losses before realizing a gain like its much bigger competitors, Google (GOOG) and Amazon (AMZN). Groupon’s goal of becoming a profitable enterprise will lie in large part with its ability to convince its merchants that its service is more than just a marketing tool, but also a legitimate way to turn a profit.