Friday, June 03, 2011

Groupon's IPO

Groupon announced yesterday that it would be issuing an initial public offering soon.   Many analysts expressed concern about the high valuation coupled with the significant losses that have mounted as the company grows rapidly.  Some analysts have talked of this IPO as further evidence of a bubble in new tech firm valuations.

How do we make sense of these concerns?   We have to ask ourselves:  Has Groupon built a significant sustainable competitive advantage?   Are they a successful first mover, or will they be like many early movers in technological industries who actually end up being overrun by later entrants?   To answer these questions, we have to look at several factors.  First, does the company's business model have significant scale economies?   If so, then they can amortize fixed costs as they grow, and therefore, they will become quite profitable.  Second, does the business model have substantial network effects?   Amazon's model has both scale economies and network effects.  Thus, Amazon turned early losses into sizeable profits as it grew, and it built a quite formidable competitive advantage.   At first glance, it does not appear that Groupon has the type of economies of scale and network effects enjoyed by Amazon.   The model seems to very labor intensive, with new staff required to drive new growth.  The jury, of course, is still out though.  As the company goes public and we learn much more about its finances and strategy, we will be able to discern this more accurately. 

Competitive advantage may derive from other sources as well. Groupon itself focuses on its relationships with local merchants.  Undoubtedly, they do have ties at the local level that are quite impressive. Yet, questions remain to be answered.   Have they built relationships that will be hard to duplicate or break?  Are there significant switching costs for these merchants?  The barriers to entry do not look huge at this point, as we have seen a flood of entrants into this space.  Of course, some big existing players also want a piece of this pie, and so we will have to watch the likes of Google, Amazon, and Facebook to see if Groupon can sustain its early lead.

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