Groupon S1 (IPO) (Marketing Spend: Subscriber Acquisition Cost or Priming the Pump?)

Following up on the previous post about Groupon’s costs, Looking more closely at the marketing line of Groupon’s financials, one wonders whether Google, Facebook, and Microsoft are better off letting Groupon have the daily deals market.   As noted in the prior post, marketing spend was equivalent to 94% of gross profit in 2010 and 77% in 2011, so essentially Groupon sent a check to advertising sources collectively (including primarily Google and Facebook and Microsoft it seems) in 2010 almost equivalent to its entire take from the merchants.  So Google and Facebook seem to be making much more money from Groupon than Groupon, without having to be directly into this business.

A key question raised by the Groupon financials is whether the marketing spend (which is primarily online spend) is upfront subscriber acquisition cost or recurring “priming the pump” type spending.  If it’s subscriber acquisition cost, then the theory is, that this marketing spend will ease over time as acquired subscribers will continue to buy Groupons without no longer needing to be prompted by much marketing spend (Groupon emails are cheap).  If it is “priming the pump,” the marketing spend is necessary to continue to stimulate existing subscribers to spend (as well as bringing in new subscribers).  This would be problematic because of the high ratio of marketing spend to gross profit, i.e. it takes an investment of almost $1 in marketing (and that’s not even considering SG&A and other costs) to get a $1 of gross profit.

The position in the Groupon S-1 is that marketing is upfront subscriber acquisition cost that will ease over time, and it has some evidence to that effect.  It appears to me that the question is still open. It seems at least possible (based on my personal experience with various daily deals sites) that the online and offline advertising gets already acquired subscribers like me to think about buying additional Groupons.  If so, Google and Facebook may be better off sitting on the sidelines and collecting their checks from Groupon.

I lay out the excerpts from the S-1 below:

*Summary from S1*

We must continue to acquire and retain subscribers who purchase Groupons in order to increase revenue and achieve profitability. We characterize online marketing expenses as subscriber acquisition costs because these expenses are intended to acquire new subscribers. We spent $179.9 million on online marketing initiatives relating to subscriber acquisition for the first quarter of 2011 and expect to continue to expend significant amounts to acquire additional subscribers. If consumers do not perceive our Groupon offerings to be of high value and quality, or if we fail to introduce new or more relevant deals, we may not be able to acquire or retain subscribers. In our limited operating history, we have not incurred significant marketing or other expense on initiatives designed to re-activate subscribers or increase the level of purchases by our existing subscribers. If such expenditures or initiatives become necessary to maintain a desired level of activity in our marketplace, our business and profitability could be adversely affected.

*Definition of Marketing Spend*

We direct consumers to our websites and applications primarily through a number of targeted online marketing channels, such as sponsored search, social networking sites, portal advertising, email marketing campaigns, affiliate programs and other similar initiatives, which we consider to be subscriber acquisition costs. Our marketing expenses are largely variable, impacted by the amount of subscriber growth we wish to pursue and changes in online marketing rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing expense. We also incur offline marketing costs from television, radio and print advertising.

Marketing is the primary method by which we acquire subscribers, and as such, is a critical part of our growth strategy. Over time, as our business continues to scale and we become more established in a greater percentage of our markets, we expect that our marketing expense will decrease as a percentage of revenue.

Marketing expense as a percentage of revenue for the three months ended March 31, 2010 and 2011 was 9.0% and 32.3%, respectively. Our marketing expense increased by $204.2 million to $208.2 million for the three months ended March 31, 2011 as compared to March 31, 2010 primarily driven by investments in subscriber acquisition in new markets. We have focused the majority of our marketing spend online, particularly on social networking websites and search engines as part of our new subscriber acquisition strategy. For the three months ended March 31, 2011, marketing expense as a percentage of revenue for the North America and International segments was 26.4% and 37.3%, respectively. The higher marketing expense as a percentage of revenue for our International segment reflects our launch into new International markets.

*Groupon’s position on marketing as subscriber acquisition cost versus priming the pump”

In 2010 and the first quarter of 2011, we spent $241.5 million and $179.9 million, respectively, on subscriber acquisition. We acquired 48.8 million and 32.5 million subscribers, respectively, during those periods. Since our inception, we have prioritized growth, and investments in our marketing initiatives have contributed to our losses. Our investments in subscriber growth are driven by the cost to acquire a subscriber as compared to the profits we expect to generate from that subscriber over time. Once acquired, subscribers have been relatively inexpensive to maintain because our interaction is largely limited to daily emails and our mobile applications. Over time, as our business continues to scale and we become more established in a greater percentage of our markets, we expect that our marketing expense will decrease as a percentage of revenue.

To demonstrate the economics of our business model, we have compared the revenue and gross profit generated from the North American subscribers we acquired in the second quarter of 2010, which we refer to as our Q2 2010 cohort, to the online marketing expenses incurred to acquire such subscribers. The Q2 2010 cohort is illustrative of trends we have seen among our North American subscriber base. The Q2 2010 cohort included 3.7 million subscribers that we initially spent $18.0 million in online marketing to acquire in the second quarter of 2010. In that quarter, we generated $29.8 million in revenue and $12.8 million in gross profit from the sale of approximately 1.2 million Groupons to these subscribers. Through March 31, 2011, we generated an aggregate of $145.3 million in revenue and $61.7 million in gross profit from the sale of approximately 6.3 million Groupons to the Q2 2010 cohort. In summary, we spent $18.0 million in online marketing expense to acquire subscribers in the Q2 2010 cohort and generated $61.7 million in gross profit from this group of subscribers over four quarters.