The Real Reason Daily Deals Are Doomed

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Groupon's (NAS: GRPN) daily deals are a dream for consumers. Who wouldn't want half off on dinner at that kitschy restaurant across town or a round of golf on the cheap with your buddies? But for the small businesses Groupon needs as partners, the benefits aren't as clear.

A study by Rice University has found that 32% of businesses surveyed lost money on the Groupon promotion, and more than 40% said they would not partner with Groupon again. Another study said that only 36% of deal users spent beyond the value of the deal. Nearly all businesses need repeat customers to survive, and the daily-deals model is no different. While Groupon's promotion with Gap (NYS: GPS) attracted a lot of attention, daily-deal sites generally rely on small business partners such as restaurants or service businesses like salons and spas so they can offer their customers a variety of new and unique experiences.

Race to the bottom
There are several problems businesses have with the Groupon model. The deal is supposed to serve as an ad for the business, attracting new customers, but just one in five daily-deal users comes back. The deal undermines the regular full-price-paying customers the partnering businesses already have, essentially encouraging customers they don't want and discouraging the ones they do, or gives a discount to a customer who would have paid full price. Many retailers think they are only creating an expectation of continued discounting, and the new customers will just hop on to the next deal when they're done with theirs. The deals seem to instill loyalty to the website offering them instead of the end businesses, and retailers feel pressure to offer the discounts to match their competitors, even though the end result seems to be squeezing margins across participating businesses.

Two's company, 300's a crowd
Currently, there are more than 300 daily-deal sites, with heavyweights such as Microsoft (NAS: MSFT) , Google (NAS: GOOG) , and Amazon.com (NAS: AMZN) now gunning for a piece of the action. Some consumers have complained of "deal fatigue" from the constant barrage of emails, and 87% said they would purchase more deals if they were conveniently located on one site. The industry has virtually no barriers to entry, and it seems as if Groupon's lead has come from its clever marketing, first-mover advantage, and huge sales force, which eats up so much of its budget that it's still operating at a loss. Consolidation seems to be inevitable, and innovation will be necessary for the industry to be sustainable.

Foolish takeaway
With Internet powerhouses like Facebook bowing out of the daily-deal racket and Yelp cutting its deals sales staff in half, it looks as if the boom may be over. Investors in deal sites Travelzoo (NAS: TZOO) and OpenTable (NAS: OPEN) don't need be reminded of that, as both stocks are down more than 60% from their 2011 highs. Until someone can develop a daily-deals model that benefits all parties involved, it looks as if this phenomenon is just the latest version of that old adage: "If it's too good to be true, it probably is."

The daily-deals industry is a quickly changing one. Keep up with any developments in the battle over discounts by adding these companies to My Watchlist.

At the time this article was published Fool contributorJeremy Bowmanholds no positions in the companies mentioned here. The Motley Fool owns shares of Amazon.com, Microsoft, Google, Gap, and OpenTable.Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Travelzoo, Google, Amazon.com, and OpenTable and creating a bull call spread position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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