Why Is Everybody Hopping Off the Groupon Bandwagon?

Groupon's (GRPN) IPO was a rousing success, but its business model still may be an endangered species.

Facebook, restaurant reviews website Yelp, and dining reservations leader OpenTable (OPEN) have all bowed out of selling prepaid vouchers for area merchants at steep discounts in recent weeks.

Google (GOOG) isn't abandoning its efforts to reach out directly to local establishments, but it has recently decided to also aggregate offerings from more than a dozen flash sale specialists. The search engine leader probably wouldn't be going this route if things were going well on its own.

The model that seemed so perfect is apparently also pretty flawed.

Selling Dollars for Quarters

The daily deals phenomenon struck quickly. Groupon was born three years ago this month. LivingSocial didn't roll out its first deal until the summer of 2009. However, both sites quickly expanded their rolls to tens of millions of bargain seekers on the lookout for cheap eats, mani-pedis, and green fees.

The model makes sense in theory. Let's say that Groupon approaches a pet grooming salon. Groupon wants to offer a $40 pooch cut and bath to its users for $20. The site offers to split the proceeds evenly with the merchant. Selling a $40 treatment for $10 sounds like a sorry business proposition for the salon owner, but let's consider a few things.

• If a business owner has excess capacity -- and that's usually the case -- taking on a client during a lull only entails the variable costs related to what's being offered.

• Groupon reaches a wide audience, so someone bringing in a Labradoodle for the first time may wind up coming back as a full-paying customer.

• Some clients will spend more than the Groupon amount. This may not apply in the case of a particular service, but a restaurant offering $50 worth of food and drinks for $25 may find a couple splurging past $100 because of the perceived value.

• These vouchers do have expiration dates, though some regulations indicate that just the promotional value expires. Either way, many of these Groupon deals do go unexercised.

You'll find a great mix of glowing testimonials and horror stories from merchants that have gone the Groupon route, but clearly business itself is growing. It's working for many merchants. It's clearly working for cash-strapped consumers trying to get more bang for their buck in this dicey economic climate.

Why isn't it working for the providers?

Different strokes

Hopping on the Groupon bandwagon was the fiscally fashionable thing to do last year. Shares of OpenTable and travel deals publisher Travelzoo (TZOO) spiked after introducing Groupon-esque initiatives.

The model seems to be working well for Travelzoo, but OpenTable conceded that Spotlight -- the name of its flash sale product -- was accounting for just 2% of revenue in its latest quarter.

OpenTable claims that it's nixing Spotlight because the deals aren't resonating with diners, but the bigger culprit is that it likely wasn't resonating with its restaurant partners. OpenTable collects an average of hundreds of dollars from each of the 16,237 North American restaurants on its platform. These are high-end foodie haunts that require reservations, unlike the typical casual dining eateries that one finds on Groupon and LivingSocial. Offering half-priced fois gras and pork belly watermelon salads was never going to fly with its high-brow restaurateurs.

OpenTable isn't killing discounts entirely. It's still honoring its partnership with Savored, a service that sells discreetly billed dining experiences at 30% off in exchange for $10 upfront. OpenTable is also rededicating its sales team to push its 1,000-point tables, a service where OpenTable users get more points from featured restaurants that can be exchanged for gift certificates. Participating establishments pay OpenTable $7.50 per seated diner booked through that promotion, a lot more than the traditional rate, which ranges from $0.25 to $1.00 per patron.

The moral of the story is that daily deals aren't for everybody.

Appealing to the Thrifty Doesn't Come Cheap

There's also the sobering reality that the Groupon model isn't as lucrative as everyone thinks it should be for the deal website. Groupon had to scale back last week's IPO, and one of the reasons was its uninspiring financials. Groupon may be growing its top line like crazy, but losses continue to mount.

This should be a scalable model, but Groupon's investing in expanding at breakneck speeds. Whether it's tacking on new countries or diving deeper domestically into smaller cities, Groupon wants to make sure that it doesn't get passed up by an even faster daily deals purveyor.

Expansion means hiring local sales teams that leave no spa operator or Korean barbecue joint unturned.

Clever copy doesn't write itself for free, either.

The shakeout will continue. Niche specialists will thrive only if offering markdowns on their sites makes sense. The networking effect will continue to attract merchants and deal seekers to the more established sites.

It would be great to see Groupon or LivingSocial post profitable financials to lay the cynicism to rest, but until then the endangered species posters will just have to stay up.

Longtime Motley Fool contributor Rick Munarriz does not own shares in any of the stocks in this article, except for Travelzoo. The Motley Fool owns shares of OpenTable and Google. Motley Fool newsletter services have recommended buying shares of OpenTable, Travelzoo, and Google.