Group-buying sites remain a VC risk

The China e-Business Research Center estimates the industry is seeing growth of more than 29% per month. According to Chinese website Tuan800.com, which tracks and analyzes China's online group-buying sector, more than $526 million was transacted in the first half of the year, against $209 million for the whole of 2010.

This comes despite there being little guarantee that the group-buying model can achieve success in an environment of cut-throat competition, which makes it difficult for these sites to turn sales into revenue.

The risks surfaced in August with reports that Gaopeng - Groupon's China joint venture with Tencent Holdings and Yunfeng Capital - had closed 10 offices and fired about 400 people over the last three months. Gaopeng, which only launched eight months ago, said the closures reflect plans to focus on major cities where the market is more developed. If an entity supported by China's largest internet player and America's most successful group-buying site can't get it right, who can?

"We looked at a couple of these group-buying sites but we couldn't pull the trigger because they're money-burning businesses. They provide discounts for people buying in bulk, but the internet is a bad environment for something like this," say Tony Luh, managing director at DFJ DragonFund. "If there are advantages to investing into these types of companies, I don't see them."

Can they monetize?

Clearly other VCs thought they saw potential. Aside from Yunfeng Capital backing Gaopeng, other notable investment targets include Lashou.com, which announced in April that it had raised $110 million in Series C financing despite having a corporate history that stretches back barely 12 months. The company has now raised a total of $166 million from three rounds of funding, with backers including GSR Ventures, Tenaya Capital, Norwest Venture Partners and affiliates of luxury goods company Richemont.

According to Analysys International, in the first half of the year, the four most-visited group-buying websites in China were Lashou, with 53.9 million unique visitors, Meituan (48.4 million), 55tuan (36.5 million), and 24qun (31.4 million). Nuomi - launched by social networking giant RenRen last June - came in fifth while Taobao-backed JuHuaSun didn't make the top 10, suggesting that the presence of a major internet player doesn't necessarily pay off.

Meituan and 55tuan have received $70 million and $50 million, respectively, from VCs.

The success of Groupon in the US has seemingly launched a race among Chinese sites to raise as much as they can to out-flank the competition. Richard Lim, managing director of GSR Ventures who co-led investments into Lashou, says the idea is to bet on the group-buying horse that has the potential to become bigger - or most successful in a particular vertical niche - and then take it public in the US. This plan mirrors Groupon's own ambitions. The company rejected a $6 billion acquisition offer from Google last December, preferring to shoot for a $750 million IPO that would value the full entity at around $20 billion.

The problem is that group-buying firms, supported by capital from investors, are able to reduce prices with a view to gaining market share, which results in razor-thin - or non-existent - profit margins.

"This much private equity money in the space becomes a disadvantage to group-buying companies because each has its own war chest that they use to fight each other," DFJ DragonFund's Lu says. "This is a case where it's very bad for private equity to be so ‘trendy' and fund these companies at such pace."

The China Internet Network Information Center (CNNIC) corroborates that competition has led to losses. According to a study last month, group-purchasing websites saw average profit margins of 15-18% last December, but the figure dwindled to 5% as of early August.

The long-term success of these businesses lies in monetization. China's sites have similar operating models, where they sell goods - many of them already inexpensive by most international standards - and apply a 5-40% discount if a certain volume of the product is purchased. The sites take a percentage cut from the products' promoters. Applying CNNIC's 5%, if a site sells 500 restaurant coupons for RMB100, it would walk away with RMB2,500.

CNNIC found that China had 42.2 million group-buying users at the end of June 2011, and their purchases add up. For example, by 5.30 p.m. on September 8, Meituan had sold 11,125 pieces of floral underwear at RMB1 apiece, discounted from RMB80. At the same time on 55tuan, 23,873 people purchased condoms, for RMB1.49, discounted from RMB3.8.

"Group-buying websites in China see substantially less money per typical transaction than in the US, but data shows that there are on average 3-10 times more transactions per particular offer occurring in China than in the US, and there are a lot of offers per site," Lim explains. "So the absolute amount of money transacted is not terribly different. This favors the top most-used sites."

Too much of a good thing?

The reality for the group-buying segment worldwide is that competition is intensifying and it is becoming harder to capture buyers' interest. Groupon, for example, reported a loss of $146 million in the first quarter of 2011. Its sales rose 14-fold year-on-year while marketing costs increased 50-fold.

But Groupon still has a savvier monetization model than most of its Chinese counterparts. Not only does the company skim profit from the top of each sale - like the Chinese sites - it also leverages its role as an advertising platform and charges deal promoters click-through fees. As a result, Groupon can capitalize on eyeballs as well as purchases.

According to Lim, Groupon's success in the US may contribute to its woes in China. "Gaopeng struggled because of several different issues. It was set up in a relative hurry and they just tried to replicate the US model, bringing in overseas executives who didn't know the language," he says. "And Tencent is a very successful organization but not the easiest to work with. People anticipated they would run into problems, and they did."

Sources agree that Gaopeng's difficulties are the first sign of a consolidation process in the industry. Weaker players have already begun to disappear, and in the coming months, the strongest sites are expected to discover greater traction, offering quality deals to customers and vetting disreputable vendors who sell out-of-date products or don't deliver on their deals.

In light of this shifting group-buying landscape, potential investors must decide whether their portfolio companies have what it takes to compete. James Fong, director of merchant bank and financial advisory firm China Tongyin, says investors should ask company management whether their business is scalable and when they expect to break even. Lashou isn't likely to become profitable until 2013.

Most of these sites in China not will make it to long-term operation, but those who do are poised to reap the benefits.

"China is the largest internet market; it will be the biggest PC market; it's the largest mobile market; it has the potential to be the largest consumer market. The group-buying model will absolutely work in China," Fong says. "And group-buying fits well with Chinese behavior. Everyone loves a bargain, and the whole thing has become a game they enjoy watching."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Technology
• Early-stage
• Yunfeng Capital
• Draper Fisher Jurvetson
• GSR Ventures
• Tenaya Capital
• Norwest Venture Partners