Why Groupon Basics Poses Little Threat to Costco

Groupon (NASDAQ: GRPN  ) chief executive Eric Lefkofsky said last year that the e-commerce company had ambitions to become more like Costco Wholesale  (NASDAQ: COST  ) , the leading warehouse retailer, than like Amazon.com (NASDAQ: AMZN  ) , the leading online retailer. 

The company finally followed up on its promise by launching Groupon Basics, a service that will offer discounts on bulk purchases of 110 home goods in select categories, including personal-care items, consumer products, and vitamins. The service is intended to compete directly with warehouse retailers like Costco and Amazon's new Prime Pantry service. But unlike Costco and Amazon, Groupon will not charge its customers a fee to enjoy the service.

Groupon shooting itself in the foot?
Groupon Basics is an extension of Groupon's Goods retail site. The service looks like a great deal compared with what Costco or Amazon have to offer. Goods will be discounted 20%-30% off retail prices, plus the company will give customers 5% of their purchases back as 'Groupon Bucks.' To sweeten the deal even further, free delivery will be available for goods priced at more than $24.99, implying that practically all purchases will be eligible for free delivery since the deal is meant for bulk purchases.

In comparison, Costco requires customers to subscribe to a $55 membership fee, or $110 for executive membership. Only executive members are eligible for a 2% annual rebate on their purchases, capped at $750. But, Costco stocks 4,000 different brands, a lot more than the 110 brands Groupon Basics will be offering.

Meanwhile, Amazon recently launched the Amazon Prime Pantry service with a much wider selection of items than what Groupon Basics offers. Amazon Prime members can fill a 4 cubic foot box with up to 45 pounds of selected items and then have the box shipped to their homes for just $5.99. The biggest downside to Prime Pantry is that delivery will take one-to-four business days compared to Amazon Prime, which takes just two days.

Groupon Basics is an extension of Groupon Goods, Groupon's fastest growing segment. The division finished fiscal 2013 with approximately $1.9 billion in revenue, or 72% of its overall revenue of $2.6 billion. The Groupon Goods segment grew 25% last year compared to the company's overall 10% revenue growth. Direct revenue from goods shipped by the company itself grew 109%.

But, the concern that immediately comes to mind is how Groupon can discount its goods 20%-30% and offer free home deliveries and still manage to make money. Although the service will be limited to the U.S. only, presumably to lower delivery costs, selling retail goods at 20%-30% discounts is usually enough to wipe out any profits since most retailers mark up their goods roughly 20%-25%. TJX, one of the leading off-price retailers, offers 20%-60% discounts on its merchandise because the company relies on order cancellations and closeouts by manufacturers to hunt for great bargains, which it then passes on to its customers.

Costco distinguishes itself from the average big-box retailer by marking up its goods only 15%. But, customers have to purchase in bulk, and of course pay a membership fee. The company's membership fee is a huge gravy train -- Costco made about $2.3 billion in membership fees from its 72 million members in fiscal 2013. The company earned approximately $2 billion on sales of $102.9 billion. This implies that the company would have made a net loss without the boost to its bottom line that it received from the membership fees.

Overall, it means that Groupon might be forced to keep its Groupon Basics goods portfolio pretty small -- if it hopes to make any money from its Groupon Goods division.

Treasure hunt
But, perhaps the biggest facet where Groupon Basics will have a hard time competing with Costco is the treasure hunt experience. Costco constantly changes the brands in its stores so that customers can never know what to expect next. This contributes to the unique treasure hunt experience that customers just seem to love. Of course, that is something you cannot duplicate with online shopping.

Costco also offers high-quality brands at competitive prices. Groupon Goods concentrates on off-brand items. Additionally, Costco does not advertise in order to keep its prices low, while Groupon's business model revolves around heavy advertising.

Foolish bottom line
It will be very difficult for Groupon to expand its Groupon Basics portfolio. That is unless it has discovered novel sourcing strategies like TJX that can help it save money on purchases and pass on the savings to its customers in the form of heavy discounts. Its limited portfolio will most likely have little impact on Costco, which offers a wide variety of brand items at competitive prices.

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