Amazon (NASDAQ:AMZN) recently announced that it will shutter its daily deals site, Amazon Local, in December. The e-commerce giant launched Local four years ago through a 30% investment in LivingSocial, one of Groupon's (NASDAQ:GRPN) main rivals. Unfortunately, the daily deals market started to weaken, and the value of Amazon's stake in LivingSocial fell from over $1 billion to just $242 million at the end of 2014. Meanwhile, LivingSocial recently laid off 20% of its staff to cut costs.
If Amazon had exited the daily deals market two years ago, Groupon investors would have cheered. But today, Amazon's exit seems to be a confirmation that the once-hyped daily deals market is dying.
Why daily deals are dying
The daily deals model has two big weaknesses. First, businesses often can't make money after offering a steep discount and paying a site its cut of the sale. Second, the "loss-leader" strategy of attracting customers to businesses with steep discounts to generate additional purchases and customer loyalty doesn't work, since many customers were only interested in the next daily deal.
Groupon typically retains a 50% cut of each sale as a marketing fee. That might seem greedy, but it's not enough to keep the company profitable due to the expenses of running the site, promoting it, and hiring sales representatives.
That's why Groupon started automating the business application process last year to replace human employees. However, that still didn't prevent the company from suffering a net loss of $27.6 million last quarter, which was wider than its loss of $21.2 million a year earlier. To further tighten its belt, Groupon announced 1,100 layoffs in September and the closure of several overseas operations. But by shrinking its footprint, Groupon's gross billings, which slipped 2% annually last quarter, will likely keep declining. That's why Groupon shares have plunged more than 60% since the beginning of the year.
Amazon makes the right move
LivingSocial takes a similar cut from sales, but has a substantially smaller market share. Although it initially seemed like Amazon Local could leverage the popularity of its main site to promote local goods and services, it quickly became a dead weight on Amazon's bottom line for the same reasons Groupon floundered -- high expenses and unattractive promotional rates.
The good news is that Amazon knows when to abandon bad ideas. In September, it killed the Fire Phone, its misguided shot at the smartphone market. In October, it killed Destinations, its travel booking site. Earlier this month, it dumped Local Register, a payment processing business that was intended to challenge Square.
Keeping Amazon Local alive simply didn't make any sense since it wasn't contributing anything to Amazon's paper-thin margins. During the first nine months of 2015, Amazon squeezed out just $114 million in net income on $71.26 billion in revenues.
But what about Groupon?
While Amazon can simply walk away from the daily deals market, the future looks bleaker for Groupon. For the fourth quarter, Groupon expects revenues to decline 6.5% to 12% from the prior-year quarter, compared to expectations for 3% growth. It expects non-GAAP EPS to come in between a loss of $0.01 and a profit of $0.01, which also misses the consensus estimate of $0.07.
To appease its shareholders, Groupon propped up its earnings with big buybacks. However, the $193 million it spent on 44 million shares during the third quarter was a pretty bad investment, considering that the stock plunged 26% on Nov. 4 after its earnings report. That money would probably have been better spent on sales and marketing to boost billings.
Groupon's new CEO, Rich Williams, who recently replaced Eric Lefkofsky, has pledged to focus on acquiring new customers, streamlining its international operations, and shifting its goods category away from "lower-margin empty calories products." Those are bold words, but they don't address the core weaknesses of the daily deals market.
The decline of the daily deals market reveals the dangers of investing in companies built on untested markets. Groupon initially looked like an evolutionary leap forward in e-commerce, but its business strategy didn't take into account the needs of businesses. Amazon is smart to walk away from daily deals, but Groupon remains stuck as the leader of this dying market.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.