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Amazon.com, Inc. (AMZN): LivingSocial, And A Growth Misunderstanding

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In just over five years, daily deal company LivingSocial went from D.C. technology start-up to one of the District’s largest employers, with the backing of marquee investors, including the heavyweight champion of e-commerce, Amazon.com, Inc. (NASDAQ:AMZN). Then, last October, the company announced a massive $566 million third-quarter loss as revenue declined and it was forced to take heavy writedowns on prior acquisitions. The following month, the company laid off roughly 10% of its workforce. What went wrong, and what happens next?

Amazon.com Inc. (AMZN)Credit: Amazon.com, Inc. (NASDAQ:AMZN)

The rationale for a bubble
At this stage, the evidence is pretty well overwhelming: There was a bubble in social networking companies and shares, and LivingSocial was no exception to that phenomenon, even though it remains a private company. We know this now because the business fundamentals of many of these companies were unable to support the wildly inflated public and private market valuations they achieved early on.

When LivingSocial completed its most recent financing round in February, it did so at a valuation of just under $1.5 billion, a decline greater than two-thirds with respect to the previous round less than 15 months earlier. LivingSocial’s publicly traded competitor, Groupon Inc (NASDAQ:GRPN), has seen its shares fall by three-quarters from the end of its first trading day in November 2011.

Bubbles are not born of euphoria; every speculative mania has a rational element at its root. At least two conditions are required: First, an important market opportunity and second, a narrative describing how a company will tap into that market. Often, the latter involves a new technology, or a new form of business or commercial organization.

Both conditions were present in the mania that propelled LivingSocial and Groupon upward, providing them with hundreds of millions of dollars of capital. LivingSocial’s story can’t be understood without reference to its larger rival. In the following discussion, I’ll sometimes refer to “GroupingSocial” as shorthand for both companies.

The opportunity
The market opportunity was local advertising and the basic enabling technology was the Internet and, more specifically, social networking. As LivingSocial’s CEO Tim O’Shaughnessy told Business Insider’s Henry Blodget in an interview in May 2011:

There hasn’t been a disruptive model in the [local advertising] space for literally decades. And so you had all this demand for a more efficient marketplace to occur and now that a more efficient marketplace is here, people are rushing to it, which is why I think you’ve seen such aggressive growth in the space.

He wasn’t wrong. Consider, for example, that, in 2011, publishers in the U.S. distributed 422 million telephone directories — a mainstay of local business advertising — for which they received a total of $6.9 billion in ad revenue (including digital operations, directory companies collected nearly 8% of total U.S. ad spend in 2011.) Phone books! There had to be a better way to bring together consumers and businesses.

Google Inc (NASDAQ:GOOG) revolutionized the advertising market for businesses selling online with paid search, but even a company with its resources, know-how, and innovative culture hasn’t really cracked local advertizing and commerce. Group-buying looked like a new model that had a legitimate chance of upending traditional practices in this marketplace. Google itself must have believed that or the company would not have offered $6 billion to acquire Groupon Inc (NASDAQ:GRPN) at the end of 2010.

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