Follow @rakeshlobster
As expected, today’s LivingSocial offer of $20 Whole Foods gift card vouchers sold out at 1 million vouchers sold.

This is a great marketing move that created buzz around the Internet, for a while was the top term on U.S. Google trends, generated news stories by Reuters, The Washington Post, Mashable and others. They even got your resident daily deals curmudgeon to say nice things about the deal.

But many people fail to understand the economics behind such deals. If the deal is structured like other such deals, it’s a customer acquisition tool. As a grocery store (even a high-priced one often referred to as Whole Paycheck) Whole Foods doesn’t have the margins for deep discounts. It’s operating margin is 5.5%. A more mainstream chain like Kroger has operating margins of 2.7%.

LivingSocial is likely spending $20 for each $10 paid by consumers. In a best case scenario, they were able to negotiate a bulk purchase discount and get the gift certificates for $18 or $19 each. That’s a net loss of $8-$10 per customer. (LivingSocial spokesman Andrew Weinstein declined to discuss the deal terms.)

This loss is increased by:

• Customers who are already LivingSocial customers. If you’re already a customer, there’s no reason for you not to buy one. It’s essentially free money! Every existing customer who buys one should be subtracted from the total customers when you’re calculating customer acquisition costs. The Amazon gift certificate promotion was more cost effective — there was a smaller base of users who were already LivingSocial customers.
• Customers who get free vouchers under LivingSocial’s 3 and free program. If you get 3 of your friends to buy, yours is free. Given how much tweeting and Facebook activity was going on, I estimate that 5-15% were given out for free.
• Customers who fraudulently purchase multiple vouchers. (Groupon and LivingSocial merchants face this all the time. Customers will set up multiple accounts to exceed stated limits.)

This loss is decreased by:

• The number of vouchers that are unredeemed. From the legalese: “Whole Foods Market code shall not be deemed purchased by the purchaser until claimed • Whole Foods Market codes will be available for purchasers to claim for ninety days following the offer period. If code is not claimed within 90 days following offer period, code will be deemed forfeited, and purchasers will be refunded the full paid value ($10) of the Whole Foods Market code in Deal Bucks to be used on livingsocial.com” Effectively, you’re buying a special gift card for LivingSocial that can be turned into a Whole Foods git card. If you don’t convert it, it’s a zero acquisition cost. In that case, you would either not use it or buy another deal on which LivingSocial would have margin.

Running deals like this puts LivingSocial in the same boat as merchants who run LivingSocial deals: customers will come in for the almost-too-good-to-be-true offer, but won’t return for the normal offer. I would buy the Whole Foods deal every single day. I also bought the Amazon and Fandango deals — all of which were likely sold at a loss. But I rarely buy anything else.

Groupon CEO Andrew Mason called out LivingSocial’s tactic of buying revenue in his controversial email to employees:

Living Social’s U.S. local business is about 1/3rd our size in revenue (and smaller in GP [gross profit]) and has shrunk relative to us in the last several months. This, in part, appears to be driving them toward short-sighted tactics to buy revenue, like buying gift certificates from national retailers at full price and then paying out of their own pocket to give the appearance of a 50% off deal. Our marketing team has tested this tactic enough to know that it’s generally a bad idea, and not a profitable form of customer acquisition.

Asked to comment on that, Weinstein responded, “we haven’t commented on Mr. Mason’s memo, except to say that any claims about our financial metrics should be treated with skepticism, as no other companies have access to our internal numbers.”

Is it worth it?

By my estimates, Groupon spent $24.08 for each new customer acquired in the second quarter. Between giving money to Google for advertising and giving money to consumers, I’d rather give money to consumers. Then there’s the value of all of the press LivingSocial received today, much of it from reporters who don’t understand the economics.

Given the timing, the bigger reason to do it is to put lipstick on the LivingSocial hog. As a company that is rumored to be on the IPO path, the Whole Foods gift card giveaway improves these metrics:

• Total number of customers. (If you bought the deal you’re a customer.)
• Conversion rate of list subscribers to customers. (Again, every one who buys this is a customer. This increases the percentage of list subscribers who have bought something.)
• Repeat customers. One of the things I knock Groupon for is more than half their customers have never purchased again. But if you bought both the Amazon deal and the Whole Foods deal, you’re a repeat customer!
• Gross revenue. If LivingSocial books revenue like Groupon does, they just generated $10 million in revenue! They just grew revenue for the quarter by $10 million. Magic.
• Total vouchers sold.

Investors should be smart enough to look past such shenanigans, but most don’t look at such details when evaluating financials.

I look forward to reading and analyzing LivingSocial’s S-1, if there is one.