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Kayak and Groupon: A Tale of Two Websites

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On Thursday, Kayak Software (NASDAQ:KYAK) surprised investors by agreeing to be sold to Priceline.com (NASDAQ:PCLN) for $40 a share just months after a July initial public offering. As tech investors took in the news, Groupon's (NASDAQ:GRPN) bigger-than-expected third-quarter loss pushed shares in the daily deals giant to all-time lows.

The two announcements shouldn't be seen in isolation.

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Tech investors should take Kayak Software and Groupon's diverging fortunes as a lesson in how to discriminate between business models that work and those that are still unproven.

The comparison highlights that a focused excellence wins out over revenue growth or scale, and can be more easily translated into earnings.

In both its appeal to consumers and to strategic acquirers like Priceline, Kayak Software offers differentiated services in an online travel market that's rife with competition from the likes of Priceline, Orbitz Worldwide (NYSE:OWW), Expedia (NASDAQ:EXPE), and more recently, Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT).

Compare Groupon to its primary competitor, LivingSocial, and the Chicago-based daily deals site appears to only have an advantage in the breadth of its offerings, the size of its overhead and its ambition to enter highly competitive markets. The difference between Kayak and Groupon is between a company with a targeted path to growing profitability, and one that's chasing revenue and cutting at margins.

Kayak's biggest breakthrough was its early adoption of meta-search - a quick way to aggregate listings from scores of airlines, hotels and competitor travel sites. More recently, the company made a big effort to build direct relationships with airlines, resorts and rental car agencies, as copycats emerged.

Since a mid-2000s launch, Kayak's held onto differentiating travel search functionality that gave it a value proposition to weather competition and grow a loyal following. According to Sequoia Partners, an early Kayak investor, it's like comparing Google's challenge to Yahoo (NASDAQ:YHOO) in the Web search market.

In fact, when Microsoft and Google entered the travel search market, they borrowed heavily from the software model that Kayak had used to carve out a niche and win millions of loyal users. Still, Kayak's standing with consumers - and increasingly with travel providers - warded off the competition.

As a result, Kayak's been able to tread a fairly consistent path to record profits, improving operating margins and increasing user loyalty. In the past four quarters, year-over-year gross margins and net income have been on the upswing. Earnings on Thursday were a record for the company.

In a blog post congratulating Kayak, Sequoia Capital detailed the company's ability to break ground in a crowded marketplace. Michael Abramson, a partner at the venture capital firm, highlights Kayak's early adoption of software to aggregate search results and its ability to shift focus to marketing and proprietary relationships when its edge wore thin.

"The company's leitmotif was to present rich results simply, intuitively and at lightning speed. Staffing at Kayak has always been tilted towards engineering and even today, when the company has an annual sales rate of more than $300M, it only has 185 employees," writes Abramson, in the post.

"Kayak has become a wonderful example of the extraordinary amplification power that springs from thoughtful software, systems and networking architecture," he adds.

Those lean operations, growing profits, and technical expertise are the keys that made Priceline an interested buyer at a premium priced valuation.

Cantor Fitzgerald analysts highlight that Priceline's acquisition allows the company to better generate user traffic and wean itself from Google, a competitor. "Kayak's acquisition allows Priceline to move up the traffic funnel with a high-quality meta-search product and reduce dependence on Google," writes Cantor. "Kayak's brands recognition, strong query growth and success with mobile are valuable assets," the firm adds.

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Deutsche Bank analysts assign a low probability that a competitor like Expedia would try to outbid Priceline and they see little reason for antitrust regulators to block the deal, given Kayak's size in comparison to the online travel market.

In contrast, Groupon appears focused on workmanlike efforts to grow users and retail relationships to a scale where size is the company's competitive advantage. While chief executive Andrew Mason talks about analytics and targeted ads, the company's results show little in the way of the technical expertise that put it apart from competition.

In an effort to add reach, users and products, Groupon's become bloated and unmanageable, as evidenced by high expense, falling gross margins and record low share prices.

Bloomberg data shows a consistent path of declining gross margins as Groupon grows revenue - and in recent quarters - escalating losses that have cut shares to all-time lows below $3 a share.

Groupon was able to lift its battered share price by launching a mobile payments venture earlier this fall; however with competition from eBay (NASDAQ:ENAY) and others, it's hard to see a comparative advantage. Other new ideas, like Groupon Goods and Groupon Getaways, are a late entrance into online retail and travel markets. A recent international push was seen as one of the biggest disappointments in the company's third-quarter earnings.

While Kayak was able to impress Priceline with its nimble and differentiated operations, Groupon's unruly set of operations may be dissuading investors from taking a look, as losses for daily deals ventures like Amazon's (NASDAQ:AMZN) LivingSocial escalate.

In third-quarter earnings, Groupon reported break-even adjusted earnings on $568.8 million in revenue. Analysts polled by Thomson Reuters were looking for earnings of 3 cents a share on $590.12 million in revenue. Revenue rose 32% year-over-year, but Wall Street was looking for more.

"Overall, the disappointing profit guidance for 4Q12, uncertainty around Groupon's direct revenue business, and the ongoing overhang from the restatement of 4Q11 results, continues to suggests to us that GRPN's business model is in flux and highlights that there remains a high degree of investment risk. Hence, we are taking a wait-and-see approach," wrote Credit Suisse analysts, in reaction to earnings.

As seen on Thursday, investors and strategic buyers are far more likely to take interest in lean operations on a targeted upswing, than sprawling businesses in a state of flux.

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