By Alistair Barr and Dan Levine
SAN FRANCISCO (Reuters) - The daily deal industry has jolted a formerly sleepy corner of the $30 billion online advertising market as Groupon battles with rivals to attract new customers.
The customer-acquisition rush centers on the local part of the paid search marketing business, which is dominated by Google Inc in the United States.
SEM, as it is known, lets companies bid in auctions to run ads above and beside the results of Internet searches, based on keywords.
Local search ads that included references to towns and cities were not in demand until daily deal companies started paying handsomely to track down people interested in neighborhood goods and services.
"Living Social and Groupon have introduced a new element to local search," said Dale Carr, chief executive of online and mobile advertising network Lead Bolt. "Previously this was dormant inventory that would have just sat there and anyone could have bought it cheaply."
The new activity is increasing costs and crowding out other local advertisers. It has also raised the cost of acquiring customers for the daily deal industry itself, putting a potential break on rapid growth of the sector.
Competition is fiercest for local services such as restaurants, spas, gym memberships and yoga classes, according to Chris Wallace of digital marketing agency iCrossing.
Groupon is the most aggressive, according to Wallace, followed by Living Social and Google, which has its own daily deal business called Google Offers.
When competition from daily deal companies is particularly intense, local advertisers can end up on page two of Google search results and that often means no one clicks on their ads, Wallace explained.
"It's scary for them," Wallace said. "Once a daily deals aggregator enters a market they're unlikely to leave. The number of services they offer will likely increase and the number of search terms they bid on will increase."
San Francisco Comprehensive Tours sued Groupon in March saying the daily deal company caused a surge in the cost of its paid search advertising.
Since 2005, Bilello's company has used Google's paid search system AdWords to promote its tours of the Bay Area.
The approach was "cost effective," placing ads on one of the top three to four spots on Google results pages when users searched with phrases including "San Francisco Tours," "Alcatraz tours" and "Napa Wine tours," the suit said.
Around September 2010, the cost of these ads began to "skyrocket" and its paid search ranking fell, while Groupon started to appear near the top for results based on the same phrases, the complaint said.
Groupon used "bait and switch" advertising techniques because the company rarely offered discounted tours in the Bay Area, the suit said.
"They're spamming Google, throwing out all of these search terms that they have nothing to do with, paying more and crowding out other advertisers so they can suck more people into their Groupon world," said Steven Williams, an attorney representing San Francisco Comprehensive Tours.
Searches using the terms "San Francisco tours," "Alcatraz tours" and "Napa wine tours" on the afternoon of October 7 showed no Groupon paid ads.
Williams said Google deactivated some Groupon ads because Groupon's deals had little relevance to the ads. Bilello said Google removed Groupon from keyword auctions of "Alcatraz tours" and "Alcatraz Tickets" due to advertiser complaints.
A Groupon spokeswoman declined to comment.
Google would not comment on the case, but a spokeswoman said it removes ads that do not "clearly include information for the particular promotion or price that is being advertised within one to two clicks of the ad's landing page."
The surging cost of local paid search ads has also made it more expensive for Groupon to acquire customers.
In 2009, when Groupon was less than a year old, it cost the company about $1.50 or $2 to acquire each subscriber. It now costs roughly $7.50 per subscriber.
Groupon has accumulated more than 100 million subscribers, so it may have an advantage over rivals that are still trying to build customer bases.
However, that advantage depends on Groupon holding on to the customers it already has.
"Their cost to acquire customers appears very high and I don't know whether they will keep all those customers," said Michael Cuggino, who helps run about $15 billion at Permanent Portfolio Funds.
"If the argument is that acquisition costs have gone up and you already have your customers and won't have to spend to keep them, my answer is prove it to me."
(Reporting by Alistair Barr, editing by Maureen Bavdek)