Wal-Mart’s Jet.com Hail Mary Is a Bad Sign for Investors

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Though many shoppers don't know it, Wal-Mart's (WMT -0.65%) e-commerce efforts have been under way for more than a decade. And while it is far and away the most powerful brick-and-mortar retailer in the world, its efforts to adapt in the age of the internet have lagged significantly behind those of Amazon.com (AMZN -1.14%) and other competitors. Last year, the king of e-commerce generated six times more Internet-based revenue than Wal-Mart.

That's a big reason why Wal-Mart is willing to fork over $3.3 billion in the recently announced acquisition of e-commerce start-up Jet.com. On the surface, the decision to acquire Jet seems logical:

• It shows investors that Wal-Mart is serious about upping its e-commerce game.
• Jet has shown remarkable growth in its one year of operations, particularly with urban millennials.
• With the acquisition, Wal-Mart gains access to (1) Jet's proprietary technology, which is responsible for offering customers attractive savings, and (2) Jet's accomplished CEO, Marc Lore.

But the more time I spend thinking about it, the more I believe Wal-Mart is throwing money away -- and that's bad news for shareholders.

Risk-taking 101, from a Nobel laureate

Nobel laureate Daniel Kahnman's Thinking, Fast and Slow is a gold mine for those interested in behavioral economics. In one of the book's sections, he lays out a simple framework to understand when and why individuals (and companies) are willing to take risks -- particularly when they actually aren't in an individual's best interests.

Imagine that you are given two options:

1. A guaranteed result

2. A bet for a more favorable outcome.

The two variables at play are (1) how likely you are to win, and (2) whether you are gaining or losing money as a result.

Author's version of graphic from Thinking, Fast and Slow, by Daniel Kahnman.

Studies have found individuals typically exhibit the behavior that's in the bold, capital letters. Critically, that is the worse of the two choices on a strictly rational basis.

For the purposes of this article, we are focused on the upper right-hand corner: a high probability for losses. If you have a 90% chance of losing $100, the value of taking that bet -- over time -- is negative $90 (90% times $100). It would be better for you to choose a guaranteed loss of $80.

But Kahnmen says that we are suckers in our hope to avoid losses, and we're likely to reject this favorable guarantee. As he states [emphasis added]: "Many unfortunate human situations unfold in the top right cell ... Risk taking of this kind often turns manageable failures into disasters." 

What this has to do with Wal-Mart

I would argue that Wal-Mart is in the upper right-hand square when it comes to an e-commerce strategy. It is clearly losing to Amazon and doesn't have many options to stem the tide. While Wal-Mart's earnings, released earlier this month, showed encouraging growth in e-commerce, the long-term trends are still decidedly negative.

More alarming, however, was the fact that Wal-Mart CEO Doug McMillon was willing to pay over $3 billion for Jet. To put that in perspective, Wal-Mart has $7.7 billion in cash on hand. Even though the company has strong free cash flow with over $21 billion over the past twelve months, that's 40% of the company's cash poured into the acquisition -- not an insignificant amount.

And though Jet.com has shown remarkable growth, it is hard to imagine any path to profitability for the company. Even if it does achieve profitability, it is even harder to see that profitability significantly moving the bottom line at a massive company like Wal-Mart.

Looking to the future

Perhaps the most important metrics at play are sustainable competitive advantages. Amazon's raison d'etre is to be the best customer service company in the world, especially when it comes to order fulfillment and shipping speeds. To that end, it currently has 80 domestic fulfillment centers, with plans to add 32 more. As best I can tell, Jet only has two (in Kansas and New Jersey), and Wal-Mart has between seven and 12 .

Those fulfillment centers are crucial, because they help guarantee that Amazon can get packages to Prime members as quickly as possible, typically two days or less. Wal-Mart and Jet fans are quick to point out that Jet also offers such guarantees on shipments from its fulfillment centers, and even for products not shipped from Kansas or New Jersey, Jet pressures third-party suppliers for similar guarantees.

The problem is that the delivery and logistics game is rapidly changing. Five years from now, Amazon may be able to offer one-day shipping, or even same-day delivery. Drone deliveries get closer and closer to becoming a reality, and with over 100 locations, there's simply no way Wal-Mart or Jet could offer the same type of customer service from just 10 to 15 fulfillment centers.

Some argue that Wal-Mart and other brick-and-mortar players could transition the use of their physical locations into quasi-fulfillment centers. Wal-Mart currently has over 780 million square feet of retail space domestically when Sam's Club is included. When Amazon's known build-out plan is completed, it will have just under 100 million square feet.

It would seem that Wal-Mart has the upper hand. But what investors need to recognize is that the company would have to cannibalize its physical retail space -- the bread and butter that pays the bills -- in order to capitalize on such an opportunity. It would be a bold move, but management has given no concrete indications that it is a move the company is willing to make.

In much the same way that we now find it unconscionable to wait 10 seconds for a website to load when just 10 years ago that seemed like lightning fast connectivity, I see a future where same-day or even next-hour delivery is the norm. Whether or not that actually pans out isn't the point: Amazon -- in addition to having a huge head start -- also has far more optionality to stay ahead in the e-commerce industry.

At the end of the day, I'm not sure what the right move for Wal-Mart would be. But I do know that as far as shareholders are concerned, there's a high probability that Jet.com's $3 billion price tag will never be justified by additions to Wal-Mart's bottom line.