On Monday morning, retail giant Wal-Mart (NYSE:WMT) announced plans to buy much-hyped e-commerce start-up Jet.com for $3.3 billion.
It may seem odd for Wal-Mart to spend that much money for a company that only opened for business a year ago and is years away from profitability. But the combination of Jet.com's technology and business model with Wal-Mart's massive scale and logistics expertise could be critical in allowing the world's largest retailer to fend off the threat from Amazon.com (NASDAQ:AMZN).
The key innovation behind Jet.com was a sophisticated pricing algorithm that encourages shoppers to help Jet reduce its costs. Most notably, the company dynamically adjusts prices based on what's already in a customer's shopping cart. Items that can be shipped from the same warehouse become cheaper.
Jet also charges less for items that are in nearby warehouses (and can therefore be shipped at a lower cost). It has additional discounts for customers who use debit cards (which are cheaper to accept than credit cards) and those who agree to make a non-returnable purchase.
The ultimate goal was for Jet.com to undercut the likes of Amazon.com and Wal-Mart on pricing. Originally, the company aimed to beat rivals' prices by 15% while relying on a $49.99 annual membership fee as its sole source of profit. Later, Jet.com abandoned its plans to charge an annual fee and aimed for a more modest 5% price advantage.
The fatal flaw
Yet there was always a fatal flaw in Jet.com's strategy. It was trying to underprice retail titans like Amazon.com and Wal-Mart while starting from scratch. In an industry where scale is massively important -- particularly for bargaining with suppliers -- there's no way to do this without losing tons of money.
To his credit, Jet.com founder Marc Lore recognized this problem even before the company started operations last year. He emphasized the necessity of incurring big losses up front in order to quickly gain scale. Lore's goal was for Jet.com to reach annual gross merchandise volume of $20 billion by 2020, at which point he thought the business could turn profitable.
A little more than a year after the Jet.com site went live, gross merchandise volume has already reached $1 billion, with the sales run-rate up 168% since last August. That's a commendable start, but as a stand-alone company, Jet.com still faced years of massive losses -- with no certainty of long-term success.
Wal-Mart provides the missing piece
E-commerce firms have three key tools for pursuing sales growth: (1) lowering their prices, (2) expanding their merchandise selection, and (3) advertising. Wal-Mart can probably help Jet.com on all those fronts.
First, as the largest retailer on the planet, Wal-Mart has huge economies of scale in purchasing and distributing merchandise. This will allow Jet.com to reduce its prices even further to win customers away from Amazon.com without incurring higher (and potentially unacceptable) losses.
Second, Wal-Mart has relationships with suppliers across the globe due to its massive scale. As a result, it can probably coax suppliers that have so far resisted Jet.com's overtures into making their products available.
Third, Wal-Mart could help Jet.com with advertising simply by providing a bigger budget. If it's willing to spend $3.3 billion to buy an unprofitable company, Wal-Mart should be also be willing to plow a lot more capital into Jet.com to keep it growing rapidly in the coming years.
There may also be opportunities to market Jet.com to existing Wal-Mart shoppers -- of which there are, of course, a huge number. However, that would come with an increased risk of cannibalizing more profitable sales at brick-and-mortar Wal-Mart locations.
A risk worth taking
Not surprisingly, the proposed Wal-Mart-Jet.com tie-up has plenty of detractors. For the most part, they argue that Amazon.com is simply too far ahead or point to the high acquisition price and Jet.com's tiny market share.
However, Wal-Mart's internal e-commerce efforts have been running out of steam lately. The company needs to do better in order to fend off the long-term threat from Amazon.com's growth. In this context, buying Jet.com is a risk Wal-Mart has to take. Combining its purchasing scale with Jet.com's technology and business model will make Wal-Mart much more competitive in the e-commerce market.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.