Successful managers can turn razor-thin margins into profit

In 1997, an upstart company sent out its first letter to shareholders to explain its business philosophy. The young chief executive reportedly measured the firm’s success not by profitability but by market leadership as defined by growing market share. “We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure,” he said.

This is a textbook approach for a fledgling company during its early investment phase. Remarkably, the same strategy is still in place 19 years later, even though the company has grown to US$100 billion in annual sales. This company is Amazon, and in every earnings call, Jeff Bezos likes to attach his original 1997 letter to investors, reminding people, “It’s still Day 1.”

Amazon built its empire selling physical books, CDs and DVDs. Next came video streaming, then the Kindle e-book library, later followed by Audible, an audiobook company Amazon owns. Added recently is Echo, a wireless speaker and voice command centre that allows users, through voice interaction, to play music, make to-do lists, set alarms, stream podcasts, order takeout, and much more. If this is not nearly enough, Amazon’s Web Services, its cloud computing division, is raking in billions every year, outstripping all competitors, including Microsoft’s Windows Azure and Google’s Cloud Storage.

None of these frantic expansions comes cheap, as sprawling investments have condemned the company to subsist on razor-thin margins. Critics have scorned Amazon as “a charitable organisation being run by elements of the investment community for the benefit of consumers,” so much so that the firm registered a net loss of US$274 million in the third quarter of 2012.

However, observers soon shrugged the loss off, as sales kept climbing. By the end of that same year, Fortune had named Jeff Bezos its Businessperson of the Year.

A favourite Bezos maxim is: “your margin is my opportunity.” Having started off from a low base, Amazon can afford to price an e-reader at US$69.99, promote a tablet at US$49.99, and drop a TV stick similar to Apple TV at US$39.99. Still, the race to the bottom has just barely begun.

Consider China’s Huawei Technologies, now the world’s third-largest smartphone maker. The Shenzhen-based company started by producing cables, routers, and switches, competing with the likes of Ericsson and Alcatel-Lucent for projects in telecom infrastructure. Having secured a foothold market based on a low pricing strategy, Huawei has increasingly shifted its focus to smartphones for new growth opportunities.

Despite rising revenues of 30 per cent in the first quarter of this year, Huawei’s margins shrunk from 18 per cent to 12 per cent. Did investors protest by dumping the company’s shares? Not if the chief executive’s shares account for 1.4 per cent of the company’s total and the rest are owned by some 82,000 company employees. Huawei is privately held.

All this has turned several pieces of conventional wisdom on their heads. Every respectable business school teaches at least one thing to its aspiring MBAs: you should prioritise investments on those innovations that promise the highest returns. This is why a watchful financial controller for each company assesses investment opportunities and carefully allocates corporate resources.

The problem is, of course, that no company actually competes in a vacuum. Huawei and Amazon on the other hand survive on razor-thin margins and turn them into an advantage by stretching into new growth areas. Rather than seeking ever higher returns, they focus on new opportunities.

At the height of the rapid ascendancy of Japan’s economy in the 1980s, Harvard professors Robert Hayes and William Abernathy warned companies against relying too heavily on short-term financial measurements like return on investment (ROI) to guide investment decisions. What managers feared most was for their companies’ new products and services with lower profit margins to directly cut into the sales of existing ones.

But that fear may ultimately forestall much-needed investments in new projects or technological progress. That sage advice may ring truer in today’s rough-and-tumble internet world.

Howard Yu is a professor of strategy and innovation at IMD Business School