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A Profitable Uber, WeWork Will Be Bad for Inflation

A Profitable Uber, WeWork Will Be Bad for Inflation

(Bloomberg Opinion) -- The current generation of tech startups modeled themselves on Amazon.com Inc.'s growth formula: accept losses now in order to become huge, when profitability would somehow magically materialize. This had one beneficial and far-reaching impact – it acted as a subsidy for consumers and put downward pressure on inflation. If the winds have now shifted and companies such as Uber Technologies Inc. and WeWork parent We Co. won't be able to eat enormous losses for much longer, then the impact on inflation may reverse, forcing the Federal Reserve to think about this new dynamic.

The flaw in the conventional wisdom about Amazon is that its willingness to incur losses or tolerate low profitability meant it was burning endless amounts of cash. It wasn't. Amazon has reported positive free cash flow every year since 2002:

A Profitable Uber, WeWork Will Be Bad for Inflation

Instead, Amazon's success was based on a more pedestrian strategy that – applied relentlessly over more than two decades – has produced fantastic results. Start with a core business, control costs, accept low but positive profit margins in order to boost sales and gain market share, and then invest whatever meager profits exist into new business lines that are complementary to existing ones. It's how Amazon grew from selling books to a wide range of consumer goods, to adding a subscription streaming service, to Amazon Web Services and so on.

In the past decade, startups have been distorting that template. The version of Amazon's history they internalized was to start with a product or service that gained positive traction with consumers. As revenues and customers rose, the next move was to enter adjacent business lines that appeal to existing customers. It was imperative to keep prices low, just as Amazon did. But rather than fund the growth through reinvested profits, they chose to raise venture capital to finance operations and expansion. Part of the reasoning for it was the belief that while Amazon had 20 years to get huge, this generation of startups would only have half as much time. The other part was that growth capital has been so plentiful that a startup would be foolish not to take the money. All along, the belief was that at a certain scale, profitability would naturally occur, or the company would have such a dominant market position it would then be in a position to raise prices.

This whole process has had a deflationary impact on the economy. Cutting prices to the bone makes sense for Amazon, which has positive unit economics. But for a broad array of startups it has meant pricing things below what it costs to produce them. By some estimates, consumer-services startups such as WeWork, Uber and Lyft will collectively lose close to $13 billion this year. Pricing their services below cost has forced other companies to cut prices to stay competitive, hence the source of deflationary pressure.

The contrary also is true: If these companies have to raise prices enough to be profitable – if that's even possible given their business models – this would put upward pressure on inflation.

We now may be at some kind of a turning point. Public markets rejected We's initial public offering last month in an indication that investor patience for companies with no viable plans to start making money probably is exhausted. The question is what kind of impact this will have on the broader economy.

The easiest thing for these companies to do initially tends to be cost cuts. It's no problem to sell the private jet, as We is doing, and to ditch the fancy coffee at offices without hurting the business. Firing staff is the next obvious move, though that's a sure sign that the rapid growth story isn't working. But when you're charging less for services than it costs to offer them, eventually that's going to mean price increases – particularly if investors are no longer willing to provide growth capital to companies that haven't demonstrated a history of producing positive unit economics.

If these price increases put upward pressure on inflation, the Fed should be thoughtful before responding with interest-rate increases. Higher prices for office space, ride-sharing and video-streaming services wouldn't reflect an uptick in demand, but rather a one-off shift in startup business models from something unsustainable to something with a chance to be viable. The upshot of this would also mean some of the deflationary fears of this decade were misplaced; they were just a function of startups and private-market investors buying into long-term business models that were never going to work.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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