Companies Sacrifice Profits to Build Customer Base

Over the last few decades, so-called “mega-companies” with negative earnings have become increasingly popular.

Between 1970 and 2019, the proportion of publicly traded companies with negative earnings increased from 18% to 54%. This trend is most prevalent in wealthier countries. Additionally, many of the companies that have negative net earnings have positive gross income.

The phenomenon is seen across many sectors and industries but is strongest in the manufacturing sector, services sector and public administration sector. The trend is less apparent in industries like finance and insurance.

When examining why there are more companies with negative earnings than in the past, researchers hypothesize that it is due to increasing returns-to-scale. Greater returns-to-scale occur when the marginal value of an additional customer relative to production costs increases.

Negative earnings are the result of companies attempting to build up their customer base to a certain level. The study’s authors give three reasons to support this hypothesis. First, earnings losses primarily come from growing customer capital expenses rather than production-related or research and development (R&D) expenses. Since the marginal value of a customer has increased with the rise of technology, companies are incentivized to spend more resources on acquiring new customers (customer capital investment).

Second, firms with higher markup tend to use their money to acquire new customers, thus lowering net earnings. Additionally, when interest rates are low, larger firms tend to spend a disproportionate amount of resources on customer capital investment.

Third, industries with low marginal production costs tend to have a higher frequency of unprofitable companies.

Overall, increasing returns-to-scale have driven the change in the way many companies allocate resources, putting more resources to customer capital investment. This, in turn, has led to many companies posting negative net earnings despite having positive gross earnings.

Source: “The Rise of (Mega-)Firms with Negative Net Earnings,” by Dan Su; Cheung Kong Graduate School of Business, March 26, 2022.