Uber Technologies, Inc. (NYSE:UBER) has recently come under heavy criticism for its inability to generate sufficient earnings to justify the seemingly high valuation multiples attached to its stock. There’s no denying that Uber has a long way to go to become the company it aspires to be. Nonetheless, Uber bears, in my opinion, are getting it wrong from a valuation perspective. While I would not add to my existing position in Uber at the current price level (because I’m a fan of seeking a high margin of safety when investing in growth companies), the recent developments do not give me enough reason to book my profits. In this analysis, the common misconceptions about valuing Uber will be discussed along with growth projections.
Uber is not and will never be an Amazon
Uber has often been compared to Amazon.com Inc. (NASDAQ:AMZN), and many articles can be found on the internet (such as this one) that compares the post-IPO era of Uber to that of tech giants including but not limited to Amazon and Facebook Inc. (NASDAQ:FB). On the flip side, bears have argued the fact that Amazon was cash flow positive within a few years from its establishment, but Uber is nowhere close to achieving this feat even though it has been in existence for over a decade.
|First profitable year (excluding unusual items)||NA||2003|
|First cash-flow-positive year||NA||2002|
Source: Company filings and Seeking Alpha Premium
It took Amazon less than a decade to become profitable and to generate positive cash flows, whereas Uber has found itself in an uphill battle to reach either of these milestones. Amazon disrupted not only one industry but also many. In fact, the company grew rapidly to become the go-to e-commerce solutions provider in literally every corner of the world, and the addressable market opportunity for Amazon was and is humongous. In addition to being the leading online marketplace in the world, Amazon is one of the leading players in the cloud computing industry that is growing in leaps and bounds as well. The two companies, in my opinion, could not have been any more different.
The expectation that Uber would turn out to be the Amazon of transportation is something CEO Dara Khosrowshahi seems to have originated. Below statements by the CEO date back to the pre-IPO period in 2019:
Cars are to us what books are to Amazon. Just like Amazon was able to build this extraordinary infrastructure on the back of books and go into additional categories, you are going to see the same from Uber. (Bloomberg article)
We want to kind of be the Amazon for transportation. (Cnet article)
Just like Amazon sells third-party goods, we are going to also offer third-party transportation services. (New York Times article)
Agreeing with the bears, I believe Uber would never be able to become an Amazon. In fact, no other company is likely to become an Amazon due to its sheer scale and the infinite number of industries the company is disrupting. Speaking about Uber on CNBC last year, Aswath Damodaran said:
The Amazon analogy has been carried too far and is being used as an excuse to justify high pricing for every money-losing, Silicon Valley venture.
This does not mean that Uber would not be able to disrupt the transportation industry on a global scale and that Uber would never be profitable. More importantly, this is by no means an indication that Uber should not trade at high valuation multiples.
Damodaran has remained skeptical about the big promises of Uber, but he is a well-known strong believer of the fact that any stock could be attractive at a certain price. Proving this once again, he revealed an investment in Uber at the lows of around $14 when Barron’s interviewed him in June to gauge a measure of his expectations for the market performance.
Here’s a better (but not popular) comparison to Uber
Uber, for now, is a story stock. In case a reader is not familiar with this classification, I strongly recommend reading the work of Prof. Aswath Damodaran. For a summary of how to value story stocks and the required adjustments to traditional valuation models to derive a more realistic value for a story-driven company, you may want to read a piece on the subject I published on Seeking Alpha a couple of months ago.
Tesla Inc. (TSLA), as far as I see, is a much better comparison to Uber than Amazon for several reasons. Tesla has struggled to remain profitable consistently despite reporting stellar numbers during a few quarters over the last decade. The company turned operating cash flow positive only during the 2018 financial year and the company has invested billions of dollars to build the necessary infrastructure including manufacturing plants to help the company gain market share in important territories such as China. Even though Tesla was in “investment mode” over the last decade, the stock has handsomely beaten the market and delivered stellar returns to investors who believed in the story of the company.
Source: Seeking Alpha
As much as Uber wants itself to be compared with Amazon, the company resembles many aspects that we are already familiar with about Tesla. The overarching reason behind Tesla’s massive gains in the market is that investors, especially growth-oriented investors, have continued to believe in the fact that Tesla is disrupting a very lucrative segment of the automobile industry.
The same is true for Uber.
The $62 billion market cap of Uber for sure sounds daunting at first when we compare this with the financials of the company, but the true factor that is driving the stock price, whether it be up or down, is the story behind the company. In other words, the belief that ridesharing is the future of transportation and that Uber will remain the clear leader of this industry despite the looming threats from its competitors.
It would be incorrect to assume that I’m a fan of valuing stocks entirely based on stories without regard for the numbers. On the contrary, I’m a strong believer and a disciple of relying on numbers when it comes to business valuation. The key, however, is to strike a balance between the numbers and the story of a company and then to look for the right numbers. More on why I’m bullish on Uber in the next segment.
A blessing in disguise?
Both the New York City and Seattle City have passed a minimum pay standard for Uber (and for other companies that conveniently classified drivers as contract workers). This doesn’t look promising news for Uber, but the long-term impact of such legislative actions could turn out to be surprisingly positive.
Uber’s strategy, so far, has been to saturate the market with drivers and to expand its horizons as infinitely as possible. The minimum pay rules, however, will force the company to take a serious look at this strategy and to shift its focus to bring in positive earnings by improving the efficiency of its business operations.
The improvements in Uber’s gross margins in the last couple of years have come at the expense of payments for drivers, which is a strategy that is destined to fail in the long run. Not surprisingly, the driver churn has increased to dramatic levels, which has resulted in hefty sales and marketing costs to acquire and train new drivers. CBI Insights reported that only about 20% of drivers remain on Uber’s platform after one year, and the primary reason behind such a sky-high turnover rate is the disappointing earnings by driving for Uber. A closer look at the financials of the company reveals that Uber has spent billions of dollars per year to attract new drivers to the platform, which the company considers as an investment because of its stance on scaling up the company.
The new pay rules in New York City have already forced the company to reduce the number of drivers employed in the respective jurisdiction, and the expectation for Seattle is similar. Even though Uber would find the situation difficult to deal with at first, I expect this new reality to trigger a change in the decision-making process of the management that would eventually push Uber from the “investment phase” to the “earnings phase” of its business cycle.
The idea behind expanding the horizons of a company is to achieve economies of scale. In Uber’s case, the company has so far failed to realize any such benefits despite the multi-billion dollars it has already invested to become the largest ridesharing company in the world. For a loss-making venture such as Uber, scaling down temporarily could become a blessing in disguise as it allows the brains behind the business to identify opportunities to improve the efficiency of the company and to make radical changes in the organization structure which would have been impossible otherwise.
In his book “The Origin and Evolution of New Businesses”, Amar Bhide wrote:
Many giga-businesses have no clue, when they start, about how they will become behemoths – think Microsoft developing Basic for the Altair in 1975, Sam Walton starting a country store, and Hewlett and Packard selling audio-oscillators. But being small, they can experiment to figure out what is profitably scalable and make radical changes if necessary.
With more states and jurisdictions around the world threatening to have a close inspection of Uber’s business model and the manner in which they treat partner drivers, the company will certainly consider pausing its massive bonus schemes to attract new drivers and find a permanent solution to the high turnover rate of drivers.
The big picture
There’s no denying that investing in Uber is only for growth investors with above-average risk appetite because many things could still go wrong with Uber. The ridesharing giant is yet to finetune its business model meaningfully, and growth at any cost is not a viable strategy in the long run. The first fix should come in the form of taking a step back in its driver acquisition costs. Uber cannot pay its drivers any less, and charging riders a higher amount could drive them to competitors such as Lyft. Uber is stuck in between, and this is not working for the company. Uber, in the recent past, has focused on existing markets where the company is unlikely to be the dominant player and examples include the Eats India segment and the ridesharing business in China. This strategy of shifting its focus to core markets is likely to help the company trim operating costs and report positive earnings sooner than expected. If the ridesharing industry grows into an oligopolistic market structure where certain companies dominate certain market segments, Uber stands in a good position to drive its earnings growth.
Adjunct professor of finance at Wharton David Wessels believes fine-tuning the business model to focus on key markets is the only way Uber can survive. In a note about the company, he wrote:
It’s not like there are 40 competitors out there. It has one or two competitors nipping at their heels, who have their own problems to deal with. So, this could be a successful business, but at some point, they’re going to have to get serious.
Uber CEO Dara Khosrowshahi used the words “efficiency”, “cost-cutting”, and “business model changes” multiple times during the second-quarter earnings call while discussing the way forward for the company in the years ahead. A lot will depend on how the business model would change in the immediate future.
The outlook for ridesharing companies and food delivery services looks promising, and I discussed this in great detail in my first article on Uber on Seeking Alpha. To summarize:
- The mobility-as-as-service market (MaaS) is projected to report a higher growth in miles traveled than miles traveled on personal vehicles in the coming decade. This gives Uber the opportunity to earn higher revenue even if its market share remains stagnant.
- Uber, even though is the leader of the ridesharing industry, still accounts for less than 1% of total miles traveled globally. This is a good indication of the addressable market opportunity for ridesharing companies.
- The successful rollout of autonomous vehicles in the future will help ridesharing companies achieve higher margins by investing in a fleet of vehicles.
- The growing internet penetration rates in developing countries increases the size of the target market for both the ridesharing and food delivery business.
The big picture remains positive, but Uber still has a long way to go. With more than $7 billion in cash, Uber is in a good position to weather the current economic downturn, and I believe this virus-induced recession and the recent changes to minimum payment requirements imposed by state governments will push Uber to make some important changes to its business structure that are long due.
It’s quite easy to be mechanical about valuing stocks. This, however, could lead to undesirable circumstances and to missed opportunities. A stock that is driven by a story is likely to remain a darling of growth investors as long as the company is making progress. Uber, arguably, falls into this category of stocks along with the likes of Tesla and Zoom Video Communications, Inc. (ZM). Because the big picture looks promising, Uber stock is unlikely to trade at multiples that are seen as conservative unless otherwise the market crashes and carries Uber with it. In March, I suggested that it was the best time to buy Uber, and I can no longer write the same to conclude this article. However, the investment conclusions drawn by analysts who compare Uber to Amazon, in my opinion, leave behind a few critical points about Uber and its valuation level. The question is whether the ridesharing industry will thrive, and my answer is in the affirmative. In this case, Uber will naturally deliver stellar returns to investors in the long run. For this reason, I am holding the stock.
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Disclosure: I am/we are long UBER. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.