What is Uber Really Worth? A Spirited Email Exchange

Joel Anderson |

uber, uber valuation, uber funding, venture capital, uber service, surge pricing, uber evil, uber investmentDecember is typically a pretty slow month for investors. The year is winding down, holidays are coming up. Sure, it’s a massive retail binge at the country’s stores (knock on wood), but that’s not going to ripple into stock-trading quite as much until we start to get back data in January.

However, December 5 brought some pretty big news on the venture capital front when Uber managed to secure another $1.2 billion in funding based on a valuation of over $40 billion, a number that was positively jaw-dropping and understandably criticized by many.

So, IS Uber so uber-valuable that is really en route to a $100 billion+ IPO? Or is this valuation taking us all for a ride (with bottled water, if we’re lucky)? Our own Senior Editor Joel Anderson and Quantitative Research Analyst Nicholas Bhandari have it out in another spirited email exchange about whether that $40 billion number is in any way justifiable.

 

Joel: So a lot of folks might have missed it amidst the Holiday fervor, but ride-sharing/taxi-service-calling-itself-ride-sharing-for-legal-reasons company Uber secured a new round of private equity funding, landing $1.2 billion to the tune of a $41 billion valuation, which is...just massive.

Here's the thing: While I'm usually one to dump cold water on any of these massive valuations, this one may actually have legs. Or wheels, as it were. 

Some are estimating the global taxi/limo market at about $50 billion a year, and Uber is poised to carve a massive piece of that pie out for themselves. And that's not even considering the potential for expansion into other prospective revenue streams like delivery services.

So, is it true? Is Uber THE service of the future for transportation needs large and small, or is this another example of people thinking way too big and failing to anticipate how the market will shift?

 

Nick: The term disruptive gets thrown around a lot these days without anyone actually considering its definition. 

A disruptive industry change moves everything in a singular direction, specifically away from the status quo. The internet was disruptive because almost anything in print became obsolete (amongst a million other things), the airplane was disruptive because you didn't have to die from typhoid while you trekked for three months across the country. These are disruptive technologies. 

Uber making cabs slightly more efficient isn't disruptive, and what's worse, I think it’s no different than the almost unanimously agreed-upon worst industry to work in, airlines.

 

Joel:I don't know about "slightly" more efficient. I just took an Uber from my apartment to LAX and then a cab from LAX back a week later and the difference was threefold. Seriously. It cost three times as much to take a cab for the same trip, that's a pretty insane level of inefficiency it's stamping out.

I agree that the service isn't exactly bringing much (any) real technological innovation to the table, but the simplicity of the way they're challenging the existing framework may be the real key here. 

Wait a second – airlines? What do you mean airlines?

 

Nick: I should preface everything by saying that I'm not completely against Uber as a business model, I think it will become a large company and achieve varying levels of success. 

What I'm saying is that it is not worth the kind of valuations people are talking about. The taxi issue is interesting though. You will likely find very few people outside of the hipster community that still prefer cabs. They are inefficient, drivers are often rude, and the whole industry is muddled with red tape. Cabs are almost an avatar of government intervention poisoning free enterprise.  You can clearly see I'm not fan.

But simply replacing cabs (even completely) will bring Uber about $50 billion in revenue per year. With a current gross margin of about 20%, they now are sitting at $10 billion in gross profit.  If I'm being generous with the rest of their costs I could give them $8 billion in EBIT (Operating Income).

Now a tech company trading at 10-15x EBIT isn't unusual, but Uber isn't a tech company. They are a company that just happens to use technology. Their service is simply rides, a service that many other companies can easily copy. This is not a trait indicative of high margin tech companies.

They are more like a famously uninhabitable transportation industry: airlines. Airlines have difficulty differentiating themselves from their competitors because they basically all offer exactly the same product, transportation from A-B. There are certainly airlines that perform slightly different tasks, but they are basically the same.

When this happens, companies whittle away at each other’s margins by cutting costs, offering incentives, and splurging on talent. Uber has already begun this process with their chief competitor Lyft. Each company is offering giant incentives for drivers to switch, and when Lyft came into the NYC area they offered free rides for two weeks. Without extreme product differentiation, there is no way for Uber to charge higher prices than a competitor, and the barrier to entry isn't high (you simply need the app and drivers willing to lend their cars).

Over time I expect the Uber margins to break further and further, making it an industry more like airlines than tech. Airlines typically trade at a 1-1 on sales, and about 10 on earnings. Giving Uber an ultimate valuation (assuming they literally control the entire transportation market) of around $50 billion - $80 billion. Currently the $40 billion valuation people are talking about is in the private market, the IPO price would likely be double that. So Uber would then be effectively priced at its maximum possible valuation.

 

Joel:Here's where the network effect may be an important factor. 

Take Facebook (FB) . Facebook arguably did nothing to differentiate itself from the competition early on aside from the appearance of an exclusivity which, of course, it more than shed en route to its IPO. What now marks Facebook's massive market advantage that essentially destroys the market for any of your Google (GOOG) Plus attempts out there is the network effect. The number of people on Facebook is what creates its value...and its monopoly. The reason you use it is BECAUSE it's got the most people on it.

Uber is anticipating a similar effect to potentially squeeze out competition. Basically, the more people have the app, the more users out there, the more drivers will sign up. More drivers means that it's that much easier to completely dominate the market. Will you keep using Lyft if it takes an additional 20 minutes before your car arrives vs. Uber? I think the idea is that there's a certain portion of the market share that, once reached, will render Uber's competitors obsolete. So there hypothetically won't be major price competition eating into their margins. If anything, Uber might be expecting to increase that margin after they push out the competition.

Whether or not that's how things will play out is hard to say, but this is all pretty new territory. There's so little data on how populations will react to social apps like this one that it makes it difficult to know what to expect. As such, gambling on Uber becoming the Facebook of ride-sharing may make the $40 billion worthwhile.

 

Nick: I've seen people argue for the network effect in regards to Uber, but there is one major difference. With Facebook, initially there was no real differentiation – the platform was essentially similar to MySpace and Friendster. However, over time people formed their lives on Facebook.

Leaving Facebook requires you to leave an entire profile you've built over many years, the fact that all your friends are on it too is only a single element. Uber does not have this advantage. What is stopping anybody from leaving Uber? Assuming there is a competent competitor (of which now there are a few), leaving Uber is the difference between one button on your phone, not leaving years-worth of work. 

While it is possible that Uber could perhaps completely dominate the market, leaving every other competitor in the dust, ask yourself why this hasn't then occurred in other transportation industries? If Delta (DAL) simply has more planes would everything not be easier? All your miles are consolidated, travel becomes more comfortable, higher margins increase the level of quality they can offer. It seems like it would make sense.

The problem is that as soon as one of their competitors senses this increased profit they will douse their own profits temporarily to stop Delta from pushing them out of the market. This is an easy strategy when the companies offer essentially the same product. This is also occurring in an industry with very high barriers to entry, Uber has almost none at this stage. Perhaps a company could be pushed out of the national market, making their wait times in excess of 20 minutes. But then a new competitor emerges in a single city, a small scale where they can offer a better product, cheaper, and eliminate Uber's size advantage. Once that competitor gains a foothold in a city they can begin to spread slowly.

The occurrence of this over an entire country’s cities creates the kind of margin killing element I'm talking about.

 

Joel:Aside from my incredible reticence at referring to what we do on our Facebook profiles as "work," I'd say you're making a strong point there. Though, if airlines could work out a system where the pilots were paying for their fuel and airplanes maybe that would change.

So the ease of switching over does raise another concern: bad PR. Given how flighty the development of a user base on social media can be, it seems like that user/driver base they've already built up is potentially susceptible to rather rapid erosion. I'm guessing that after all of the revelations about sketchy business practices, less-than-ideal background checks for drivers, and the Machiavellian plans their CEO conveyed at a private dinner party; they're probably regretting naming their company a German word with a little history.

That said, you're right that competing with Uber shouldn't be hard. There's no proprietary technology, you really just have to steal their idea and slap a new name on it. 

 

Nick: I think an element, too, that we are ignoring is the legal issues they're facing.  There are two major problems associated with it.  

The first is the obvious one: If cities and countries continue to deny them access, their market begins to shrink.  Already, states like California and New York have issued cease and desist orders against Uber (ones they haven't necessarily complied with), and countries like Germany and South Korea have straight-up banned them from operations. Brazil, Spain, and Canada are now considering similar actions. Cab unions are not lacking in power or money in this country, I wouldn't rule them out so quickly.  

The second problem is perhaps even more insidious. Uber’s costs are not currently public, so it's impossible to tell what kind of money they are spending on lobbying, but as this legal battle intensifies their lobbying costs could skyrocket, further skimming their already slim margins. 

 

Joel: This is true, there’s a lot of potential issues that are up in the air.

I hate to even mention this, but if there continue to be stories about really terrible people becoming Uber drivers as a way to find new victims, things may change. Push comes to shove, I think Uber obviously did find a number of ways in which we can reorganize the cab industry to improve efficiency by utilizing existing and available technology, but I also think a significant portion of that three-fold price increase for a cab represents layers of careful regulation that didn't come from nowhere. It came from years and years of experience and calls for reform that we've long since forgotten and/or taken for granted.

As such, I feel like Uber is slowly going to demonstrate to the general public exactly why most of the regulations exist: to protect riders. Uber drivers aren't required by law to serve bad neighborhoods like cabs are, too. You’re not wrong about cabs being a pretty clear example of overregulation, but that doesn’t mean that it’s not all coming from somewhere important.

By gum, it sounds like we're actually coming together on this one in the end! I agree, the projections for growth that Uber is counting on appear to not be factoring in a wide variety of serious headwinds that are just now taking shape. If and when Uber goes public, I'm staying away from the IPO. We may be wrong, but I think there's just too many question marks to feel all that good about the company.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 116.62 1.22 1.06 4,704,954
DAL Delta Air Lines Inc. 48.72 0.41 0.85 1,053,670
GOOG Alphabet Inc. 763.20 12.70 1.69 289,524

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