Uber: A High-Risk, High-Reward Investment

Investment thesis

Uber Technologies Inc. (UBER, Financial) set out to change the way people commute from one place to another. Today, the company is the leading player in the ride-hailing industry. Over the past several years, it has expanded to partner with a slew of restaurants to deliver food to customers' doors.

Despite operating in two industries that are experiencing explosive growth, Uber is not currently making a profit. Based on the output of a financial model that factored in the growth of these two industries and Uber's market share, it is expected to turn toward profitability in 2027. From an enterprise value-revenue perspective, Uber shares are undervalued. However, this investment opportunity is only suitable for long-term-oriented growth investors.

Industry analysis and business strategy

The major businesses of Uber are personal mobility and Uber Eats. The personal mobility segment offers ridesharing services, while Uber Eats delivers meals ordered from restaurants. Over the past three years, the two segments accounted for more than 90% of net revenue. Therefore, the company’s performance is highly influenced by industry dynamics affecting these two segments.

The ridesharing segment has huge potential demand. At the end of 2018, for instance, Uber estimated its total addressable market in terms of worldwide vehicle miles traveled - a metric for measuring transport demand- was about 11.9 trillion miles, with a value of $5.7 trillion. Companies in this industry currently address about 1% of global vehicle miles traveled. The market opportunity for these companies is massive and the leading players in the space are growing at stellar rates. Lyft (LYFT, Financial) and Uber, for example, grew their U.S. vehicle miles traveled at a compounded annual rate of more than 100% between 2013 and 2018, according to data from McKinsey and filings with the Securities and Exchange Commission.

Demand in the ride-share segment is also likely to grow with the increasing number of trips per customer. According to a recent survey by McKinsey, 63% of people who use ride-hailing services expect to increase their usage in the next two years. Further, 67% hope to increase their usage of vehicle sharing options.

Even with the high growth potential, companies in this industry will have to overcome several challenges to be profitable. One of the main problems facing these companies is high driver turnover. Based on McKinsey's estimates, rideshare companies have 100% driver turnover every two years.

High turnover rates hurt the company’s margins in various ways. Primarily, higher turnover increases the cost of acquiring and retaining drivers. To build a service that has a higher customer retention rate requires providing high customer satisfaction levels. This becomes difficult when a company has high driver turnover. As a result, these companies tend to provide discounts and attractive offers to keep customers satisfied, rather than providing a better customer experience. As a result, these companies have high selling and marketing expenses as well as a high cost of revenue.

Another issue is high competition from car owners. For many people, it is more economical to own and drive their own cars. According to data from Ridester and the American Automobile Association, the average cost per mile for an Uber ride is $2, compared to $1.17 in an individual's own car in the U.S. This makes it difficult for Uber to attract customers by providing better prices. Rather, growth depends on how Uber and its competitors can provide more personalized and convenient services.

The Uber Eats segment operates in a growing market as well. According to a Euromonitor report for 2019, the total addressable market in the Global Consumer Food Service industry stands at $2.8 trillion. Home delivery, take away and drive through have total addressable markets of $161 billion, $472 billion and $162 billion, while Eat-In has the largest share at $2.04 trillion. The latter’s market share is, however, expected to decline due to increased home deliveries.

Uber’s strategy is to dominate the industry first and then raise the take rate, which is defined as the core-platform-adjusted net revenue as a percentage of core platform gross bookings. Core platform, on the other hand, refers to the company’s ride-sharing and Uber Eats services. The company hopes the strategy will lead to a liquidity network effect, in which the value of a product or service increases in line with the number of people using the platform.

A network effect of this sort could lead to lasting competitive moats. Companies that develop sustainable moats often end up being profitable for decades. At Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual meeting in 2000, Warren Buffett (Trades, Portfolio) had this to say about moats:

“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way — it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses — or virtually all of our businesses — have pretty darned good moats.”

Uber’s strategy is to build such a moat by capturing the bulk of the market share in both its business segments.

Drivers are at the heart of Uber’s strategy. The company hopes that by creating a large supply of drivers, it will reduce wait times and fares for riders. In turn, drivers will get more riders per hour and, eventually, more earnings. This would prompt more riders to join the platform, thereby speeding up the realization of the liquidity network. Given the central role drivers play in the strategy, reducing churn is critical to the company’s success.

Financial performance

Except for in the final quarter of 2018, Uber has reported net revenue growth over the last 10 quarters. An increasing number of monthly active users drove growth during this period. Between June 30, 2017 and June 30, 2019, the number of monthly active users per car increased from 57 million to 99 million. The company attributes the increase to higher market penetration. An increase in the number of trips per active user has also contributed to revenue growth.

In the last quarter of 2018, each user of the company’s platform took 5.5 trips per month on average, up from 5.2 trips per month in the prior-year quarter. The growth in adjusted revenue has, however, slowed in recent quarters. For example, revenue increased 4.1% in the second quarter of 2019 and 4.4% in the first quarter, relative to 6.2% growth in the comparable quarters of 2018. In those same periods in 2017, Uber recorded 21.6% and 15.1% growth.

Source: Data from company filings.

Despite recording continuous revenue growth, Uber’s adjusted earnings before interest, taxes, depreciation and amortization remain negative. Moreover, its adjusted Ebitda margin has declined from the second quarter of 2018.

Adjusted Ebitda is a popular measure of performance for companies without positive earnings because it removes the distortions caused by non-recurring items and non-cash expenses such as stock compensation and depreciation. In general, companies with negative earnings that become profitable over time have improving adjusted Ebitda. The metric can be negative provided it is improving. Without improving adjusted Ebitda, a company has to become more efficient in managing some of its cost components to be profitable.

Source: Calculations based on data from company filings.

Several factors contributed to the deterioration of the company's adjusted Ebitda margin over the last five quarters. First, Uber's cost of revenue as a percentage of net revenue has been increasing after reaching its lowest level in the first quarter of 2018. Second, sales and marketing expenses as a percentage of sales have been on the rise, though they were lower in the second quarter. In contrast, research and development costs and general and administrative expenses maintained a stable percentage of sales over the period, indicating these expenses have high proportions of fixed costs. Consequently, the company needs to increase its efficiency in managing the cost of sales as well as sales and marketing expenses to achieve profitability.

Source: Data from company filings.

Valuation

In 2018, Uber had $11.27 billion in net revenue and adjusted Ebitda of -$2.61 billion. To be profitable, the company has to reduce three key variable costs—the cost of revenue, operations and support, sales and marketing. In the last financial year, the cost of revenue bore the highest proportion of sales (51.43%), followed by sales and marketing (33.90%) and research and development (15.80%). However, the latter cost together with general and administrative expenses has a high proportion of fixed costs. Therefore, these expenses as a percentage of revenue will decline significantly in the future, even when revenue grows.

Source: Estimates and data from company filings.

According to a 2018 report by Frost and Sullivan, the food delivery industry will grow at a compounded annual rate of 14.54% between 2019 and 2030 to reach a market value of $365 billion. The 2018 sales for the industry were estimated to be $82 billion. Using Uber Eat’s revenue and the estimated sales of the industry in 2018, it’s apparent that Uber serves 10% of the food delivery market. The take rate of 10% was used in the financial model to derive Uber’s intrinsic value.

Another report by Goldman Sachs indicates the ride-sharing market's size will increase from $73 billion in 2018 to $285 billion in 2030. In most regions where it operates, Uber’s market share is between 50% and 70%, while its average take rate is about 20%. In the model, it’s expected that Uber will maintain its market share as the market grows.

Based on these estimates, Uber’s revenue will grow from $11.27 billion in 2018 to $34.53 billion in 2028. Further, the company’s cost of revenue and operating expenses will decline due to scale. However, the decline will occur with a considerable time lag. Without the occurrence of major changes in the company’s cost of revenue, operations and support, and selling and administration expenses, the company is expected to report operating profits in 2027.

Source: Results of the financial model used to estimate Uber’s intrinsic value.

Ride-hailing companies listed recently or financed by venture capital firms include Uber, Lyft, and Grab. On average, the enterprise value-revenue ratio for these transactions was 8. Uber is expected to post about $12.2 billion in revenue for 2019. Therefore, its enterprise value based on the enterprise value-revenue ratio is $97.6 billion. The company has 1.7 billion shares outstanding. As a result, its intrinsic value per share is $57.41, which is $24.16 higher than the current market price of $33.25. Hence, the stock is undervalued based on enterprise value-revenue multiples.

Source: DBS Group Research and author’s calculations.

Conclusion

While Uber's shares are undervalued, the company is not expected to turn a profit before 2027. As such, the risk of investing in the stock is high. If Uber executes its growth strategy according to plan and becomes profitable by at least 2027, however, the stock should skyrocket and provide staggering returns to early investors. Considering the significant risks involved and the heavy reliance on estimates, growth investors should allocate only a small percentage of their portfolios to Uber, if at all.

Disclosure: I do not own any stocks mentioned in this article.

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