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The executives at Uber Technologies have found themselves in a predicament, where they must produce exceptional results to justify the hype associated with the brand, as the company has become the quintessential unicorn in the ride-hailing industry. Dara Khosrowshahi parachuted into the CEO spot just in time for the company's historic initial public offering (IPO) in mid-2019. Right out of the blocks, Mr. Khosrowshahi faced the difficult task of matching pre-IPO investors' expectation for huge returns with the reality as perceived by the market. It turned out, that the market's expectation for the company fell short of that expected by the pre-IPO investors. As the competitive landscape around the business model changed, the pressure intensified for management to pull a "rabbit out of a hat". With Uber's purchase of Postmates - a food delivery company, management continues to set the stage for its defining act.
There is very little confusion about whether Uber's IPO was a disappointment for new investors in the company. New investors, who bought-in at the time of the IPO, would have bought in at a price of US$41.0 per share over a year ago, and today the stock trades 21.2% lower (US$32.48). Coronavirus may have played a role in the current price, but it is more likely that, if it played any role at all, the role is minimal, as the stock declined to a much lower level before the spread of the disease. Perhaps, the greatest evidence of investor disappointment is the drama that unfolded in the months leading up to the IPO. Investment bankers, along with the executive suite painted a very rosy picture in their minds, where Uber is valued US$120Bn - the biggest American company to list on an American stock exchange. As the bankers and the management team went on the usual road-show to sell the dream, the reality of the value of the business began to hit home. Potential institutional investors argued that the company was worth about half of "the dream value", putting the per share price at around US$43.0.
Investors had a number of pain points about the company and the industry in which the company is operating, some of which are still true today. First, the growth rate of the company began to dwindle below historical and expected future rates. There were a number of new competitors entering the space and taking market share in key growth markets around the world - Didi Chuxing in China, 99 in Latin America, Grab and Go-Jek in Southeast Asia, and Yandex.Taxi in Russia. The rising competition created resistance for the growth of its core ride-hailing business internationally. In the US, Lyft began to accelerate growth after it raised several capital rounds. There was also increased competition in the Uber Eats business from Doordash in the US market, while in Latin America the growth of Rappi reduced the potential for international expansion. The company faced a number of headwinds on multiple fronts while it continued to record huge losses.
WHY IS THIS IMPORTANT? The fact is that a mountainous expectation has been assigned to this company, so much that, according to information in Forms S-8 and 8-k, even the CEO's pay is tied to the company's valuation exceeding US$120Bn. At the same time, the company is facing tougher competition. In order to fend off the emerging challengers and create additional shareholder value, the management team has to do a lot more than take orders for food and rides from customers. They must go on the offensive, and consolidate industry verticals where necessary, cut cost, gain pricing power, and use it.
At this important juncture, Uber is coming off a number of successful initiatives that set the stage for the company to do something magical in the ride-sharing business. At the same time, there continue to be significant challenges in the food delivery business. Uber's business rests on three key pillars: Ride-hailing - Uber, Food Delivery - Uber Eats, and Uber Freight (in order of development, with the most developed being the ride-hailing business). When Mr. Khosrowshahi took over the reins of the company, he embarked on a cost-cutting drive in the ride-hailing business that saw the company lay off 1,000 employees, and implement a hiring freeze. The company also turned over operational control in unprofitable markets such as Russia and South Korea to partners, and increased fees such as the "service fee”, and “booking fee” which effectively increased the company's take rate to about 22.5% in its core market (USA). The result of all these initiatives is the improvement in the earnings potential of the ride-sharing business, but the earnings of Uber Eats continued to languish.
Getting Uber Eats to profitability will be challenging, as the business is still small, and there are quite a few competitors in the space. Today, you have Grubhub, Doordash, EatStreet, Delivery.com, Favor, Slice, Ritual, Waitr, EZCater, Just Eat, and many others. This many small competitors in the space create the perfect conditions for cut-throat competition and tiny margins. It goes without saying, that a key part of improving profitability has to be increasing scale and consolidating the industry. The purchase of Postmates is a manifestation of both of these strategies, but the purchase is also likely the second-best option, as Uber initially attempted to purchase Grubhub.
According to company presentation, the addition of Postmates will bring an additional US$643Mn in gross bookings, US$200Mn in synergies, and U$107Mn in net revenues in Q1 of 2020 which is approximately 20% of the total Q1 revenues for the Uber Eats business. Despite the acquisition of Postmates, the combined entity (Uber Eats + Postmates) will still be sub-scale given the size of the industry which is about US$20Bn. In the food delivery business, small operations cannot compete over the long run due to very large start-up and growth costs required. This underscores why this acquisition is probably seen as the second option. Going forward there will likely be more acquisitions in the space, particularly if there is a long-tailed economic recovery, which would keep stock prices contained.
Much of the deal mechanics can be ascertained from the attached presentation. The financing of the deal says a lot about how Uber's execs feel about the current valuation of the business and its current market positioning. Uber bought Postmates for US$2.65Bn in an all-stock deal, where additional Uber stock will be issued at US$31.45 per share, despite having about US$11Bn in cash and short term investments available. This deal structure highlights the fact there is a high degree of consensus among management around the current valuation of the business, and so the dream of a US$120Bn valuation is a mirage for now. Certainly, management has a tonne of work to do to add more shareholder value. Fortunately, there is also consensus, certainly among Postmates shareholders, that there is tremendous value-add in a long term marriage between the two companies, otherwise Postmates shareholders would have opted for cash. Despite all the negative press around Uber of late, there is good reason to keep them on your radar.
Uber, under the leadership of Dara Khosrowshahi, has done enough to keep the future of the company interesting, despite the company having a sky-high valuation. There is much work ahead before the company can grow into investor expectations, and so it would be prudent for investors to wait for the right signals. The spread of COVID-19 has created a lot of uncertainty about how the business will evolve in the near term. Since the spread of the disease began, Uber has slashed 25% of its workforce (approx. 7500 people) and announced major strategic changes for its automated driving division and Uber freight. All of the changes can significantly impact valuation. With that said, the company seems clear on the direction of Uber Eats and Uber ride-hailing, and as such clues for potential additional shareholder value will likely be in one of these areas.