The Ride Sharing Business: Playing Pundit

This is the third and final post in a series of three on the ride sharing business. In the first, I valued Uber and looked at the evolution of its business over the last 18 months. In the second, I valued Lyft and looked at pricing across ride sharing companies. In this one, I look at the future of the ride sharing business from the perspective of an outsider with no expertise in this business.

In my last two posts, I first valued Uber, with its expansive narrative, and then looked at putting numbers on Lyft's less ambitious storyline. In my Uber post, I argued that the ride sharing market was proving to be bigger, broader and growing faster than I had estimated it would be in June 2014. In the Lyft post, I examined how VCs were pricing ride sharing companies. In this post, I want to complete the story by looking at the current state of the ride sharing market and for scenarios for the market over time, with consequences for investors, car riders and drivers. 

The Ride Sharing Market: The State of the Game

In my posts on ride sharing, I noted that the ride sharing market has grown exponentially in the last two years, drawing in new users and redefining the car service business. That growth can be seen  in multiple dimensions:

1. Anecdotal & Qualitative evidence: I am usually wary about using anecdotal data but I have been keeping tabs on Uber usage in my travels and I have been amazed at the company's global reach. This summer, I did seminars in São Paulo, Moscow and Mumbai, and in each venue, a significant proportion of the attendants had taken Uber to the event. In fact, my children talk about Ubering to destinations unknown, rather than taking a cab, just as xeroxing and googling became synonyms for copying and online searching. 
2. Operating metrics at ride sharing companies: The operating metrics at the ride sharing companies individually, and in the aggregate, back up the proposition that this is a high growth business.

Company	Revenues in 2014	Revenues (2015)	Growth Rate (2015)
Lyft	$125	$300	140.00%
Uber	$400	$2,000	400.00%
Didi Kuaidi	$30	$450	1400.00%
Ola	$50	$150	200.00%
GrabTaxi	$15	$50	233.33%
BlaBlaCar	$30	$72	140.00%

3. Investor expectations: The increases in the values attached to ride sharing companies indicate that investors are also scaling up expectations of future growth in this business. Using Uber's estimated value of $51 billion in its most recent VC funding to illustrate the process, I estimated imputed revenues of $51.4 billion in 2026, which, if you hold its revenue slice share at 15% (my assumption) yields an imputed gross billing of $342.8 billion in 2026. If I repeat this exercise with the other ride sharing companies, the collective revenues being forecast by investors may exceed attainable revenues, an example of what I termed the big market delusion.

Company	Estimated Value (Price)	Revenue Share	Operating Margin	Failure Probability	Imputed Revenue(2026)	Imputed Gross Billing (2026)
Lyft	$2,500	15%	25%	10%	$2,800	$18,665
Uber	$51,000	15%	25%	0%	$51,418	$342,787
Didi Kuaidi	$15,000	15%	20%	0%	$20,044	$133,629
Ola	$2,500	15%	20%	15%	$3,927	$26,183
GrabTaxi	$1,500	10%	20%	15%	$2,392	$23,923
BlaBlaCar	$1,600	12%	20%	10%	$2,392	$19,935
Total	$74,100	NA	NA	NA	$82,974	$565,123

The growth in ride sharing has been accompanied with more intense competition and rising costs, as can be seen in the large and growing operating losses reported by the companies in this business. The reasons for these losses are manifold, as I noted in my Uber post. Some of the costs come from intense competition for drivers and customers, with companies following the Field of Dreams model, that Amazon has used to such effect in the last decade. Some costs come from outside, higher insurance costs and employee expenses, as ride sharing companies go from being fringe players to larger businesses. Some costs flow from legal fights with regulators, licensing agencies and other rule-writers, whose desire to control the business clashes with the market-driven imperatives of ride sharing. The optimistic view is that these costs will become smaller as companies scale up, but will they? As revenues scale up, the number of drivers will increase proportionately, and unless the competition disappears, the costs of fighting for drivers and customers will continue. In brief, the existing ride sharing model looks like a long term money loser, unless something fundamental changes.

 Future Shock

At the risk of playing market prognosticator in a market where I am a novice, I see four possible scenarios that can unfold in this market, all possible, but perhaps not equally probable.

1. Winner-takes-all: The big prize in many technology businesses is that there is a tipping point, where the winner ends up capturing much of the market. That is the template that Microsoft used two decades ago with MS Office to capture the business software business and that Google used to scale the heights of online advertising. The payoff to such a strategy is that you not only control the dominant market share but that you get pricing power (and higher profits). It does seem to be the strategy that Uber is following in the ride sharing business, but there remain three road blocks that may get in the way. First, you have to remove your competitors from the playing field and while Uber had the cash buffer and capital raising upper hand last year, that advantage has narrowed as a result of partnerships and new capital flowing into other ride sharing companies. In a perverse way, Uber's best chance of succeeding at this strategy is if there is a hitch or stop in the flow of capital to tech companies, though that may work against its objective of going public in the near future. Second, you have to navigate your way through the anti trust and monopoly questions that will inevitably follow, not an easy or an inexpensive task, as Google and Microsoft have discovered over the last decade. Third, while technology remains a focal point for ride sharing companies, the car service or logistics business needs physical infrastructure, making it more difficult to preserve global networking benefits.
2. The Losers' Game: While the winner-take-all is alluring, its logical conclusion, if you have multiple players pursuing it, and none winning, is that you can make the business a loser's game, one in which the market grows as promised and companies generate high revenues, but make very little in profits. A big business can sometimes be a bad one, as I noted in this post on bad businesses and why companies in these businesses continue to invest and grow in them.
3. The Divide and Rule Game: As the old colonial empires discovered a few centuries ago, and the Sicilian crime families realized in the late 1920s in the United States, the most profitable end game, when competition is cut-throat (literally), is to negotiate a truce, where the spoils are divided up and each competitor is given control of a segment. In the ride sharing market, if the business boils down to two or three large players, they may be able carve up the global market and each player will get a free run in their carved up portion . This will be, of course, terrible news for drivers and customers and may attract regulatory or legal scrutiny, but for investors collectively, it will be most value-adding scenario. There are two potential weak links. The first is that this truce, by its very nature, will not be a friendly one and small violations can lead to it unraveling. The second is that it rests on the premise that there is no outside party that is powerful enough to step in and take advantage of the soft spots in the market.
4. The Game Changer: I believe that the existing ride sharing model is an unstable one. As I argued in my post on Uber, the very strengths of the models (bare bones infrastructure, drivers as independent contracts and no car ownership) makes it unsustainable in the long term, since ride sharing companies have to compete for drivers on a continuous basis, offering them incentives to switch from competitors, and customers, with special deals. It is therefore likely that a new model will emerge, though it remains an open question of whether it will come from one of the players in the game, or from an outsider. Thus, Uber's hiring of robotics engineers may be a precursor of a different ride sharing game, with driverless cars and infrastructure investments, or it may be Google or Tesla who enter the picture with a different way of operating this business. 

If these scenarios remind you a little little of the prisoner's dilemma, where two rational individuals are given a choice between cooperating and competing, there are parallels. Consider one possible version, where the ride sharing companies globally boil down to two competitors: Uber, as a global ride sharing behemoth, and the Not-Uber, an alliance of  national ride ride sharing companies (Ola+Didi Kuaidi + GrabTaxi + Lyft..). The box below captures the possible outcomes of this game, which will get infinitely more complicated if there is an outsider player lurking on the fringes.

Based on my very limited knowledge of the companies in this space, I would give the highest odds to the ride sharing business becoming a loser's game, attach about equal probabilities to it becoming a winner-take-all or a game changer emerging, and see the least chance that the ride sharing companies will collude to maximize profits and value. There are others, who know more about this business than I do, who see this game evolving differently over time. Mark Shurtleff at Green Wheels Mobility Solutions, the ride sharing expert that I referenced in my last post thinks that I am being too pessimistic on some counts and perhaps too optimistic on others and feels that there are small start ups that are finding a better business model than the big players. There are some who believe that I am underestimating the pull of the familiar and that ride sharing companies, once established, will be difficult to displace. 

The Dance of the Disrupted

In a post from a few months ago, I looked at the the dark side of disruption, i.e., the businesses being disrupted, both with the intent of identifying the businesses most at risk and to look at the stages, at least as I see them, of how the disrupted business deal with the chaos of seeing established business models being upended. Using that five stage process, it seems to me that the taxi cab business is now at an advanced stage:

Stage of disruption	The Taxi Cab Business
1. Denial and Delusion	This is long in the past, but in the first year or two of Uber’s existence, there were many in the conventional car service and taxi cab businesses, who were convinced that not only was this a passing phase, but that no customer in his right mind would want to miss the comfort, convenience and safety of a yellow cab experience. (Irony alert!)
2. Failure and False Hope	With each misstep by a ride sharing company (and Uber in particular), whether it be an employee with a loose tongue or a assault by an Uber driver, the hope that this misstep will put an end to the ride sharing business rises among taxi operators and regulators. However, only the most delusional among these hold on this hope.
3. Imitation and Institutional Inertia	In the mistaken belief that all that separates the ride sharing companies from conventional car service is an app, taxi operators have turned to putting apps in the hands of drivers and customers. At the same time, any attempts to introduce flexibility into the existing car service business are fought by politicians, regulators and some of the operators who benefit from the current structure.
4. Regulation, Rule Rigging and Legal Challenges	This seems to be the place where car service companies are making their stand, aided and abetted by regulators, courts and politics. By restricting or even banning ride sharing, they are slowing it’s growth but as I see it, the fight is on its way to being lost, since it is the customers who ultimately will determine the winner in this game, and they are voting with their dollars.
5. Acceptance and Adjustment	It may be slow in coming, but a portion of the conventional car service business is adjusting to the new reality, sometimes because they realize that it is a fight that is unwinnable and sometimes because the financial hill is getting steeper to climb. This is especially true for cab operators who have borrowed much or most of the money that they used to buy medallions and are discovering that they cannot pay their debt.

So what does the future hold? Will there be no taxi cabs left on the streets of New York, London and Tokyo in a few years? I think that the taxi cab business will shrink, but not disappear, and that it will retain a portion of its business in those public spaces where regulators have the most say, airports, train stations and public arenas. If this is the future, it is also clear that there is more pain to come and it will take the form of continuing decline in taxi cab revenues and market capitalization at these companies. As for the private car service business, it will either adapt and share revenues with the ride sharing companies  (which still needs cars and drivers) or focus on corporate relationships (offering discounted and on-demand services to companies that do not want their employees using multiple ride sharing services). 

Coming soon to a business near you?

As I watch the traditional taxi cab business flailing and ride sharing companies grow at their expense, and am tempted to pass judgment on the inability of those in the business to adapt to the world that they live in, there are two general lessons that come to mind. From the disruptor's standpoint, I think that the success of Uber and its peer group in changing the car service business is a reminder that existing business models can be disrupted in short order by new technologies, but the collective losses reported by these companies are also a reminder that making money on disruption is much more difficult.

Looking at the same process from the perspective of the disrupted, it is a reminder that the pain inflicted on the car service business could very easily be coming to the business that you are in. If you are in the financial services business,  the entertainment business or the health care business, all of which are deserving of disruption, I wonder whether you would react any more rationally than the London cabdrivers who went on strike to stop Uber, and ended up getting many of their customers to try Uber for the very first time. I operate in the education business, a large and extraordinarily inefficient business, and there is no group more resistant to change and more unprepared to adapt than tenured professors at research university. I cannot wait to see this group, convinced of its intellectual superiority and attached to unreal perks (minuscule teaching loads, research assistants and sabbaticals),  go through the throes of disruption.

YouTube Version

Ride Sharing Series (September 2015)

1. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns
2. Dream Big or Stay Focused? The Lyft Answer!
3. The Future of Ride Sharing: Playing Pundit

No Light at the end of the Tunnel: Investing in Bad Businesses

I am a cynic when it comes to both CEOs and equity research analysts. I think that many CEOs are political animals, bereft of vision and masters at using strategic double-speak to say absolutely nothing. I also believe that many equity research analysts are creatures of mood and momentum, more market followers than leaders. Once in while, though, my cynicism is upended by a thoughtful CEO or a well-done equity research report and even more infrequently by both happening at the same time, as was the case in this recent interplay between Sergio Marchionne, Fiat Chrysler's CEO, and Max Warburton, the auto analyst at Sanford Bernstein.

The CEO/Analyst Exchange on Fiat Chrysler

Sergio Marchionne is an unusual chief executive, a man who is not afraid to talk the language of investors and is open about the problems confronting not only his company, but also the entire automobile business. While he has been arguing that case for a while, sometimes in public and sometimes with other auto company executives, he crystallized it in a presentation he made in an analyst conference call, titled "Confessions of a Capital Junkie". In the presentation, he argues that the auto business has not generated its return on capital over its last cycle and that without significant structural changes, it will continue to under perform. He then diagnoses the reason for the under performance as over investment in R&D and capital costs, with companies duplicating each other's efforts. He concludes with the remedy of consolidation, where with mergers and joint ventures, companies could co-operate and reduce their capital costs, and asks analysts and investors in auto companies to apply pressure for change. Mr. Marchionne's pitch was unusual was two reasons.  First, how many CEOs admit that their businesses have gone bad and that fundamental change is needed in how they are run? Second, it is unusual for a CEO to ask investors to become more activist and push for change, since most CEOs prefer a pliant and forgiving shareholder base.

Max Warburton, Bernstein's auto analyst who was at the conference, responded by asking "“Do you think the German [car manufacturers] have any interest in what we say?', arguing that investors and analysts were powerless to push for change. In an extended analyst report, Mr. Warburton went further, making the point that shareholders are way down the list of priorities for the typical auto company, and especially so in Europe and Asia. 

As I said at the start, this is the type of exchange between CEOs and analysts that you hope to see more of, and I agree with both Mr. Marchionne and Mr. Warburton on some aspects and disagree on others. I agree with both men that the auto business has been in trouble for a while and I made this point earlier in my post on GM buybacks. However, I don't think that the problem is one of duplication of expenses and that the answer is the consolidation of companies, as argued by Mr. Marchionne, and here is why. For consolidation to generate higher profits at auto companies, they will have to ensure that they don't  pass the cost savings on to customers by cutting car prices, and nothing in the behavior of the auto industry in the last decade leads me to believe that they are capable of this concerted action. I agree with Mr. Warburton that the auto business is not shareholder-focused and that institutional forces (governments, unions) will make it difficult for investors to be heard. While there are investors in the market who will continue to supply capital at favorable terms to this business, sensible investors are under no obligation to play this game. Abandoning the auto business is not feasible if you are the auto analyst at Sanford Bernstein, but it is a viable option for the rest of us, at least until prices reflect the quality of these businesses. This debate also raises interesting fundamental questions that I hope to examine in the rest of the post, including how we categorize businesses into good and bad ones, why businesses become bad, why companies continue to operate and sometime expand in bad businesses and why investors may still seek to put their money in these companies.

What is a bad business?

If Mr. Marchionne's point is that the automobile business is a bad one, it is worth starting this discussion with the question of what it is that make a business a bad one. At an extremely simplistic level, you can argue that a bad business is one where many or most companies lose money, but that definition would encompass young sectors (social media, biotechnology) that tend to lose money early in the life cycle. It also would imply that any sector that collectively makes profits is a good one, which would not make sense, if the sector has huge amounts of capital invested in it. Thus, any good definition of business quality has to look at not only how much money a company makes but how much it needs to make, given its risk and the capital invested in that business. In corporate finance, we try, to capture this by looking at both sides of the equation:

While there are some business (banks, investment banks and other financial service companies), where the equity comparison is more useful, in most businesses, it is the comparison on a overall capital basis that carries more weight. If you accept the proposition that the return on invested capital measures the quality of a company’s investment and the cost of capital is the hurdle rate that you need to earn, given its risk, the spread between the two becomes a snapshot of the capacity of the company to generate value.

Why a snapshot? If the return on invested capital is estimated, as it usually is, using the operating income that the company generated in the most recent time period and the cost of capital reflects the expected return, given the risk free rate and equity risk premium in that period, it is also possible that looking at a single period can give you a misleading sense of whether the company in question is generating value. With cyclical and commodity companies, in particular, where earnings tend to move through cycles, a good case can be made that we should be looking at earnings over a cycle and not just the most recent year. Finally, the return on invested capital is an accounting number and is hence handicapped by all the limitations of accounting principles & rules, a point I made in this long, torturous examination of accounting returns. If you bring the two strands of discussion together, there are two levels at which a sector has to fail to be called a “bad” business.

1. Collective, weighted under performance: Most companies in the sector should be earning returns on their invested capital that are less than the cost of capital, not just a few, and the aggregate return on capital earned by a sector has to lag the cost of capital.
2. Consistent under performance: These excess returns (return on capital minus cost of capital) should be negative over many time periods.
3. No delayed payoff: There are some infrastructure businesses that require extended periods of large investment and negative excess returns, before they pay off in profitability.

In my post on GM, I made the case that the automobile business was a bad one, using these two metrics. Collectively, the distribution of returns on capital across global automobile companies in 2014 looked as follows:

If you look at the return on capital across time for the auto industry, you see the same phenomenon play out.

It should come as no surprise that I agree with Mr. Marchionne that the auto business is a bad one and with Mr. Warburton that the companies in this business are in denial. The bad news for investors is that the auto business is not alone in this hall of shame. I computed returns on capital, costs of capital and excess returns for all non-financial US companies, by year from 2005 to 2014, and then looked for the sectors that delivered a negative excess return on average during the decade, while also generating in excess returns in at least 5 of the 10 years:

Raw data from Capital IQ with my estimates of costs of capital by year

Some of the businesses on this list have a good reason for being on the list and perhaps can be cut some slack. For instance, the green and renewable energy business has delivered negative excess returns both in the aggregate and in every year for the last decade, but in its defense, it may be a business that needs time to mature. The real estate sector is well represented on this list, with REITs, homebuilding, building materials and real estate operations & development all making the list with negative excess returns. An optimist may argue that the last decade created the perfect storm for real estate, unlikely to be repeated in the near future, and that these businesses will return to adding value in the future. There are some surprises, with entertainment software, wireless telecom and broadcasting all making the list, suggesting that you can have bad businesses that are growing. Finally, there were 169 companies that were classified as diversified, and their excess returns were negative every year for the entire decade, making a strong argument that many of these companies would be better off broken up into constituent parts. It is true that the returns on capital in this table were computed using standard accounting measures of operating income and debt, and I recomputed them, with leases capitalized as debt to derive the following table:

Operating Income and Invested Capital, adjusted for leases treated as debt

The list looks almost identical to the unadjusted excess return rankings, though the excess returns for restaurants, retailers and other larger lessees became much smaller with the adjustment and airlines make the worst business list, once you consider leases as debt.

How do businesses go bad?
So, why do businesses go bad? There are a number of reasons that can be pointed to, some rooted in sector aging, some in competition, some in business disruption and some in delusions about growth and profitability.

1. The Life Cycle: I have used the corporate life cycle repeatedly in my posts as an anchor in trying to explains shifts in capital structure, dividend policy and valuation challenges. It is a useful device for explaining why some sectors fail to deliver returns that meet their costs of capital. In particular, as sectors age, their returns seem to drift down and if the sector goes into decline, with revenues stagnant or falling, companies are hard pressed to generate their costs of capital. At the other end of the life cycle, young sectors that require large infrastructure investments often deliver extended periods of negative excess returns.
2. Competitive Changes: A business can be changed fundamentally if the competitive landscape changes. This can happen in many ways. A legal barrier to competition (patents, exclusive licenses) can be removed, opening up existing companies to price competition and lower margins. Globalization has played a role as well, as companies that used to generate excess returns with little effort in protected domestic markets find themselves at a disadvantage, relative to foreign competitors. 
3. Disruption: Disruption is the catchword in strategy and in Silicon Valley, and while it is often hyped and over used, technology has disrupted established businesses. Uber and its counterparts are laying to waste the taxi business in many cities and Amazon has changed the retail business beyond recognition, driving many of its brick and mortar competitors out of business.
4. Macro Delusion: While all of the above can be used to explain why an old business can become a bad one, there are new businesses that sometimes never make it off the ground, even though they are launched in markets with significant growth potential. One reason is what I have termed the macro delusion, where the sum of the dreams and forecasts of individual companies

Why do companies stay in bad businesses?

If you are a company that finds itself in a  bad business, there are four options to consider. The first is to exit the business, extracting as much of your capital you can to invest in other businesses or return to the suppliers of capital. While this may seem like the most logical choice (at least from a capital allocation standpoint), there is a catch. It is unlikely that you will be able to get your original capital back on exit, because buyers will have reassessed the value of your assets, based on their diminished earnings power. Consider, for instance, a company that generates a 3% return on capital on invested capital of $1 billion and assume that its cost of capital is 6%. If a sale of the assets or business will deliver less than $500 million, the best option for the company is to continue to operate in the bad business. The second is to retrench or shrink the business, by not reinvesting back into the business and returning cash from operations back to stockholders (as dividends or buybacks). That was the rationale that I used in supporting the GM buyback. The third is to continue to run the business the way you used to when the business was a good one, hoping (and praying) that things turn around. That seems to be the response of most in the auto business and explains the cold shoulder that they gave to Mr. Marchionne's prescription (of consolidation). The last is to aggressively attack a bad business, with the intent of changing its characteristics, to make it a good one. This is a strategy, with the potential for high returns if you do succeed, but with low odds of success. Not surprisingly, it is the strategy that appeals the most to CEOs who want to burnish their reputations and it one reason that I posited that my returns on my Yahoo! investment would be inversely proportional to Marissa Mayer's ambitions.

Of the four strategies, the one that is least defensible is to the third one (doing nothing), but that seems to be most common strategy adopted by companies in bad businesses and I can think of four reasons why it continues to dominate. The first is inertia, where managers are unwilling or unable to change their learned behavior, with the resistance become greater, if they have long tenure in the business. The second is poor corporate governance, where those who run firms view shareholders as just another stakeholder group and view costs of capital as abstractions rather than as opportunity costs. The third are institutional factors which can conspire to preserve the status quo, because there are benefits derived by others (labor unions, governments) from that status quo.  The final factor is behavioral, where the easiest path for managers, when faced with fundamental changes in their businesses, is to do nothing and hope that the problem resolves itself. 

Why do investors invest in these companies?

If it is difficult to explain why companies choose to stay and sometimes grow in bad businesses, it is far easier to explain why investors may invest in these companies. At the right price, any company, no matter how bad its business, is a good investment, just as at the wrong price, any company, no matter how good its business, is a bad investment. To decide whether to invest in a company in a bad business, investors have to value these companies and there are challenges. The first is that with these companies, growth is almost always more likely to destroy value than to increase it. Consequently, the value of these companies is maximized as they minimize reinvestment, shrink their businesses and liquidate themselves over time. The second problem is that while designing a valuation model that allows for a shrinking company is easy enough to do, the value that you get is operational only if management in the company does not undercut you, by aggressively seeking out growth with expensive reinvestment. I present responses to these problems in this paper.

As a passive investor, you have to accept your powerlessness over management and build, into your expectations, what you believe that the management will do in terms of investment, financing and dividend policy, no matter how irrational or value destroying those actions may be. As an activist investor, though, you may be able to force managers to reassess the way they run the company. It should come as no surprise that the classic targets of activist investors tend to be companies in bad business that are run by managers in denial. Finally, while the debate about corporate governance has atrophied into one about director independence, corporate governance scores and CEO pay, the real costs of poor corporate governance are felt most intensely in companies that operate in bad businesses, where without the threat of shareholder activism, managers often behave in irrational, value-destructive ways.

Closing Thoughts

As I look at the excess returns generated by companies in different sectors, I am struck by how little margin for error there seem to in many businesses, with excess returns hovering around zero. If we attach large values to the disruptors of existing businesses, consistency requires us to reassess the values of the disrupted companies. Thus, if we are bidding up the values of Tesla,  Uber and Google (driverless cars) because they might disrupt the automotive business, does it not stand to reason that we should be bidding down (at least collectively) the values of Volkswagen, Ford and Toyota? More generally, we seem to be more willing to anoint the winners from disruption than we are in identifying and repricing the losers.

Datasets

1. Industry averages excess returns, by year: 2005-2014
2. Industry average costs of capital: US
3. Industry average cost of capital: Global

Papers

1. Measuring Accounting Returns 
2. Valuing Companies in Decline