The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn!

In my last post on Uber, I noted that it was burning through cash and that this cash burn, by itself, is neither unexpected nor a bad sign. Since I got quite a few comments on what I said, I decided to make this post just about the causes and consequences of cash burn. In the process, I hope to dispel two myths held on opposite ends of the investing spectrum, the notion on the part of value investors, that a high cash burn signals a death spiral for a business and the equally strongly held belief, at the start-up investing end , that a cash burn is a sign of growth and vitality. 

Cash Burn: The what?
Since it is cash burn, not earnings burn, that concerns us, let’s start with the obvious. It is cash flow, not earnings, that is at the heart of a cash burn problem. While many money losing companies have cash burn problems, not all cash burn problems are money losing, and not all money losing companies have a cash burn problem. To understand cash burn, you have to start with a working definition of cash flows and my definition hews closely to what I use in the context of valuing businesses. The free cash flow to the firm is the cash left over after taxes have been paid and reinvestment needs (to maintain existing assets and generate future growth) have been met:

For mature, going concerns, the after-tax operating income and free cash flow to the firm will be positive (at least on average) and that cash flow is used to service debt payments as well as to provide cash flows to equity in the form of dividends and stock buybacks. Any remaining cash flow, after debt payments and dividends/buybacks, augments the cash balance of the company.

But what if the free cash flow to the firm is negative? That can happen either because a company has operating losses or because it has large reinvestment needs or both occur in tandem. If you have negative free cash flow to the firm, you can draw down an existing cash balance to cover that need and if that turns out to be insufficient, you will have to raise fresh capital, either in the form of new debt or new equity. If this negative cash flow is occasional and is interspersed with positive cash flows in other years, as is often the case with cyclical or commodity companies, you consider it to be a reflection of normal operations of the firm and it should cause few issues in valuation. If, on the other hand, a business has negative cash flows year in and year out, it is said to be burning through cash or having a “cash burn” problem.

To measure the magnitude of the cash spending problem, analysts use a variety of measures. One is to compute the dollar cash spent in a time period, usually a month, and that is termed the Cash Burn rate. Another is to compute the Cash Runway, the time period that it will take for a company to run through its existing cash balance. Thus, a firm with a $1 billion cash balance and a negative cash flow of -$500 million a year has a 2-year Cash Runway. In contrast, another company with a $1 billion cash balance and a negative cash flow of -$ 2 billion a year has only a 6-month Cash Runway. 

Cash Burn: The Why?

Looking at the definition of cash flows should give you a quick sense of why you get high cash burn values (and ratios) at some companies. If your company is and has been losing money or generating very small earnings for an extended period and it sees high growth potential in the future (and invests accordingly), your cash flows will reflect that reality. 

That combination of low operating income/operating losses and high reinvestment is what you should expect to see at many young companies and the resulting negative free cash flow to the firm will be the norm rather than the aberration. As the companies move through the life cycle, the benign perspective on cash burn is that this will cease to be a problem.

As the company scales up, its operating income and margins should increase and as growth starts to scale down (in future years), the reinvestment should start dropping. 

Cash Burn: The what next?
The combination of higher operating margins and lower reinvestment should generate a cross over point where cash flows turn positive and these positive cash flow will carry the value. Rather than talking in abstractions, let me use the numbers in my August 2016 Uber valuation to illustrate. The story that I am telling in these numbers is of a going concern and success, with high revenue growth accompanied by improving operating margins as the first leg, followed by declining growth (and reinvestment) converting negative cash flows to positive cash flows in the second leg and a steady state of high earnings and cash flows reflected in a going concern value in the final phase.

In my Uber forecasts, the cash flows are negative for the first six years, with losses in the first five years adding on to reinvestment in those years. The cash flows turn positive in year 7, just as growth starts to slow and accelerate in the final years of the forecasts.  Though these numbers are specific to Uber, the pattern of cash flows that you see in this figure is typical of the good cash burn story.

The life cycle story that I have laid out is the benign one, where after its start-up pains, a young company turns the corner, starts generating profits and ultimately turns cash flows around. Before you buy into the fairy talk that I have told you, you should consider a more malignant version of this story. In this one, the firm starts off as a growth firm with negative margins and high reinvestment (and cash burn). As the revenues increase over time and the company scales up, the cost structure continues to spiral out-of-control and the margins become more negative over time, rather than less. In fact, with reinvestment creating an additional drain on the cash flows, your free cash flow will be negative for extended and very long time periods and you are on the pathway to venture capital hell. To illustrate what the cash flows would look like in this malignant version of cash burn, I revisited the Uber valuation and changed two numbers. I reduced the operating margin (targeted for year 10) from 20% down to 5% (making ride sharing a commoditized business) and increased reinvestment to match a typical US company (by setting the sales to capital ratio to two, instead of three). The effects on the cash flows are dramatic.

The cash flows stay negative over the next ten years. In this scenario, it is very unlikely that Uber will make it to year 10 or even year 5, as capital providers will balk at feeding the cash burn machine?

So, when is cash burn likely to be value destructive or fatal? If the company operates in a market place, where competition keeps pushing product prices down and the costs of delivering these products continue to rise, it is already on a course to report bigger and bigger losses, even before considering reinvestment. If this company reinvests for growth and the product market conditions do not change (i.e., price cutting and rising costs are expected to continue), it is likely that the reinvestment will not deliver the earnings required to justify that investment. Here, there is no light at the end of the tunnel, as negative cash flows will generally become more negative over time and even when they do turn positive, will be insufficient to cover the burden of negative cash flows in earlier time periods.

Cash Burn: So what?

Though stories about young companies and their cash burn problems abound, there are few that try to make the connection between cash burn and value other than to point to it as a survival risk. To make the connection more explicit, it is worth thinking about why and how cash burn affects the value of an enterprise. 

1. Dilution Effect: A company has to raise cash to burn through it and if that cash is raised from fresh equity, as it inevitably has to be for young growth companies, the existing owners of the business will have to give up some of their ownership of the company. If you are an equity investor, the greater the cash burn in a company, the less of the company you will end up owning, even if it survives and prospers.
2. Growth Effect: The dilution effect presumes that there are capital providers who will be supply the cash needed to keep the firm going through its cash burn days, but what if that presumption is incorrect? The best case scenario for the firm, when capital dries up, is that it is able to rein in discretionary spending (which will include all reinvestment for growth) until capital becomes available again. In the meantime, though, the company will have to scale back its growth plans.
3. Distress Effect: The more dangerous consequence of capital drying up for a young firm with negative free cash flows Is that the firm’s survival is put at risk. This will be the case if the company is unable to meet its operating cash flow needs, even after cutting discretionary capital spending to zero. In this scenario, the firm will have to liquidate itself and given its standing, it will have to settle for a fraction of its value as a going concern.

In intrinsic valuation, both of these effects can and should be captured in your intrinsic value. 

1. The dilution effect manifests itself as negative cash flows in the early years and a drop in the present value of cash flows. For instance, in my Uber valuation, the present value of the expected cash flows for the first seven years, all negative, is $4.4 billion. While the positive cash flows thereafter more than compensate for this, I am in effect reducing the value of Uber by about 20% for these negative cash flows and this reduction can be viewed as a preemptive discounting of my equity stake in the company for future dilution.
   
2. When I discount the negative cash flows back to today and assume that Uber has no chance of game-ending failure, I am assuming that Uber has and will continue to have access to capital, partly because of its size and partly because existing investors have too much to lose if the company goes into death throes. If you believe these assumptions to be too optimistic, you can adjust the valuation in two ways. The first is by putting a cap on how much new capital the firm can raise each year, which will also operate as a constraint on future growth. The other is by allowing for a probability that the firm will fail, either because capital markets shut down or cash flows are more negative than expected. In my Lyft valuation in September 2015, for instance, I allowed for a 10% probability of this occurring and assumed that equity investors would get close to nothing if it did, effectively reducing my valuation today.

In pricing, how does it show up? In a young company, pricing usually involves forecasting revenues or earnings in a future time period, applying a multiple, at which you believe the company will be priced by a potential buyer or the market in an IPO, to these revenues and pricing and then discounting back that end price to today using a target rate of return.

As you can see, there is no explicit adjustment for cash burn in this equation. While you could bring in the effect of negative cash flows, just as you did in intrinsic valuation, by discounting them back to today and netting out against the pricing, doing that removes one of the biggest reasons why investors and analysts like pricing, which is that it is simple. The only adjustment mechanism left is the target rate of return and, in my view, it becomes the mechanism that venture capitalists and investors use to deal with cash burn concerns. Given that these target rates of return also carry the weight of reflecting failure risk, it should come as no surprise that VC target rates of return for investment look high (at 30%, 40% or even 50%) relative to rates used for established companies.

An Investor Checklist for Cash Burn

If you are an investor in a company, public or private, that is burning through cash, you may be wondering at this point what you would look at to determine whether a company’s cash burn is benign or malignant and whether it is on a glide path to glory or a Hari Kari mission. Here are some things to consider:

1. Understand why the company is burning through cash: Looking back at the constituents of free cash flows, there are multiple paths that can lead to negative free cash flows. The most benign scenario is one where a money making company reports negative cash flows because of large reinvestment. Not only is this negative cash flow a down payment for future growth but it is also discretionary, insofar as managers can scale back reinvestment if capital becomes scarce. The most dangerous combination is a money losing company that reinvests very little, since there is little potential for a growth payoff and management will be helpless if capital freezes up.
2. Diagnose the operating business: While there is often a lot of noise around the numbers, you still have to make your best judgments about the profitability of the underlying business. In particular, you want to focus on the pricing power that your company has and the economies of scale in its cost structure. The most benign scenario on this dimension is one where the company has significant pricing power and a cost structure that benefits from scale, allowing for margin improvement over time.
3. Gauge management skills: Managing a cash-burning company does require management to keep costs under control, while reinvesting to generate growth and to take care of short term cash flow problems, while mapping out a long term strategy. The best case scenario for investors is that the company is run by a management team that works within the cash flow constraints of today while mapping out pathways to profitability over time. The worst case scenario is that the company is managed by those who view negative cash flows as a badge of honor and a sign of growth rather than a temporary problem to overcome.
4. Growth/Reinvestment trade off: Since reinvesting for future growth can be a big reason for negative cash flows, to assess the payoff in value terms, you have to both estimate how much growth will be created and its value effect. In its most value-creating form, reinvestment will generate high growth coupled with high returns and its most value-destructive form, reinvestment will drain cash flows while generating low growth and poor profits.
5. Capital Market A firm with a cash burn problem is more depending upon capital markets for its survival, since a closing of these markets may be sufficient to put the firm into receivership. It is no surprise, therefore, that cash burning companies that have larger cash balances or more established capital providers are viewed more positively than cash burning companies that have less cash and have less access to capital.

This checklist requires subjective judgments along the way and you will be wrong sometimes, in spite of your best efforts. That should not stop you from trying.

The Bottom Line
If you are an investor in a company that is burning through cash, don't panic! If your investments are in young companies, it is exactly what you should expect to see though you should do your due diligence, examining the reasons for the cash burn in and the soundness of the underlying business model. If you are an old-time value investor, weaned on large dividends, positive cash flows and margin of safety, you may find yourself avoiding companies that have these cash burn problems but be glad that there are investors who are less risk averse than you are and willing to bet on these companies.

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Posts on valuing young companies

1. Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations
2. Billion Dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs
3. The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn

DCF Myth 3: You cannot do a valuation, when there is too much uncertainty!

Uncertainty, both imminent and resolved, has been on my mind these last two weeks. I posted my valuation of Valeant on April 20, making the argument that, at least based on my expectations on what could be revealed in the delayed financial filings, the stock was worth about $44, approximately $12 more than the prevailing stock price. Many of you were kind enough to comment on my valuation, and one of the more common refrains was there were too many unknowns on the stock to be taking a stand. In fact, one of the comments on the post was that "regardless of the valuation, a sufficient margin of safety does not exist (on the stock)". On April 21, we got news that Volkswagen had come to an agreement with US authorities on the compensation that they would offer buyers of their cars and a day later, the company announced that it would take an $18.2 billion charge to cover the costs of its emissions misrepresentations. It was a chance for me to revisit my valuation of Volkswagen, in the immediate aftermath of the scandal in October 2015, and take stock of how the the investment I made in the stock then looks, as the uncertainty gets slowly resolved. All through these last two weeks, there were signs that Yahoo's journey, that was starting to resemble the Bataan Death March lately, was nearing its end, as the company reviewed bids for its operating assets. Since it is a stock that I valued almost two years ago (and bought after the valuation) and labeled as a Walking Dead company, I am interested, both financially and intellectually, to see how this end game plays out. As I wrestle with the resolution of uncertainties from the past and struggle with uncertainties in the future on every one of my investments, I thought it would be a good time to look at good and bad ways of responding to I uncertainty in investing and valuation.

The Uncertainty Principle

Uncertainty has always been part of human existence, though it has transitioned from the physical uncertainty that characterized the caveman era to the economic uncertainty that is more typical of today, at least in developed markets. Each generation, though, seems to think that it lives in the age of the greatest uncertainty. That may be partially a reflection of a broader sense of "specialness" that afflicts each generation, where it is convinced that its music and movies were the very best and that it had to get through the biggest challenges to succeed. The other is a variation of hindsight bias, where we can look at the past and convince ourselves that what actually happened should have been obvious before it occurred. I am surprised at how many traders, investors and portfolio managers, who lived through the 2008 crisis, have convinced themselves that November 2008 was not that bad and that there was never a chance of a catastrophic ending.  That said, uncertainty not only ebbs and flows over time but also changes form, making enduring fixes and lessons tough to find. As investors bemoan the rise of uncertainty in today's markets, there are three reasons why they may feel more under siege now than in prior decades:

1. Low Interest Rates: In my post on negative interest rates, I pointed to the fact that as interest rates in many of the leading currencies have dropped to historic lows, risk premiums have increased in both stock and bond markets. The expected return on the S&P 500 in early 2008, before the crisis, was 8% and it remains at about that level today, even though the treasury bond rate has dropped from 4% to less than 2%, but the equity risk premium has risen to compensate. Even though the expected return may be the same, the fact that more of it can be attributed to a risk premium will increase the market reaction to news, in both directions, adding to price volatility.
2. Globalization: Globalization has not only changed how companies and investors make choices but has also had two consequences for risk. The first is that there seem to be no localized problems any more, with anyone's problem becoming everyone's problem. Thus, political instability in Brazil and too much local government borrowing to build infrastructure in China play out on a global stage, affecting stock prices in the rest of the world. The second is that the center of global economic power is shifting from the US and Europe to Asia, and as it does, Americans and Europeans are starting to bear more of world's economic risk than they used to.
   
3. Media/Online Megaphones: As an early adopted of technology, I am far from being a Luddite but I do think that the speed with which information is transmitted around the world has allowed market risks to go viral. It is not just the talking heads on CNBC, Bloomberg and other financial news channels that are the transmitters of these news but also social media, as Twitter and Facebook become the place where investors go to get breaking investing news.

I am sure that you can add other items to this list, such as the disruption being wrought by technology on established businesses, but I am not sure that these are either uncommon or unusual. Every decade has its own disruptive factors, wreaking havoc on existing business models and company values.

The Natural Responses to Uncertainty

Much of financial theory and a great deal of financial practice was developed in the United States in the second half of the last century and therein lies a problem. The United States was the giant of the global economy for much of this period, with an economy on an upward path. The stability that characterized the US economy during this period was unusual, if you look at long term history of economies and markets, and much as we would like to believe that this is because central bankers and policy makers learned their lessons from the great depression, there is the very real possibility that it was just an uncommonly predictable period. That would also mean that the bedrock of financial practice, built on extrapolating from past data and assuming mean reversion in all things financial, may be shaky, and that we have to reevaluate them for the economies that we operate in today. It is unfair to blame the way we deal with uncertainty entirely on the fact that our practices were honed in the United States. After all, it is well chronicled in both psychological annals and behavior studies that we, as human beings, deal with uncertainty in unhealthy ways, with the following being the most common responses:

1. Paralysis and Inaction: The most common reaction to uncertainty, in my experience, is inaction. "There is too much uncertainty right now to act" becomes the refrain, with the promise that action will come when more of the facts are know. The consequences are predictable. I have friends who have almost entirely been invested in money market funds for decades now, waiting for that moment of clarity and certainty that never seems to come. I have also talked to investors who seem to view investing when uncertain as a violation of value investing edicts and have found themselves getting pushed into smaller and smaller corners of the market, seeking elusive comfort.
2. Denial and Delusion: At the other end of the spectrum, the reaction that other investors have to uncertainty is go into denial, adopting one of two practices. The number crunchers fall back on false precision, where they add more detail to their forecasts and more decimals to their numbers, as a defense against uncertainty. The story tellers fall back on story telling, acting as if they have the power to write the endings to every uncertain narrative, when in fact they have little control over either the players or the outcome.
3. Mental Accounting and Rules of Thumb: The brain may be a wondrous organ but it has its own set of tics that undercut investing, when uncertain. As Richard Thaler has so convincingly shown in his work on mental accounting, investors and analysts like to use rules of thumb, often with no basis in fact or reality, when making judgments. Thus, a venture capitalist who is quick to dismiss the use of intrinsic value in a young start-up as too fraught with estimation error, seems to have no qualms about forecasting earnings five years out for the same company and applying a price earnings ratio to those earnings to get an exit value.
4. Outsourcing and Passing the Buck: When stumped for answers, we almost invariably turn to others that we view as more knowledgeable or better equipped than we are to come up with solutions. Cynically, you could argue that this allows us to avoid taking responsibility for investment mistakes, which we can now attribute to consultants, text book writers or that person you heard on CNBC. 
5. Prayer and Divine Intervention: The oldest response to uncertainty is prayer and it has had remarkable staying power. There are large segments of the world where big investment and business decisions are preceded by prayers and divine intervention on your behalf. 

If the first step in change is acceptance, I have come to accept that I am prone to do some or all of the above, when faced with uncertainty, but I have also discovered that these reactions can do damage to my portfolio. 

Dealing with Uncertainty

To reduce, if not eliminate, my unhealthy responses to uncertainty, I have developed my own coping mechanisms that will hopefully push me on to healthier tracks. I am not suggesting that these will work for you, but they have for me, and please feel free to modify, abandon or adjust them to your own needs.

1. Have a narrative: As many of you who read this blog know, I have long believed that a company valuation without a story to bind it together is just numbers on a spreadsheet and a story that uses no numbers at all is a fairy tale. There is another advantage in having a narrative underlie your valuation and tying numbers to that narrative. When faced with uncertainty about specifics, the question that I ask is whether these specifics affect my narrative for the company and if yes, in what way. In my valuation of Volkswagen, right after the diesel emissions scandal, I did not find a catastrophic drop in value for the company because my underlying narrative for Volkswagen, that of a mature business with little to offer in terms of expansion or growth opportunities, was dented but largely unchanged as a result of the scandal. With Valeant, in my November 2015 valuation, I argued that the attention brought to the company by its drug pricing policies and connections to Philidor would result in it having to abandon its strategy of growth driven by acquisitions and growth and to shift to being a less exciting, lower growth pharmaceutical company. That shift in narrative drove the inputs into my valuation and my lower assessment of value. 

2. Categorize uncertainty: Uncertainty can come from many sources and it is useful, when valuing a company in the face of multiple uncertainties, to classify them. Here are my groupings:

Since it is easy to miss some uncertainties and double count others, I find it useful to keep them isolated in different parts of my valuation:

Specifically, in my Volkswagen and Valeant valuations, it was micro risk that concerned me, with some of that risk being continuous (the effect of the diesel emissions scandal on Volkswagen car sales) and some being discrete (the fines levied by the EPA on Volkswagen and the risk of default in Valeant). That is why both companies, at least in my conventional valuations, have low costs of capital, notwithstanding the risky environment, but their values are then adjusted for the expected costs of the discrete events occurring.

3. Keep it simple:  This may seem ironic but the more uncertainty there is, the simpler my valuation models become, with fewer inputs and less levers to move. One reason is that it allows me to focus on the variables that really drive value for the company and the other is that it reduces my need to estimate dozens of variables in the face of uncertainty. Thus, in my valuations of start-up companies, my focus is almost entirely on three variables: revenue growth, operating margins and the reinvestment needed to sustain that growth. 

4. Make your best estimates: As I start making my estimates in the face of uncertainty, I hear the voice in the back of my mind pipe up, saying "You are going to be so wrong!" and I silence it by  reminding myself that I don't have to be right, just less wrong than everyone else, and that when uncertainty is rampant, most investors give up.

5. Face up to uncertainty: Rather than cringe in the face of uncertainty and act like it is not there, I have found that it is freeing to admit that you are uncertain and then to take the next step and be explicit about that uncertainty. In my valuations of tech titans in February 2016, I used probability distributions for the inputs that I felt most shaky about and then reported the values as distributions. Since some of you have been curious about the mechanics of this process, I will take a lengthier journey through the process of running simulations in a companion piece to this post.

6. Be willing to be wrong: If you don't like to be wrong, it is best not  to value companies in the face of uncertainty. However, if you think that Warren Buffet did not face uncertainty in his legendary investment in American Express after the salad oil scandal in 1964 or that John Paulson knew for sure that his bet against the housing bubble would pay off in 2008, you are guilty of revisionist history. There is a corollary to this point and it relates to diversification. As I have argued in my post on diversification, the more uncertain you feel about individual investments, the more you have to spread your bets. It is not an admission of weakness but a recognition of reality.

If you are a value investor, you will notice that I have not mentioned one of value investors' favorite defenses against uncertainty, which is the margin of safety. Seth Klarman is one of my favorite investment thinkers but I am afraid that the margin of safety, at least as practiced by some in the investing community, has become an empty vessel, an excuse for inaction rather than a guide to action in risky times. I will come back to this measure as well in another post in this series.

Conclusion

If you are an active investor, you are constantly looking for an edge, something that you can bring to the table that most other investors cannot or will not, that you can exploit to earn higher returns. As the investing world gets flatter, with information freely accessible and available to almost all investors, and analytical tools that anyone can access, often at low cost, being comfortable with uncertainty may very well be the edge that separates success from failure in investing. There may be some who are born with that comfort level, but I am not one of them. Instead, my learning has come the hard way, by diving into companies when things are most uncertain and by valuing businesses in the midst of market crises, "by going where it is darkest". That journey is not always profitable (see my experiences with Vale as a precautionary note), sometimes makes me uncomfortable (as I have to make forecasts based upon little or bad information), but it is never boring. I am wrong a hefty percent of the time, but so what? It's only money! I am just glad that I am not a brain surgeon!

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Uncertainty Posts

1. DCF Myth 3: You cannot do a valuation, when there is too much uncertainty
2. The Margin of Safety: Excuse for Inaction or Tool for Action?
3. Facing up to Uncertainty: Probabilities and Simulations

DCF Myth Posts

Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool

1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
2. A DCF is an exercise in modeling & number crunching. 
3. You cannot do a DCF when there is too much uncertainty.
4. It's all about D in the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
5. The Terminal Value: Elephant in the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
7. A DCF cannot value brand name or other intangibles. 
8. A DCF yields a conservative estimate of value. 
9. If your DCF value changes significantly over time, there is something wrong with your valuation.
10. A DCF is an academic exercise.

Runaway Stories and Fairy Tale Endings: The Cautionary Tale of Theranos

I saw the new Steve Jobs movie, with the screenplay by Aaron Sorkin, over the weekend. As a long-time Apple user and investor, I must confess that I was bothered by the way in which the film played fast and loose with the facts, but I also understand that this is a movie. Sorkin clearly saw the benefit of using the launches of the Macintosh in 1984 and the iMac in 1997 as the bookends of the movie and the tortured relationship between Jobs and his daughter to create an emotional impact, and took dramatic license with the truth. As I watched the movie though, I kept thinking about Theranos, a company with a gripping narrative and a CEO who, like Steve Jobs, wears only black and who seemed headed for a biopic until a few weeks ago.

The Theranos Story: The Build Up

The Theranos story has its beginnings in March 2004, when Elizabeth Holmes, a 19-year old sophomore at Stanford, dropped out of college and started the company. The company was a Silicon Valley start-up with a non-Silicon Valley focus on an integral, but staid part, of the health care experience, the blood test. Ms. Holmes, based on work that she had been doing in an Stanford lab on testing blood for the SARS virus, concluded that she could adapt technology to allow for multiple tests to be run on much smaller quantities of blood than the conventional tests did and a quicker and more efficient turn around of results (to doctors and patients). In conjunction with her own stated distaste for the needles required for conventional blood tests, this became the basis for the Theranos Naotainer, a half-an-inch tube containing a few drops of blood that would replace the multiple blood containers used by the conventional labs.

The story proved irresistible to just about everyone who heard it, her professor at Stanford who encouraged her to start the business, the venture capitalists who lined up to provide her hundreds of millions of dollars in capital and health care providers who felt that this would change a key ingredient of the health care experience, making it less painful and cheaper. The Cleveland Clinic and Walgreens, two entities at different ends of the health care spectrum, both seemed to find the technology appealing enough to adopt it. The story was irresistible to journalists, and Ms. Holmes quickly became an iconic figure, with Forbes naming her the “the youngest, self-made, female billionaire in the world” and she was the youngest winner of "The Horatio Alger award" in 2015.

From the outside, the Theranos path to disrupting the business seemed smooth. The company continued to trumpet its claim that the drop of blood in the Nanotainer could run 30 lab tests and deliver them efficiently to doctors, going as far as listing prices on its website for each test that were dramatically lower (by as much as 90%) than the status quo. In venture capital rankings, Theranos consistently ranked among the most valuable private businesses with an estimated value in excess of $9 billion, making Ms. Holmes one of the richest women in the world. The world seemed truly at her feet and reading the news stories, the disruption seemed imminent.

Source: Wall Street Journal

The Theranos Story: The Let Down

The Theranos story started to come apart on October 16, when a Wall Street Journal article reported that the company was exaggerating the potential of the Nanotainer and that it was not using it for the bulk of the blood tests that it was running in house. More troubling was the article’s contention that senior lab employees at the company found that the nanotainer’s blood test results were not reliable, casting doubt on the science behind the product.

In the following days, things got worse for Theranos. It was reported that the FDA, after an inspection at Theranos, had asked the company to stop using the Nanotainer on all but one blood test (for Herpes) because it had concerns about the data that the company had supplied and the product's reliability. GlaxoSmithKline, which Ms. Holmes had claimed had used the product, asserted that it had not done business with the start up for the previous two years and the Cleveland Clinic also backed away from its adoption. Theranos initially went into bunker mode, trying to rebut the thrust of the critical articles rather than dealing with the substantial questions. It was not until October 27 that Ms. Holmes finally agreed that presenting the data that the Nanotainer worked as a reliable blood testing device would be the most “powerful thing” that the company could do. It is entirely possible that the data that the company has promised to deliver will be so conclusive that all doubts will be set aside, but it does seem like the spell has been broken. 

The Lessons

Looking back at the build up and the let down on the Theranos story, the recurring question that comes up is how the smart people that funded, promoted and wrote about this company never stopped and looked beyond the claim of “30 tests from one drop of blood” that seemed to be the mantra for the company. I don’t know the answer to the question but I can offer three possible reasons that should operate as red flags on future young company narratives:

1. The Runaway Story: If Aaron Sorkin were writing a movie about a young start up, it would be almost impossible for him to come up with one as gripping as the Theranos story: a nineteen-year old woman (that already makes it different from the typical start up founder), drops out of Stanford (the new Harvard) and disrupts a business that makes us go through a health ritual that we all dislike. Who amongst us has not sat for hours at a lab for a blood test, subjected ourselves to multiple syringe shots as the technician draw large vials of blood, waited for days to get the test back and then blanched at the bill for $1,500 for the tests? To add to its allure, the story had a missionary component to it, of a product that would change health care around the world by bringing cheap and speedy blood testing to the vast multitudes that cannot afford the status quo. The mix of exuberance, passion and missionary zeal that animated the company comes through in this interview that Ms. Holmes gave Wired magazine before the dam broke a few weeks ago. As you read the interview, you can perhaps see why there was so little questioning and skepticism along the way. With a story this good and a heroine this likeable, would you want to be the Grinch raising mundane questions about whether the product actually works?
2. The Black Turtleneck: I must confess that the one aspect of this story that has always bothered me (and I am probably being petty) is the black turtleneck that has become Ms. Holmes’s uniform. She has boasted of having dozens of black turtlenecks in her closet and while there is mention that her original model for the outfit was Sharon Stone, and that Ms. Holmes does this because it saves her time, she has never tamped down the predictable comparisons that people made to Steve Jobs. If a central ingredient of a credible narrative is authenticity, and I think it is, trying to dress like someone else (Steve Jobs, Warren Buffett or the Dalai Lama) undercuts that quality. 
3. Governance matters (even at private businesses): I have always been surprised by the absence of attention paid to corporate governance at young, start ups and private businesses, but I have attributed that to two factors. One is that these businesses are often run by their founders, who have their wealth (both financial and human capital) vested in these businesses, and are therefore as less likely to act like “managers” do in publicly traded companies where there is separation of ownership and management. The other is that the venture capitalists who invest in these firms often have a much more direct role to play in how they are run, and thus should be able to protect themselves. Theranos illustrates the limitations of these built in governance mechanisms, with a board of directors in August 2015 had twelve members: 

Board Member	Designation	Age
Henry Kissinger	Former Secretary of State	92
Bill Perry	Former Secretary of Defense	88
George Schultz	Former Secretary of State	94
Bill Frist	Former Senate Majority Leader	63
Sam Nunn	Former Senator	77
Gary Roughead	Former Navy Admiral	64
James Mattis	Former Marine Corps General	65
Dick Kovocovich	Former CEO of Wells Fargo	72
Riley Bechtel	Former CEO of Bechtel	63
William Foege	Epidemologist	79
Elizabeth Holmes	Founder & CEO, Theranos	31
Sunny Balwani	President & COO, Theranos	NA

I apologize if I am hurting anyone’s feelings, but my first reaction as I was reading through the list was “Really? He is still alive?”, followed by the suspicion that Theranos was in the process of developing a biological weapon of some sort. This is a board that may have made sense (twenty years ago) for a defense contractor, but not for a company whose primary task is working through the FDA approval process and getting customers in the health care business. (Theranos does some work for the US Military, though like almost everything else about the company, the work is so secret that no one seems to know what it involves.) The only two outside members that may have had the remotest link to the health care business were Bill Frist, a doctor and lead stockholder in Hospital Corporation of America, and William Foege, worthy for honor because of his role in eradicating small pox. My cynical reaction is that if you were Ms. Holmes and wanted to create a board of directors that had little idea what you were doing as a business and had no interest in asking, you could not have done much better than this group of septuagenarians.

My sense of Ms. Holmes's unquestioned authority was reinforced when I read a December 2013 letter that she sent to investors in the company, asking them to agree to a five for one stock split and the creation of two classes of shares with different voting rights (class A would have one vote per share and class B would get 100 votes per share), with Ms. Holmes retaining the voting shares and voting control of the company. Lest I be accused of being sexist in begrudging her this power, I have been just as harsh in my assessments of Mark Zuckerberg (with Facebook) and the Brin/Page duo (with Google) for their desire to raise money from investors but not give them a proportional say in how the business gets run, and Ms. Holmes has not quite earned the rights (that Zuckerberg and Brin/Page have claimed) to be a corporate dictator.

Bottom Line

I would like to believe that I would have asked some fundamental questions about the science behind the product and how it was faring in the FDA approval process, if I had been a potential investor or journalist. However, it is entirely possible that listening to the story, I too would have been tempted to go along, wanting it so much to be true that I let hope override good sense. Some of my worst mistakes in investing (and life) have been when I have fallen in love with a story so much that I have willed a happy ending to it, facts notwithstanding.

The question of whether Theranos makes it back to being a valuable, going concern rests squarely on the science of its product(s). If the Nanotainer is a revolutionary breakthrough and what it needs is scientific fixes to become a reliable product, there is hope. But for that hope to become real, Theranos has to be restructured to make this the focus of the business and become much more transparent about the results of its tests, even if they are not favorable. Ms. Holmes has to scale back many of her high profile projects (virtuous and noble though they might be) and return to running the business. If the Nanotainer turns out to be an over hyped product that is unfixable, because it is scientifically flawed, Theranos has a bleak future and while it may survive, it will be as a smaller, low profile company. The investors who have put hundreds of millions in the company will lose much of that money but as I look at the list, I don’t see any of them entering the poor house as a consequence. There is a chance that the lessons about not letting runaway stories stomp the facts, never trusting CEOs who wear only black turtlenecks and caring about governance and oversight at even private businesses may be learned, but I will not hold my breath expecting them to have staying power.

YouTube Version


Blog Posts in this series

1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
2. Checkmate or Stalemate? Valeant's Fall from Grace
3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
4. Value and Taxes: Breaking down the Pfizer- Allergan Deal

Dream Big or Stay Focused? Lyft's Counter to Uber!

This is the second in a series of three posts on the ride sharing business. In my first, published in both TechCrunch and my blog, I valued Uber, trying to incorporate the news that has come out about the company and its competition in the last year. In this one, I first turn to valuing Lyft, which is telling a narrower, more focused story to investors than Uber and also look at how the pricing ladder in ride sharing companies has pushed up prices across the board. In the last post, due out on Wednesday, I will look at the ride sharing market as a business.

In my last post, I valued Uber and admitted that the company has made its way to my list of obsessions. My focus on Uber, though, has meant that I have not paid any attention to the other ride sharing company in the US,  Lyft, and I don’t think I have been alone in this process. An unscientific analysis of news stories on ride-sharing companies in the last couple of years suggests that Uber has dominated the coverage of this business. Rather than view this as a slight on Lyft, I would argue that this is at least partially by design, and that it is part of both companies' strategies. Uber is viewed as the hands-down winner of this battle right now, but this is just one battle in a long war and investors define winners differently from corporate strategists.

Valuing Lyft

To value Lyft, I will employ the same template that I used for Uber, though the choices I will make in terms of total market, market share, operating margins and risk will all be different, reflecting both Lyft’s smaller scale and more limited ambitions (for the moment).

The Leaked Numbers

The place to start this assessment is by comparing the ride sharing reach of Lyft with Uber and that comparison is in the table below:

	Uber	Lyft
Number of cities in US	150	65
Number of cities	>300	65
Number of countries	60	1
Number of rides - 2014	140	NA
Number of rides (in millions) - 2015E	NA	90
Number of rides (in millions) - 2016E	NA	205
Gross Billings (in millions $) - 2014	$2,000	$500
Gross Billings (in millions $) - 2015E	$10,840	$1,200
Gross Billings (in millions $) - 2016	$26,000	$2,700
Estimated Growth for 2015	442%	140%
Estimated Growth for 2016	140%	125%
Operating loss in 2014 (in millions $)	-$470	-$50

The key differences can be summarized as follows. First, Uber is clearly going after the global market, uninterested in forming alliances or partnerships with local ride sharing companies. Lyft has made explicit its intention to operate in the US, at least for the moment, and that seems to have been precursor to forming alliances (as evidenced by this news story from two weeks ago) with large ride sharing companies in other markets. Within the US, Uber operates in more than twice as many cities as Lyft does. Second, both companies are growing, though Uber is growing at a faster rate than Lyft, and that is captured in both the number of rides and gross billings at the companies. Third, both companies are losing money and significant amounts at that, as they go for higher revenues. Note that, for both companies, the bulk of the information comes from leaked documents, and should therefore considered with skepticism. In addition, there are some numbers that come from press reports (Lyft's loss in 2014) that are more guesses than estimates.

The business models of the two companies, at least when it comes to ride sharing, are very similar. Neither owns the cars that are driven under their names and both claim that the drivers are independent contractors. Both companies use the 80:20 split for ride receipts, with 80% staying with the driver and 20% going to the company, but that surface agreement hides the cut throat competition under the surface for both drivers and riders. Both companies offer incentives (think of them as sign-up bonuses) for drivers  to start driving for them or, better still, to switch from the other company. They also offer riders discounts, free rides or other incentives to try them or, better still, to switch from the other ride sharing company. At times, both companies have been accused of stepping over the line in trying to get ahead in this game, and Uber’s higher profile and reputation for ruthlessness has made it the more commonly named culprit. 

The other big operating difference is that unlike Uber, which is attempting to expand its sharing model into the delivery and moving markets, Lyft, at least for the moment, has stayed much more focused on the ride sharing business, and within that business, it has also been less ambitious in expanding its offerings to new cities and new types of car services than Uber.

The Narrative Contrast and Valuation

In my valuation of Lyft, I will try to incorporate the differences that I see (from Uber) into my narrative:

	Lyft	Uber
Potential Market	US-centric, ride-sharing company.	Global, logistics company
Growth Effect	Double ride-sharing market in US in next 10 years	Double logistics market globally in next 10 years
Market Share	Weak national networking benefits	Weak global networking benefits
Competitive Advantage	Semi-strong competitive advantages	Semi-strong competitive advantages
Expense Profile	Drivers as partial employee	Drivers as partial employees
Capital Intensity	Low capital intensity	Low capital intensity, with potential for shift to more capital intense model
Management Culture	Aggressive within ride sharing business, Milder with regulators and media.	Aggressive with all players (competitors, regulators, media)

In short, the Lyft narrative is narrower and more focused (on ride sharing and in the US) than the Uber narrative. That puts them at a disadvantage, at least at this stage in the ride sharing market, in terms of both value and pricing, but it could work in their favor as the game unfolds. 

The adjustments to the Lyft valuation, relative to my Uber valuation, are primarily in the total market numbers, but I do make minor adjustments to the other inputs as well. 

1. Smaller total market: Rather than use the total global market, as I did for Uber, I focus on just the US portion of these markets. That reduces the total market size substantially. In addition, I assume that, given Lyft’s focus on ride sharing, that its market is constrained to be the US car service market. Notwithstanding these changes in my assumption, the potential market still remains a large one, with my estimate about $150 billion in 2025. 
2. National networking benefits: Within the US market, I assume that the increased cost of entry into the business that I referenced in my last post on Uber will restrict new competitors and that Lyft will enjoy networking benefits across the country, enabling it to claim a 25% market share of the US market. 
3. Drivers become partial employees: My assumptions on drivers becoming partial employees and competition driving down the ride sharing company slice of revenues will parallel the ones that I made for Uber, resulting in lower operating margins (25% in steady state) and a smaller slice of revenues (15%). 
4. Lyft is riskier than Uber: Finally, I will assume that Lyft is riskier than Uber, given its smaller size and lower cash reserves, and set its cost of capital at 12%, in the 90th percentile of US companies, and allow for 10% chance that the company will not make it.

The value that I derive for Lyft with these assumptions is captured in the picture below:

Spreadsheet with Lyft Valuation (September 2015)

The value that I get for Lyft is $3.1 billion, less than one seventh of the value that I estimated for Uber ($23.4 billion) in my last post.

The biggest danger that I see for investors in Lyft is that the company has to survive the near future, where the pressure from Uber and the nature of the ride sharing business will create hundreds of millions of dollars more in losses. If the capital market, which has been accommodating so far, dries up, Lyft faces the real danger of not making it to ride sharing nirvana. It is a concern amplified by Mark Shurtleff at Green Wheels Mobility Solutions, a long-time expert and consultant in the ride sharing and mobility business, who points to Lyft's concentration in a few cities and cash burn as potential danger signs.

Pricing The Ride Sharing Companies

While none of the ride sharing companies are publicly traded and there are therefore no prices (yet) for me to compare these valuations to, there have been investments in these companies that can be extrapolated at some risk to estimate what these investors are pricing these companies at. In keeping with my theme that price and value come from different  processes, recognize that these are prices, not values.

The VC Pricing

I took at look the most recent VC investments in ride sharing companies and what prices they translate into.

Company	Last VC round investment amount (in US$ millions)	Date	Lead Investors	Imputed Pricing for the company (in US $ millions)
Lyft	$530.00	15-May	Rakuten, Didi Kuaidi, Carl Icahn	$2,500.00
Uber	$1,000.00	15-Jul	Microsoft	$51,000.00
Didi Kuaidi	$2,000.00	15-Jul	China Investment Fund	$15,000.00
Ola	$310.00	15-Mar	DST Global	$2,300.00
GrabTaxi	$200.00	15-Jul	Coatue Management & others	$1,500.00

* Sources: Public News Reports, Mark Shurtleff
The danger in extrapolating VC investments to overall value, which is what the press stories that report the overall prices do, is that the only time that a VC investment can be scaled up directly to overall value is if it comes with no strings attached. Adding protections (ratchets) or sweeteners can very quickly alter the relationship, as I noted in this post on unicorns. 

The Drivers of Price

Notwithstanding that concern, is there a logic to this pricing? In other words, what makes Uber more than three times more valuable than Didi Kuaidi and Didi Kuaidi six times more valuable than Lyft? To answer these questions, I pulled up the statistics that I could find for each of these companies:

Company	Estimated Value (Price)	Gross Billing in $ millions (2015)	Revenues (2015)*	Operating Profit or Loss (2015)	Cities served (2015)	# rides	Potential Market (in $ millions)	# Drivers
Lyft	$2,500	$1,200	$300	-$100	65	156	$55,000	100000
Uber	$51,000	$10,840	$2,000	-$470	300	1460	$205,000	800000
Didi Kuaidi	$15,000	$12,000	$450	-$1,400	137	2190	$50,000	2600000
Ola	$2,500	$1,200	$150	NA	85	100	$13,000	250000
GrabTaxi	$1,500	$1,000	$50	NA	26	300	$6,000	75000
BlaBlaCar	$1,600	$600	$72	NA	100	NA	$20,000	NA

* The revenues are estimated using the revenue slice that these companies report, but with customer give aways and other marketing costs, the actual revenues were probably lower.

Note that almost all of these numbers come from leaks, guesses or judgment calls, and that there are many items where the data is just not available. For instance, while we know that Ola, GrabTaxi and BlaBlaCar are all losing money, we do not know how much. At the risk of pushing my data to breaking point, I computed every possible pricing multiple that I could for these companies:

Company	Value/Gross Billing	Value/Revenues	Value/City	Value/Ride	Value/Potential Market
Lyft	2.08	8.33	$38.46	$16.03	0.0455
Uber	4.70	25.50	$170.00	$34.93	0.2488
Didi Kuaidi	1.25	33.33	$109.49	$6.85	0.3000
Ola	2.08	16.67	$29.41	$25.00	0.1923
GrabTaxi	1.50	30.00	$57.69	$5.00	0.2500
BlaBlaCar	2.67	22.22	$16.00	NA	0.0800
Average	2.38	20.54	70.18	$17.56	0.1861
Median	2.08	22.22	48.08	$16.03	0.2205
Aggregate	2.76	22.98	103.93	$17.24	0.2123

On a pure pricing basis, Lyft looks cheap on every pricing multiple, and Uber looks expensive on each one, perhaps providing some perspective on why Carl Icahn found Lyft to be a bargain, relative to Uber. Didi Kuaidi looks expensive on any measure other than gross billing and GrabTaxi looks cheap on some measures and expensive on others.  It is worth noting that these companies have different revenue models, with Lyft and Uber hewing to the 20% slice model, established in the US and Ola (which has more of a taxi aggregating model), at least according to the reports I read, follows the same policy. BlaBla is mostly long-distance rides and gets about 10-12% of the gross billing as revenue, GrabTaxi gets only 5-10% of gross billings, Didi Kuaidi, which had its origins in a taxi hailing app, gets no share of a big chunk of its revenues and BlaBlaCar derives its revenues more from long distance city-to-city traffic than from within city car service. Given how small the sample is and how few transactions have actually occurred, I will not attempt to over analyze these numbers, other than wondering, based on my post on corporate names, how much more an umlaut would have added to Über's hefty price.

With all of these companies, the prices paid have risen dramatically in the last year and a half and I believe that this pricing ladder is driven by Uber's success at raising capital. In fact, as Uber's estimated price has risen from $10 billion early in 2014 to $17 billion last June to $40 billion at the start of 2015 to $51 billion this summer, it has ratcheted up the values for all of the other companies in this space. That should not be surprising, since the pricing game almost always is played out this way, with investors watching each other rather than the numbers. As with all pricing games, the danger is that a drop in Uber's pricing will ratchet down the ladder, causing a mark down in everyone's prices.

Big versus Small Narratives

If narrative drives numbers and value, which is the argument that I have made in valuing Uber and Lyft in these last two posts, the contrast between the two is also in their narratives. Uber is a big narrative company, presenting itself as a sharing company that can succeed in different markets and across countries. Giving credit where it is due, Travis Kalanick, Uber’s CEO, has been disciplined in staying true to this narrative, and acting consistently. Lyft, on the other hand, seems to have consciously chosen a smaller, more focused narrative, staying with the story that it is a car service company and further narrowing its react, by restricting itself the US. 

The advantage of a big narrative is that, if you can convince investors that it is feasible and reachable, it will deliver a higher value for the company, as is evidenced by the $23.4 billion value that I estimated for Uber. It is even more important in the pricing game, especially when investors have very few concrete metrics to attach to the price. Thus, it is the two biggest market companies, Uber and Didi Kuaidi, which command the highest prices. Big narratives do come with costs, and it those costs that may dissuade companies from going for them. 

1. It can distract: Big narratives will require companies to deliver on multiple measures and that may distract management from more immediate needs. 
2. It can be costly: Having to grow faster and in multiple markets (different businesses and different geographies) at the same time will be more costly than focusing on a smaller market and having more measured ambitions.
3. It can create disappointments: The flip side of convincing investors that you can reach for the heights is that if you don’t make it, you will disappoint them, no matter how good your numbers may be. 

With Uber, you see the pluses and minuses of a big narrative. It is possible that Uber Eats (Uber’s food delivery service), UberCargo (moving) and UberRush (delivery) are all investments that Uber had to make now, to keep its narrative going, but it is also possible that these are distractions at a moment when the ride sharing market, which remains Uber’s heart and soul, is heating up. It is undoubtedly true that Uber, while growing at exponential rates, is also spending money at those same rates to keep its big growth going and it is not only likely, but a certainty, that Uber will disappoint their investors at some time, simply because expectations have been set so high. 

It is perhaps to avoid these risks that Lyft has consciously pushed a smaller narrative to investors, focused on one business (ride sharing) and one market (the US). It is avoiding the distractions, the costs and the disappointments of the big narrative companies, but at a cost. Not only will it cede the limelight and excitement to Uber, but that may lead it to be both valued and priced less than Uber. Uber has used its large value and access to capital as a bludgeon to go after Lyft, in its strongest markets.

As an investor, there is nothing inherently good or bad about either big or small narratives, and a company cannot become a good investment just because of its narrative choice. Thus, Uber, as a big narrative company, commands a higher valuation ($23.4 billion) but it is priced even more highly ($51 billion). Lyft, as a small narrative company, has a much lower value ($3.1 billion) but is priced at a lower number ($2.5 billion). At these prices, as I see it, Lyft is a better investment than Uber. 

Block and Draft

It is clear that Uber and Lyft have very different corporate personas and visions for the future and that some of the difference is for outside consumption. It serves Uber well, in its disruptive role, to be viewed as a bit of a bully who will not walk away from a fight, just as it is Lyft’s best interests to portray itself as the gentler, more humane face of ride sharing. Some of the difference, though, is management culture, with Uber drawing from a very different pool of decision-makers than Lyft does. If this were a bicycle race, Uber reminds me of the aggressive lead rider, intent on blocking the rest of the pack and getting to the finish line first, and Lyft is the lower profile racer who rides just behind the leader, using the draft to save energy for the final push. This is going to be a long race, and I have a feeling that its contours will change as the finish line approaches, but whatever happens, it is going to be fun to watch!

YouTube Version

Ride Sharing Series (September 2015)

1. 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

Spreadsheets

1. Lyft: Valuation
2. Ride Sharing Companies: Metrics and Pricing

On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns!

A slightly abbreviated version of this post appeared in TechCrunch on October 9, 2015, and it is the first of series of three on the ride sharing business. In the second post, I value Lyft, the other ride sharing company, and also look at how ride sharing companies globally are being priced. In the third and final post, I look at ride sharing as a business and at four possible scenarios for its evolution. Those posts will also appear in TechCrunch over the next two weeks and will be reproduced here soon after.

It seems like ages ago, and perhaps even in a far-off galaxy, that I first valued Uber on my blog, but it was in June of 2014. One reason it seems like a lot of time has elapsed is that Uber has managed to be in the news, for good and bad reasons, almost all through this period. With each news story, the response is either rapturous or funereal, depending on the responder’s prior views on the company. Given how eventful this last year has been, I think it is time for me to revisit my estimates, eat some humble pie and redo my valuation.

A look back

I became interested in Uber after reading a news story in June 2014 that indicated that it had been valued at $17 billion in a venture capital round. I posted my first valuation of Uber in June 2014, viewing it as an urban car service company, with local (but not global) networking benefits. Assuming that it would increase the size of the urban car service market by about 40%, while preserving its low capital-investment business model, I valued Uber at just under $6 billion.

While some in the VC community were quick to dismiss the valuation, I will remain grateful to Bill Gurley for a post where he took me to task for having too narrow a vision of Uber’s business model. In his counter narrative, he argued that Uber was not just urban (it could create inroads in suburbia), not just a car service (it was in logistics & transportation) and that it was working with other businesses to create global networking benefits. Since Bill, as an early investor in Uber with access to its internal workings, clearly knew far more about the company than I did, I revalued Uber using his narrative and arrived at $54 billion as the value that reflected the narrative.

I was then taken to task by value investors who took issue with the value changing so dramatically from my assessment to his, and my response was that this was exactly what you should expect, early in the life of a company, where there is room for widely divergent narratives, and values that reflect these divergences. In December 2014, I tried to show this by creating a build-your-own-Uber valuation template, where I let readers choose Uber’s market (urban car service, all car service, logistics or mobility services), the effect it would have on that market’s size (from none to doubling it), the competitive advantages that would determine its cut of the ride receipts (from the existing 20% down to 5%), the networking benefits it would have (none, local, partial global, global) and business model (from its current no capital intensity to higher capital investments), and derived values for Uber, ranging from less than $1 billion to close to $100 billion.

The news keeps coming..

As I noted at the top of this post, it is an understatement to say that Uber has been in the news. Each week brings more Uber stories, with some containing good news for those who believe that the company is on a glide path to a $100 billion IPO, and some containing bad news, which evoke predictions of catastrophe from Uber doubters. For me, the test with each news story is to see how that story affects my narrative for Uber, and by extension, my estimate of its value. In keeping with this perspective, I broke the news stories down based upon narrative parts and valuation inputs.

The Total Market 
The news on the car service market has been mostly positive, indicating that the market is broader, bigger, growing faster and more global than I thought it was, even a year ago. 

1. Not just urban and much bigger: While car service remains most popular in the urban areas, it is making inroads into exurbia and suburbia. The evidence for this lies not only in anecdotal evidence and the market capitalizations commanded by ride sharing companies, but also in the numbers that have been leaked by these companies. A presentation to potential investors in the company put Uber’s gross billings for 2015 at $10.84 billion. It is true that these are unofficial and may have some hype built into them, but even if that number over estimates revenues by 20% or 25%, that represents a jump of 400% from 2014 levels.
2. Drawing in new customers: One reason for the increase in the car service market is that it is drawing in customers who would never have taken been in this market in the first place. While the evidence for this is still mostly anecdotal, another leaked report out of Uber indicates that ride sharing has created a market three to four times larger that the original taxi cab/ limo market in San Francisco, the city with the longest history with new ride sharing services. While San Francisco is unusual in terms of the high proportion of its population that is young, tech-savvy and single, the argument that ride sharing is increasing the size of the market elsewhere, though not to the same magnitude that it did in the Bay Area, seems to be a solid one.
3. With more diverse offerings: The other reason for the jump in the size of the ride sharing market is that it is no longer just a cab service, but instead has expanded to include alternatives that expand choices, reduce costs (car pooling services) or increase flexibility.
4. And going global: The biggest stories on ride sharing came out of Asia, as the ride sharing market has exploded in that part of the world, and especially so in India and China. That should really come as no surprise since these countries offers the trifecta for ride sharing opportunities: large urban populations, with limited car ownership and bad mass transit systems. 

The bad news on the car service market front has come mostly in the form of taxi driver strikers, regulatory bans and operating restrictions. Sao Paulo may be the latest city to restrict Uber, but it is part of a long list of cities or entire countries that have tried to ban or restrict ride sharing. Even that bad news, though, contains seeds of good news, since the status quo would not be trying so hard to stop the upstarts, if ride sharing was not working. In my view, the attempts by taxi operators, regulators and politicians to stop the ride sharing services reek of desperation, and the markets seem to reflect that. Not only have the revenues collected by taxi cabs in New York city dropped significantly in the last year, but so has the price of NYC cab medallions, dropping almost 40% in value (roughly $5 billion in the aggregate) in the last two years. While auto sales may not have been affected materially yet, there are worries that there will be a drop in sales in future years, as people replace a "second" car or even a "first" car with ride sharing services.

In my December post, I noted the possibility that Uber could move into other businesses. The good news is that it has delivered on this promise, offering logistics services in Hong Kong and New York, and food delivery service in Los Angeles. The bad news is that it has been slow going, partly because these are smaller businesses (than ride sharing) and partly because the competition is more organized. However, these new businesses have moved from just being possible to plausible, thus expanding the total market.

Bottom line: The total market for Uber is bigger than the urban car service market that I visualized in June 2014, and will attract new customers, and expand in new markets (with Asia becoming the focus), and perhaps even in new businesses.

Networking & Competitive Advantage (Market Share and revenue sharing)

The news on this front is more mixed. The good news is that the ride sharing companies have increased the cost of entry into the market, with tactics such as paying large amounts to drivers as sweeteners to sign up. In the US, Uber and Lyft have become the biggest players, and some of the competitors from last year have either faded away or been unable to keep up with these two. Outside the US, the good news for Uber is that it is not only in the mix almost everywhere in the world but that Lyft has, at least for the moment, decided to stay focused on the United States in its expansion choices. 

The bad news for Uber is that, especially in Asia, the competition has been intense, and that it is fighting against domestic ride sharing companies that dominate these markets, Ola in India, Didi Kuaidi in China and Grabtaxi in South East Asia. Some of the domestic company dominance can be attributed to these companies being first movers and understanding local markets better, but some of it also reflects that the market is tilted (by local investors, regulation and politics) towards local players. There is even talk, though it may be just that, that these competitors will band together to create a “not-Uber” network that can share resources and users, though the news story, two weeks ago, that Didi Kuaidi and Lyft were going to create a formal partnership adds heft to the thesis. To add to the mix, all of these ride sharing companies have been able to access capital at sky-high valuations, reducing the significant cash advantage that Uber had earlier in the process.

No matter how this process plays out, one of the key numbers that will be (and in some cases is already) under pressure, due to this more intense competition, is the sharing of the gross billing, currently set at 80% for the driver and 20% for the ride sharing business. In many US cities, where Lyft is challenging Uber most aggressively, Lyft is already offering drivers the opportunity to keep all of their earnings, if they drive more than 40 hours a week. While the threat of mutually assured destruction has kept both companies from directly challenging the 80/20 sharing rule, it is only a matter of time before that changes.

Bottom line: The ride sharing market is becoming competitive, but as costs of entry rise and the capital requirements become intense, it looks like this will be a market with fewer players with larger regional networking benefits and more capital.

Cost structure

This is the area where the most bad news has been delivered. Some of the pain has been from within the ride sharing business, as companies have taken to offering larger and larger up-front payments to drivers to get them to switch from competitors, pushing up this component of costs. Much of the cost pressure, though, has come from outside:

1. Drivers as partial employees: Early in the summer, the California Labor Commission decided that Uber drivers were employees of the company, not independent contractors. That ruling was further affirmed by a court decision that Uber drivers could sue the company in a class action suit, and it is likely that there will be other jurisdictions where this fight will continue. While ride sharing companies may be able to delay the effect, it is almost inevitable that at the end of the process, drivers for ride sharing companies will be treated perhaps not as employees but as semi-employees, entitled to some (if not all) of the benefits of employees (leading to higher costs for ride sharing companies).
2. The insurance blind spot will be filled: The other shoe that is poised to drop is the cost of car insurance. Ride sharing companies in their nascent years have been able to exploit the holes in auto insurance contracting, often just having to add supplemental insurance to the insurance that drivers already have. As both regulators/legislators and insurance companies try to fix this gap, it is very likely that drivers for ride sharing companies will soon have to buy more expensive insurance and that ride sharing companies will have to bear a portion of that cost.
3. Fighting the empire is not cheap: Earlier in this post, I noted that the status quo (the taxi business and its regulators) was fighting back and that its cause was hopeless. However, the fight will still be expensive as the amount of money spent on lobbying and legal fees will increase, as new fronts open up. 

The evidence that costs are running far ahead of revenues again comes from leaked documents from the ride sharing companies. This one, for instance, shows that Uber was a money loser last year and in this one, the contribution margins (the profits after covering just variable costs) by city not only reveal big differences across cities, but are uniformly low (ranging from a high of 11.1% in Stockholm and Johannesburg to 3.5% in Seattle).

Bottom line: The costs of running a ride sharing business are high, and while some of these costs will drop, as business scales up, the operating margins are likely to be smaller than I anticipated just over a year ago.

Capital Intensity and Risk

The business model that I assumed when I first valued Uber was minimalist in its capital investment requirements, since Uber not only does not own the cars driven by its drivers but invests little in corporate offices or infrastructure. That translated into a high capital turnover ratio, with a dollar in capital generating five dollars in additional revenues. While that basic business model has not changed, ride sharing companies are recognizing one of the downsides of this low capital intensity model is that it has increased competition on other fronts. Thus, the high costs that Uber and Lyft are paying to sign up drivers can be viewed as a consequence of the business models that they have adopted, where drivers are free agents who are not bound to either company. 

For the moment, there is no sign that any of the ride sharing companies is interested in altering the dynamics of this model, by either upping its investment in infrastructure or in the cars themselves, but this news story about Uber hiring away the robotics faculty at Carnegie Mellon may be suggestive of change to come.

Bottom line: Ride sharing companies will continue with the low capital intensity model, for the moment, but the search for a competitive edge may result in a more capital intense model, requiring more investment to deliver sustainable growth.

Management culture

Though not a direct input into valuation, it is unquestionable that when investing in a young business, you should be aware of the management culture in that business. With Uber, your responses to the news stories about its management team will reflect your priors on the company. If you are predisposed to like the company, you will view it as confident in its attacks on new markets, aggressive in defending its turf, and creative in its counter-attacks. If you don’t like the company, the very same actions will be viewed as indicative of the arrogance of the company, its challenging a status quo will signal its unwillingness to play by the rules and its counter attacks will be viewed as overkill.

In New York, I saw this come into play when the mayor and city council decided to restrict the ride sharing companies (and Uber in particular) from expanding in the city, using the argument that it was worsening traffic conditions in the city. In response, Uber struck back with a counter publicity blitz which included not only radio and TV ads, but also add-ons to the Uber app that left no doubt in Uber users’ minds about how these restrictions would affect their choices. I thought that the DeBlasio option on the Uber app was clever, and while Uber won this battle with New York city, I wonder whether the scorched earth policies that it used will come back to hurt the company down the road.

Bottom line: While there are a few indications that Uber might be trying to soften its image, there seems no reason to believe that the company will become less aggressive in the future. The question of whether this will hurt them as they scale up remains unresolved.

Uber: An Updated Valuation

In summary, a great deal has changed since June 2014, partly because of real changes that have happened to the ride sharing market since then and partly because I had to fill in gaps in my ignorance about the market. I think that the best way to capture the shifts in my valuation is to compare my inputs on key numbers in June 2014 with my estimates in September 2015.

Uber valuation (6/14), Uber valuation (9/15)

I was wrong about Uber’s value in June 2014, when my estimate of $6 billion was below the $17 billion assessment by venture capitalists then. Correcting for both my cramped vision and the changes that have occurred since June 2014, my estimated value today is $23.4 billion.

Über valuation Spreadsheet (Ignore the umlaut, spell check did it..)

I know my estimated value lags the $51 billion value that VCs are attaching to the company today. This may very well be a reflection that my vision is still too cramped to capture Uber’s possible businesses, but it is what it is.

Fire away

When teaching and writing, my objective is to evoke interest and excite my audience, and failing that, to provoke dissent and incite argument, but the reaction that I dread the most is boredom. The very fact that you are reading this post still is good news, but if you are in complete agreement with my valuation of Uber, I have failed. I would rather that you fall into one of three groups: that you think my value is too high, that you feel it is too low or that you believe that I have no business even valuing Uber.

• If you think I have over estimated the value of Uber, it should not be because it is losing money (given its growth trajectory, you should be suspicious if it did not), is trading at a high multiple of revenues (it should) or because your stable growth dividend discount model gives you too low a number (it is the wrong tool for a growth company). It should because you think the regulatory roadblocks will make the ride sharing market smaller than I have forecast it to be, and that competition will be much more intense (reducing market share and operating margins). 
• If you think that I have under estimated the value of Uber (again), don’t blame DCF models for being biased against growth companies. The fault lies with me, and it has to be somewhere in my inputs, i.e., that I am not foreseeing other markets that Uber could enter, that its networking benefits are far stronger globally than I predict them to be (giving it a higher market share) or that the operating margins will bounce back to much healthier levels once they navigate their way through the growth phase. 
• If your view is that I have no business valuing Uber because I am not a tech person, that I am not an expert in the ride sharing business and/or that I have not made money as a VC, my responses are guilty as charged, you are right and without a doubt. I don’t have a tech background, don’t work on the right coast and know technology only as a user, but I don’t think any of those are prerequisites for investing in technology companies. I have tried to incorporate what I have learned from technology companies in the market into the valuation, in the form of easier scaling up, larger networking benefits and bigger market effects, but I might not have done it well enough. There are many who know a great deal more about ride sharing than I do, and while I have tried to learn about the inner workings of this business from Harry Campbell and about the Chinese growth potential from Drake Ballew, my ride sharing know-how is limited. Finally, if we did restrict writing about the valuation of young companies only to venture capitalists who have been consistently successful over long periods, the list of potential writers would be very short, and most of the people on the list would be too busy investing in these startups to write about them. 

Whatever group you belong to, rather than complain about my mistakes (which are too many to count) or bemoan my limitations (which are legion), please take my Uber valuation and make it yours, putting your superior knowledge and experience into the numbers. In fact, let’s give this a crowd valuation twist and get a shared Google spreadsheet going, where you can post your results.

To be continued..

Notwithstanding the dressing down that I got from some in the technology/VC space for my first valuation of Uber, or perhaps because of it, there is no company that I have enjoyed valuing and talking about more during the last year, than Uber. Thecompany illustrates all the broad themes in valuation that I have returned in my blog posts and teaching: that uncertainty is part and parcel of valuation, that narratives drive numbers and that the pricing and valuation processes can yield different numbers. As a teacher, I am constantly on the look out for learning and teaching moments, and few companies have offered me more than Uber. 

To show you how much Uber has found its way into my every day thinking, I will end with a personal story. Towards the end of last summer, my youngest son, who is fifteen had a friend over for the afternoon, and when it was time for the friend to leave, I looked out at the driveway, expecting the “Mom car", the typical mode of transportation for a 15-year old in the middle of suburbia (where I live). When I saw a strange sedan with a bearded man in the driver’s seat, I was taken aback, until I was told that it was an Uber car. Since this happened only two months after my valuation of Uber in June 2014, where I labeled it an urban car service company, my first reaction after I got over my surprise was that I needed to revalue Uber afresh. Of such small actions are obsessions born!

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

Previous Blog posts

1. A Disruptive Cab Ride to Riches: The Uber Payoff
2. Possible, Plausible and Probable: Big Markets and Networking Effects
3. Up, up and away: A crowd valuation of Uber

Spreadsheets

1. My first Uber valuation (June 2014)
2. My crowd valuation of Uber (December 2014)
3. My current valuation of Uber (September 2015)