Survival of the fittest.

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Uber Needs an $11 Billion War Chest

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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The decision by Saudi Arabia's sovereign wealth fund to put $3.5 billion in Uber is further evidence of the ride-sharing company's spectacular success in attracting top-flight investors. But what will Uber do with its cash pile, which now exceeds $11 billion?

There are two easy answers -- one for haters and one for boosters. The former would say Uber burns the money, the latter would point to the enormous financial resources required for the company's top-line growth and geographic expansion. Both would be right -- but only to a degree.

QuickTake The Sharing Economy

Uber doesn't publish any financial data, but a picture of its performance over the last four years can be pieced together from confidential documents leaked by Gawker and The Information. The company's costs have been growing much faster than its net revenue -- the money Uber keeps after discounts, refunds and the drivers' cut, which is 80 percent of gross bookings less those same discounts and refunds. 

The Money-Burning Machine
Uber's net revenue and costs in 2012-2015, thousands of dollars
 
Source: Leaked Uber documents via Gawker.com and Theinformation.com

As Uber grows, investors can expect it to reap more  economies of scale. Indeed, its operating expenses are growing slower than its net revenue. The widening losses are driven by the fast-growing cost of revenue, which usually includes staff salaries and sales and marketing expenses associated with each specific sale. In the first half of 2015, the last period for which data are available, cost of revenue increased almost 60 percent compared with all of 2014, while net revenue grew 34 percent. 

Uber won't comment on the leaked numbers, but in its case marketing expenses incurred in specific markets as they come online are probably included in the cost of revenue. Just as Uber boosters say, the company is investing heavily in its expansion.

Even if it didn't incur these expansion costs, Uber would still be unprofitable. Its operating costs eat up the net revenue and then some. But as the company scales up and the cost of revenue growth slows, a path to  profitability begins to appear. My back-of-the-envelope calculations show that if the company keeps expanding and increasing its operating costs at the current rate, and the cost of revenue growth slows to 20 percent a year, Uber will make money in 2018. Given the speed at which the company has expanded so far -- net revenue was just $16.1 million in 2012 -- investors as demanding as the Saudi sovereign fund, Russia's LetterOne and China's Baidu are willing to believe the growth will not lapse.

And yet their investments give the company a valuation of $62.5 billion, which seems iffy.

Uber makes most of its revenue in a few big U.S. cities. The company's chief executive, Travis Kalanick, boasted early in 2015 that in San Francisco its gross revenue -- before the drivers' cut -- amounted to $500 million a year, about three times more than is generated by the city's traditional taxi market. If that is true, and leaked Uber numbers appear to support the assertion, a full 20 percent of Uber's gross bookings in 2014 came from San Francisco alone.

That may suggest that the big cities that came online later will someday be as reliably lucrative. Based on announced fares, Uber undercuts traditional taxis by a wide margin almost everywhere it operates, so it should be able to grab market share easily. 

A Predatory Competitor
Standard taxi fare for a three-mile trip as a percentage of UberX's fare for the same trip
 
Sources: Uber, Numbeo.com, Taxifarefinder.com, author's calculations

Yet it's not going to get an easy ride. In Europe, Uber is far from universally popular because it's seen as a brash U.S. invader. In addition, it has lost its status as the triumphant first entrant: Other ride-hailing apps, local and international (one example is the Tel-Aviv-based Gett), offer similar hailing convenience and sometimes lower prices. Taxi services catch on and start using apps that are no less user-friendly than Uber's. And users find out that the fare difference in Uber's favor is not as great as its announced tariffs would suggest. In New York, for example, a traditional yellow cab is cheaper than Uber when traffic is slow and, say, on trips between Manhattan and the JFK airport, so Kalanick's company hasn't grabbed share from the taxi industry as effectively as it has in San Francisco. 

It speaks in Uber's favor that many big cities are underserved by taxis because the industry has lobbied to keep the number of licenses down. In Paris, there are only 3.4 taxis per 1,000 inhabitants, compared with New York's 13.5. Yet Uber's no longer cutting into these cities like a knife into butter: Regulators resist it, and local competition is arming itself.

That's why profitability may have to wait, and Uber is raising billions to spend as it struggles to establish itself.

Projecting Uber's international growth rates from its strong U.S. base is only an assumption. A slowdown is inevitable sooner rather than later, and competition is likely to make it impossible for Uber to raise prices much above the lows it established to smooth its entry.

Savvy, wealthy investors are putting money into a very big private taxi company with an eroding competitive advantage. Clearly, they don't expect to recoup their investments from dividends. For all the talk about Uber being a new breed of company that may never need to go public, an initial public offering is the only chance for its backers to win out. Amazon.com, after all, is, for the most part, just a huge e-commerce operation -- but it is a powerful global brand, present everywhere. That allows it to trade at a price-to-earnings ratio of 296. If Uber can keep its magic alive as a mature operation the way Amazon does, it'll make money for those who helped bloat its valuation as a private company.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net