Uber (UBER - Free Report) and Lyft (LYFT - Free Report) burst into the IPO scene in 2019 after years of speculation about their growth and prospects. But investor sentiment at launch and thereafter haven’t lived up to the hype. That’s because the market is waking up to the fact that these companies don’t have a convincing roadmap to profitability and possibly, an unsustainable business model.
It’s also likely the reason that Uber accounted for around 49% of venture capital exits in the second quarter of 2019, driving total VC exits to $138 billion, or the highest level since 2012. VCs typically are early investors in new ventures that cash out partially or wholly when the venture is acquired by a larger company or goes public through an IPO. The enthusiasm with which they cash out obviously has an impact on sentiments on the stock.
Even if they do, it doesn’t automatically mean that the company is not going places. In 2012 for example, Facebook (FB - Free Report) was the biggest driver of VC exits, but look where it is now. Could Uber be one day where Facebook is now? Could Lyft? That’s a big question that boils down to the business model.
A business model is effective when the underlying objective is strong, or when there’s a big or complex problem it solves. This is especially true for a technology company, since technology can presumably calculate faster than humans.
The problem that Uber, Lyft et al are trying to solve is possibly best defined as connecting drivers with riders, which requires that it ensures optimal drivers at optimal locations to cover most rides. Now, while software can provide us with algorithms to create a technical possibility of an ideal situation, the company offers drivers flexibility in accepting rides, which tends to skew the equation. To ensure that it still works, the company needs oversupply of drivers. This is one problem.
The second problem is to do with the need to ensure that drivers operate flexibly, or as independent contractors. If drivers become permanent employees, the company must pay benefits like social security, unemployment insurance, health benefits, a minimum wage and the right to form a union, which will of course increase cost significantly. That’s why the Assembly Bill 5 (AB5) that seeks to codify a California Supreme Court ruling from 2018 is so important.
In that case, the court ruled that delivery firm Dynamex had misclassified its workers. It also laid down three principles that define an independent contractor: A) they must be “free from the control and direction of the hiring entity” in their work; B) must perform work outside the “usual course of the hiring entity’s business;” and C) must usually be engaged in an independent job or business of the same nature as the work they do for the hiring entity.
This puts a large number of tech startups on the spot because they employ delivery individuals for their central business who have no enterprise of their own, without benefits. Moreover, they just don’t make enough to pay benefits. Uber and Lyft are in the same boat. So we are seeing them lining up for exemptions, backed by the California Chamber of Commerce.
This week, the Labor, Public Employment and Retirement Committee of the California Senate voted in favor of the bill, 3 to 1, so it is very likely to go through.
The third problem is to do with the human element. Technology companies are accustomed to picking the brains of engineers and paying them a percentage. This amounts to a lot because the product is highly valuable. Engineers are also personally involved with their projects. Patents are issued in their name and can significantly add to their prestige and recognition.
This is very different from a job like driving, which doesn’t involve a whole lot of innovation. Drivers are therefore focused on increasing their pay, irrespective of the value of the good they offer. This focus takes them to at least try to game the system. For example, it’s very common for drivers to go offline in quiet periods and online again when surge rates are on. So this is in tension with the original objective of providing a service that covers most rides.
The fourth problem is that the only person paying is the customer. So the customer finds that as has always been the case, it’s hard to quickly hail a cab especially in quiet periods. The only time there are a lot of taxis available is when surge prices are on. Moreover, even the cost of regular rides is going up exponentially (as Uber/Lyft raises prices). To make matters worse, because they have sucked out drivers from the traditional taxi system, those taxis are also relatively scarce and so, more expensive.
So the result is that the problem the ride-sharing companies were trying to solve isn’t solved and they have in fact created new problems.
The California bill doesn’t automatically apply to the rest of the country. But California has an outsized impact on the industry because most tech startups are headquartered there and most of them hugely exposed to the state. Uber is relatively better off in this respect because it operates not only in other states, but also in 60+ other countries.
As far as the rest of the market is concerned, one can only hope that level 5 automation of cars comes sooner rather than later. But even then, we’ll have to take a wait-and-see approach because there could be teething problems.
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
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