The Unicorns come out of the woods.

Uber and Lyft were celebrity IPOs. Lyft was luckier with timing; it IPO’d in a bull-market and saw its stock shoot up more than 20% on debut. Uber was unlucky; their stock retreated on the first day because they debuted just as Trump’s trade war started resurfacing. Both Uber and Lyft are decidedly “growth stocks”, in which most of the market capitalization is undoubtedly related to expectations of massive growth. You’ll see.

In this worldview, I’ll go down the income statement as it were – first with revenue, then costs, and finally over to cash flow. The point of this worldview is simple: What do I need to believe about the companies’ futures for either stock to be attractive? What do I need to believe for these stocks to qualify as “investments” as opposed to “speculations”?

Same difference?

Obviously, they’re direct competitors. But as I was listening to their maiden earnings calls for Q1 2019, I was struck by a stark contrast in strategy. Here’s how I would summarize it:

Uber: Build on the shared-ridership technology to move into other industries like Food Delivery and Logistics – all on a common tech platform, with potential cross-selling opportunities.

Lyft: Focus on 1) Transportation only, 2) Transportation contracts with cities and 3) Transportation partnerships with Enterprises such as Delta Airlines and Waymo.

Those are very different approaches. I’m not sure which one will win. Maybe both will. The Uber strategy of using a common tech platform to spread their wings across other industries gets me a little more excited. The Lyft strategy of “focus” on transportation looks nice on paper but I wonder how that gives them an advantage over Uber. This business is about scale and a massive user-base. What’s the fastest way to grow the user-driver-vehicle flywheel? I’m sure both management teams have the Amazon Flywheel at the back of their minds at all times.

While their strategies are different, those are not the competitive advantages. Those are ways of widening their respective Moats. But what is the castle that this moat protects? Why would a user choose Uber over Lyft or vice versa? Both CEOs acknowledged that competitive advantage may come down to this ephemeral concept called Brand. Said another way, it may come down to image. Uber has been receiving some negative press (maybe rightly so) about driver complaints. Lyft’s Co-CEOs wanted to make a point about the company being much more driver-friendly – in the earnings call, they specifically claimed that drivers prefer Lyft over Uber. Of course, both companies MUST attract enough drivers to ensure a good experience for riders. If users have to wait a long time to get a ride because of a shortage of drivers in the area, business will be tough.

Financially, one of the biggest differences between the two is Debt. Lyft has none. Uber has some. Debt is not a real problem with Uber now, but I wonder if it’s a sign of things to come. With all their growth plans into Food Delivery, Freight Logistics and Robotaxis, I wonder whether management will allow debt to shoot up in the coming years just to fund those ambitious plans. Uber’s CEO Dara Khusrowshahi admitted that Uber Eats still needs significant capital to incentivize restaurants, drivers and users – just to grow the ecosystem. In this regard, maybe Lyft’s strategy of remaining focused on transportation is a more prudent approach. Partnerships eat up less capital compared to launching a service in a whole new industry that has its own nuances and problems.

Otherwise, the numbers for these two companies look like any tech company in the early stages of growth: high revenue growth and massive losses. Investing in these types of companies is not about cash flow right now, but about the promise of future cash flow that’s sustainable.

The rest of this article is more numerical in nature – an exercise in visualizing a plausible path, if there is one, to sustainable cash flow.

OK. Let’s talk numbers!

Revenue growth is fantastic.

You can see below why they IPO’d. Sure, it was because the markets were on a bull-run during the first quarter, so the timing was good. But the bigger reason was to cash in on this terrific revenue growth story, possibly before a decrease in growth. Even professional analysts tend to extrapolate current trends into eternity. Taking advantage of that is only fair. Extrapolating these trends would explain current Uber/Lyft valuations:

Investor euphoria is also fueled by the fact that they really like the products. There is no doubt that the apps are amazing. Two or three clicks and a car shows up on your doorstep in a few minutes? That is magic! Personally, Uber takes a lot of stress out of my trips abroad – just to know that I can Uber it anywhere in many places around the world. No reason to get taken for a ride (literally and figuratively) by a local cabbie.  

But as amazing as the apps are, they’ve become commoditized by now. That seems unfair, if you ask me. But it’s the reality. For example, I don’t really care whether I use Uber or Lyft if I’m in the US. Do you? I find myself using Uber more than Lyft just when I travel abroad but that’s because Lyft hasn’t expanded its international business. And for me, it’s also muscle-memory to click on that familiar app (this might be Lyft’s uphill battle as a later entrant to the party) to summon a car in a different city or country. But I’m sure there are people who prefer to use Lyft in the US, Ola in India, or Didi in China with the same type of muscle memory.

So far, it seems like there is enough room for both companies to carve out their respective fan-bases. They’re both growing amazingly fast. Their competitive advantage may be Brand or Muscle-Memory. I don’t know. Maybe, competitive advantage isn’t that important at this stage in the game. Maybe, the ride-sharing tailwind is enough for a few more years. This discussion of competitive advantage and its durability is best left for a full-fledged investment thesis in customary Buylyst style. For now, let’s stick to the numbers.

I thought it would be useful to break down Uber and Lyft’s revenue numbers into 2 relevant price and volume variables:

1. Average monthly users
2. Revenue per user

Here’s how these variables have progressed since 2017. Lyft gave us quarterly data. Uber’s is annual.

I like any sort of (Price X Volume) expression. When I break it down, it helps me “project” future revenue. I put “project” in quotes because it’s a bit of a misnomer. The point of projections at The Buylyst is to quantify what is believable and what is not. That’s the whole point of this article.

I’ll do projections in a section below, but let’s acknowledge right away the main investor concern about Uber and Lyft: Will almost-inevitable price declines undercut ridership increases? There must be a floor to price declines, but how low can they go? Obviously, costs play a role in answering that question. While revenue growth has been stupendous, the picture doesn’t look as pretty as we go down the income statement.

Costs have skyrocketed as well.

You could argue that costs don’t matter at this stage. Everyone remembers the Amazon story – scale up at tremendous speed and eventually, at some revenue threshold, marginal revenue will outpace marginal costs. And then profitability will follow, even if it takes a decade. It rhymes with that old joke on Wall Street, “I have negative margins, but I’ll make it up on volume…”. That joke may become a workable scenario if most of the costs are fixed. And in any of these “scale will take care of everything” stories, the obvious question is: Are most of the costs fixed or variable? High fixed-costs businesses can “make it up on volume”. High variable-cost businesses will be the butt of that old joke.

Let’s breakdown Uber and Lyft’s costs into its reported segments:

How much of this is fixed? They don’t tell us. But I’ll use some common-sense and make the following assumptions:

1. Assumed that ALL these costs can be classified as Fixed: 
   1. Sales & Marketing
   2. Research & Development
   3. General Administrative
2. Everything else – Cost of Goods Sold, Operations & Support, and Depreciation is Variable Cost.

So, if we re-allocate cost items into Fixed and Variable, this is how the chart above will look:

This classification helps us put some tangible numbers around the question: Can Uber/Lyft make it up on volume? We’ll need to “project” based on this data – we’ll get to that in a minute. But first, let’s keep going down the income statement and reconcile it with cash flow – the most important metric of them all.

And they bleed Cash.

Annoyingly, profitability has many definitions. But in this case, once you go below the “Cost of Goods Sold” line, both companies show losses based on any definition of profitability. Now, if you’ve been a longtime reader of The Buylyst, you’ll know that we prefer Free Cash Flow to Profit. That’s because many definitions of profit (like Earnings or Net Income) have many non-cash costs included in them. Non-cash costs tend to be accounting assumptions made by management. Many of them are arbitrary because they follow standard accounting practices that have little to do with the particular nature of their business. We prefer cash because, well, cash is cash is cash. There is no ambiguity.

Many analysts start with the most basic (albeit flawed) measure of cash flow: EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). Some analysts even end with it. Here’s why the measure is flawed:

“References to EBITDA make us shudder; does management think the tooth fairy pays for capital expenditures?” – Warren Buffett

If you’ve checked out any of our Valuation Details pages for any of our stock theses, you’ll know that we start deducting other CASH costs from EBITDA, with the intention of distilling it all down to Free Cash Flow. From EBITDA, we deduct Maintenance Capital Expenditure, Cash Paid for Interest on Debt, and Cash Taxes. Let’s start cutting.

This is weird because Free Cash Flow seems to be better than EBITDA. That’s because of Working Capital swings that have benefited both companies. I explain it briefly in the next section. But look at it any which way, they’re bleeding cash. But will they always bleed cash? That’s the million-dollar question; no, the billion-dollar question.

What do I need to believe?

This is the crux of this worldview article. As an Intelligent Investor, what do I need to believe to even consider investing in Uber or Lyft? Asked another way, is there a plausible pathway to some Free Cash Flow generation?

To answer these questions, I made some foundational assumptions. This may look a little complicated. But the gist is this: I’m starting at 2019 Q1 levels for Price and Volume, and then I’m stress-testing price while assuming rosy scenarios for volume.

1. Revenue assumptions are:
   1. Prices – average spend per user (ASU) – decreases because of competition.
   2. Assumed starting ASU at 2019 Q1 levels for both companies.
   3. Volume – number of active users (MAU) – increases as ride-sharing proliferates and replaces traditional car ownership among younger, increasingly urban generations.
   4. Assumed starting MAU at 2019 Q1 levels for both companies.
2. The cost structure is: 
   1. Fixed Costs: For Uber, $8 billion (compared to $6.7 billion in 2018). For Lyft, $2 billion compared to $1.5 billion in 2018.
   2. Variable Costs: Assumed Variable Cost at the same margin as 2018.
3. EBIT (Earnings before Interest and Taxes) equals Free Cash Flow because: 
   1. Expect Maintenance Capital Expenditure to roughly equal Depreciation.
   2. Expect decreases in Working Capital to offset increases in Cash Interest charges + Cash paid for Taxes.

On the Working Capital issue, most of the cash inflows in 2016, 2017 and 2018 have occurred due to a “release” of insurance reserves. This is a boring detail to ponder over for the purposes of this article. It’s good enough to assume, for now, that these working capital “in-swings” will continue but not to the extent that they’ve benefited these companies so far. Until now, changes in working capital have overshadowed cash interest plus cash tax charges. We’ll assume that they offset each other over the long-term.

OK – let’s play. Let’s do some scenario analysis. In each of the matrices below, the left axis is the “Price Axis”. As mentioned earlier, I expect user-spend to decrease. The top axis is the “Volume Axis” – which shows increments in each company’s user-base. Based on the assumptions listed above, I’ve painted some bold scenarios just to see what it would take for these companies to generate some serious cash flow. Are these plausible?

OK – all that looks complicated. But let me distill it down for you. It seems to me that – given current valuation – I’d have to believe that Uber’s user-base will grow 5 times where it is today, and Lyft’s user base will grow about 4 times where it is today. 

How can I make the statement above? Sorry, I made some more (presumably reasonable) assumptions:

1. Let’s say prices go down 10-12%. So, that would mean I’d zoom in to the middle ASU line in the table above.
2. Let’s say the market will attach a 15X to 30X multiple to both companies. That’s a wide range, I know, but valuation isn’t an exact science. If you recall, at The Buylyst, we usually attach a 20X multiple to Sustainable Free Cash Flow of companies we find “comfortable”.
3. This is not an assumption: Uber is trading at a Market Cap of roughly $70 billion. Lyft is trading at a Market Cap of roughly $18 billion.

I was surprised to see higher ASU for Lyft compared to that of Uber. I don’t have a nuanced explanation for this at this stage other than the fact the Uber’s numbers have Uber Eats included in them – that probably lowers the ASU. Just this fact makes Lyft the more “reasonable” choice. That’s assuming that Lyft’s ASU won’t converge to Uber’s over time. However, as things stand now,  here are the valuation ranges for our (now distilled) scenario: Prices down by roughly 10%, Volume up by 4X for Lyft, and 5X for Uber:

Here’s the FINAL TAKEAWAY: I’d have to assume at least a 300% growth in Active Users to be able to convince myself to buy either of these stocks. 

The Upshot is hard to quantify.

I’ll end this exercise with a short statement about what I have NOT factored in:

1. Success in Autonomous Vehicles and Robotaxis
2. Success in deals with cities, companies and other enterprises.
3. Assumptions about Uber Freight.
4. Any types of subscription models.

Mr. Market may well have factored in these assumptions. But assuming any numbers for these upshot scenarios is pure speculation. There is no precedent. There is no data to go by. At best, the way to think about Uber and Lyft is this:

If 300% growth in volume is something I can believe, then all these upshot revenue streams can be considered gravy. The big caveat is: how much do these upshots cost? Nobody knows. But with these unicorns coming out of the enchanted forest, does anybody in the market care about costs?