From Knowledge@Wharton:
As global ride-hailing startup Uber heads toward a possible IPO this year, Wall Street’s eyes will be on its financials. Revenues have continued to grow quickly for the eight-year-old Silicon Valley company, but the bottom line isn’t pretty: Uber was on track to lose about $3 billion in 2016 on net revenue of $5.5 billion, according to Bloomberg News. That’s remarkable for a startup that has raised more than $11 billion with scant capital costs — it does not own a global fleet of cars or much of other hard assets. Uber itself is valued at more than $60 billion.
Can Uber slow its rate of cash burn before losses start to threaten the company’s viability? On the surface, stemming the red ink doesn’t sound so hard. Since it does not own vehicles or employ drivers, the company saves a fortune in capital and workforce costs. But Wharton experts point to other substantial costs: In helping to create an innovative new market — the sharing economy — Uber spent a fortune training, recruiting and subsidizing drivers, giving away free rides so consumers would get hooked on the service, setting up a global system of local and regional offices as well as hiring lawyers to deal with lawsuits and regulators.
“I think Uber thought, ‘We have this platform — this app, this technology — that can be leveraged anywhere in the world, so let’s just go and conquer the world,’” says Wharton management professor Exequiel Hernandez, who wrote two case studies on Uber for his classes, based on interviews with executives. “What Uber underestimated were the costs that didn’t have to do with their technology and their business model, costs that have to do with the politics of being legitimate, [addressing] regulatory resistance and even cultural differences across markets.”
The idea for Uber came to co-founders Travis Kalanick and Garrett Camp one snowy evening in Paris when they could not get a cab. Camp’s first idea was to start a “limo timeshare service” where riders booked cars on-demand through a smartphone app to fill the down time of livery car services. Later, Uber expanded its options to add lower-price rides such as UberX, UberXL, UberSELECT; new premium services UberBLACK UberSUV and UberLUX; and carpooling rides with UberPOOL. Uber now operates in more than 500 cities and 70 countries.
Uber’s innovation did not stop there. It applied the concept of “surge pricing” to its service — prices would go up when demand for cars in an area outstripped supply. The idea was that higher prices would prompt more drivers to come out until demand and supply reach equilibrium. Hernandez says Uber developed a dashboard that provided real-time supply-and-demand data in a city that helped managers see the high traffic areas they could send drivers to and adjust prices accordingly. Rides were booked by passengers using stored debit, credit or prepaid cards so they did not need to have cash on hand as they do in taxis. Further, a bilateral ratings system rated both drivers and riders.
While the practice of surge pricing isn’t new — airlines have been using it for years — it was new to car services. Uber got riders to accept the practice. “People got used to it” as long as the cost was transparent, open and fair, says Senthil Veeraraghavan, Wharton professor of operations, information and decisions. For example, riders wouldn’t flinch about paying $7 during busy times for a ride that normally costs $4. While there was an outcry initially when some New Year’s Eve revelers were hit with short rides costing hundreds of dollars, people have learned to plan for it. Uber has come out with tips to avoid such surprises. “Uber tells people demand will be high so plan around it,” he says.
Wharton marketing professor Ron Berman notes that Uber operates in a classic “two-sided market” where Uber is the “market maker” between the driver and rider by providing a platform for them to connect. As such, he adds, there is a “strong network effect” taking place. “The more drivers there are on the road, the less time riders wait and the better service they get. [That brings in more riders, and] more drivers want to join Uber, since they know they will have high demand and less idle time.”
Bull and Bear Case
For this model to work, Uber needed to reach critical mass. The company’s pursuit of growth is largely the reason behind its rapid cash burn. Berman says that for companies to reach critical mass under these circumstances, they need to subsidize both sides of the market — pay them to join the system. He notes that the costs for Uber are high: “They are losing about $3 for each $1 they make.” However, getting to critical mass also typically results in a “winner-take-all effect,” which is what happened with Google in search and Facebook in social networks, he adds. “In this case, Uber’s strategy to try and grow as fast as possible at the expense of making a profit makes a lot of sense.”...MUCH MORE
