July 24, 2024

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Hedge Funds Are Buying Uber Despite Headwinds

Since its IPO in May of 2019, Uber Technologies Inc. (NYSE:UBER) shares have remained volatile. There were many reasons behind this, including the regulatory pressure for ridesharing companies, the massive losses the company reported since going public and the criticism attracted by burning billions of dollars to enter new markets.

When it comes to investing, however, it’s important to focus on the big picture and not short-term fluctuations of equity prices. In an article published in September, I assigned a buy rating for Uber after closely evaluating the prospects of the company. Since then, the stock has gained 22.5%, but there seems to be no reason for growth investors to liquidate their positions and book the profits just yet. The long-term industry trends are positive and supportive of the company’s growth, and hedge funds seem to be taking notice. Uber was one of the top buys of hedge funds during the fourth quarter of 2019.

Source: Bloomberg

Tiger Capital, led by Chase Coleman (Trades, Portfolio), tripled its stake in Uber, making it the eighth largest U.S. holding of the fund. The numbers indicate that it’s still a good time to get onboard the leader of the global ridesharing industry.

The economic moat of Uber

For a company to generate sustainable earnings, at least for a few decades, strong competitive advantages are required. As stated in many of his annual letters to shareholders, this is one characteristic Warren Buffett (Trades, Portfolio) seeks for in evaluating potential investments in equity securities of a company. Uber, not surprisingly, has plenty of that.

There are many moat sources for the company. The network effect of its platform stands out as the most prominent one of these. As the first mover of the industry it operates in, Uber was quick to gain traction on a global scale. According to data from company filings, Uber currently has 3 million drivers and 75 million riders globally. In comparison, Lyft has just 1.4 million drivers and 23 million users. As behavioral finance theories suggest, the sheer size of the network makes Uber the go-to choice of new customers, which only makes the platform even bigger.

Facebook (NASDAQ:FB) is a classic example of a company that thrived and built a massive economic moat through the network effect. Even though many social media platforms were launched over the last decade, none could be as successful as Facebook because the platform had already emerged as the place to be on the internet. It’s a stretch to conclude that Uber will be as successful as the social media giant, but its competitors are already finding it difficult to gain market share.

The industry dynamics in the United States are a good proxy to evaluate Uber’s prospects internationally. Lyft, which is Uber’s main rival, came into the spotlight in 2017, but it has yet to eat into Uber’s market share meaningfully.

Source: Statista

As evident, the company has been able to retain its share of the U.S. ridesharing market even though its peers were aggressively promoting their services.

The brand value and the global presence of the company are two other sources of competitive advantages. At the end of 2019, Uber operated in more than 700 cities across the globe. To pose a threat to Uber’s prospects, a competitor would have to invest billions of dollars to build the necessary infrastructure and the platforms to scale up to such a level, which doesn’t seem to be happening anytime in the next few years.

The profit margin problem

One thing many Uber bears cite is that the operating margins are still in the red, even after a decade of business operations. This needs close attention as a significant expansion in margins is required for the company to become profitable in the future.

The management, as confirmed in the fourth-quarter earnings call, has implemented several initiatives to improve the margins. First, there’s a focus on reducing the overall costs of business operations. Second, the company is divesting unprofitable business operations in a bid to improve its profitability. For example, Uber sold its food delivery business in India to Zomato and exited the Chinese ridesharing market.

So far, Uber has been successful in improving its Ebitda margins with all these measures. This is a step forward in its plan to generate a profit by the end of 2021.

Source: Company presentation

Diving deeper into the financial results, it becomes evident that the rides segment is already reporting positive margins. Over the long term, the company expects to improve the Ebitda margin to 45%.

Source: Company presentation

A closer look at these numbers reveals that Uber is on track to transform from a loss-making company to a profitable one in the future. This could be why hedge funds are loading up the stock to get an early advantage before retail investors identify this massive opportunity.

A business model that works

Over the last decade or so, Uber spent time, energy and money on building a ridesharing platform that will disrupt global markets. As the world is now aware, the company did just that. Uber is now the leader of many markets it is operating in. When the company unveiled its business plan in 2009, becoming the leader of the industry was listed as the top priority – not bringing in profits.

Source: Company presentation

In the last couple of years, the company management focused on getting the numbers right as well, and as discussed in the previous segment, there has been massive progress from that front as well. This strategy is similar to that of Facebook. When the social media giant first emerged, the focus was to become a household name and not a word was said about profitability. As the company gained traction and the number of users crossed a few hundred million, it was easy for Facebook to generate profits as the clear leader of the industry. Many analysts and investors doubted the company would ever make a profit, but today, they are bringing in billions of dollars in earnings. This is what Uber is doing as well, and there are already early signs of success. With the exponential growth expected in the global ride-hailing market, a few companies will emerge as clear winners. Uber, most likely, will be one of those companies due to its economic moat and the first-mover advantages.

Takeaway: still a good investment but not for the faint-hearted

Investors have a wide variety of objectives, profiles and time horizons. Therefore, an investment suitable for one would not be so for another. Uber is certainly not for value investors. The company has yet to report positive earnings, and there’s a significant amount of risk involved in this idea.

There are also rewards, however. Growth investors should consider embracing this opportunity and allocating a portion of a well-diversified portfolio to this unicorn, which could deliver stellar returns in the long term. The share price will likely remain volatile in the future as the company navigates regulatory scrutiny and competition from rivals. However, the future looks bright, which tilts the odds in favor of investors.

Disclosure: I own shares of Uber.

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This article first appeared on GuruFocus.

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