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Uber’s Real Challenge: Leveraging the Network Effect

Uber’s Real Challenge: Leveraging the Network Effect

JUNE 13, 2014

Neil Irwin

Most of the headlines about Uber, the rapidly growing transportation service, involve its battles to do business in more cities around the world. Not surprisingly, cabdrivers who have enjoyed being part of tightly regulated cartels in cities like Madrid, Miami, London and Los Angeles do not much care for the San Francisco-based upstart that brings them new competition.

But whether Uber will ultimately become the kind of wildly profitable company that will justify the valuation of $18.2 billion reportedly assigned to it by its latest funding round doesn’t come down to those regulatory battles. If the recent past is a guide, it will eventually win them.

The question for Uber as a business boils down to two words: network effects. That’s the concept in which users of a service benefit from the fact that everybody else uses the service as well. It isn’t much use being the only person to own a fax machine, or the only person to show up at a stock exchange. Things like these become more valuable the more widely they are embraced. Network effects are the key to the wild profitability of a firm like Microsoft; Windows and Office are hard to displace, even if a competitor offers a better, cheaper product, because Microsoft products are entrenched as an industry standard.

And when one company controls a market with strong network effects, it can be one of the few sustainable ways to generate huge profits, holding on to customers and fending off competitors. The billion-dollar question is whether Uber’s model for offering transportation services has some of the same network effects as those of great information industry monopolies (Microsoft, Google), or is more like, say, the travel website business, a brutally competitive industry of middlemen.

Uber is itself a middleman, of course. On one side, it recruits drivers, who typically own or lease their cars. On the other side, it markets to consumers who may want a ride. Then it matches them up; the consumer orders a car, a driver accepts the request, the service is provided, and Uber charges the consumer’s credit card. It keeps a 20 percent commission for itself and pays the rest to the driver.

So where in that exchange are network effects? You can see in some ways how it’s like a stock exchange. Every driver wants to be part of the network with the most consumers, so that they spend more time driving and less time waiting for a call. Every consumer wants to use the service with the most drivers, to minimize the wait time when they need a ride. Uber, because it is first and biggest, will have both more users and better data with which to match up supply and demand.

The bullish case for Uber, then, is that it rapidly becomes entrenched as the biggest, most vibrant marketplace for both buyers and sellers of ride services. Competitors may arise, offering lower commissions and better software, but the fact that everybody already uses Uber will make it impossible for them to get a toehold.

But here’s the negative case: That 20 percent commission is a big, honking target for competitors. So after Uber has done the heavy lifting of hiring lobbyists and fighting the taxi regulators in capitals around the world, acclimating drivers and consumers alike to ride-sharing services and attaining that $18 billion valuation, it will have an enormous bull’s-eye on its back.

Competitors could take a smaller commission, and use the savings to offer higher rates to drivers and/or lower prices for consumers. Uber would face the choice of matching the lower commissions (cutting into its profitability) or risk losing drivers and consumers to more favorable prices offered by others.

You can imagine situations in which both consumers and drivers stick not with Uber but with whichever service offers the best deal at any given moment. Rather than automatically ordering a car through Uber, a person looking for a ride might check several competing services to see which has the closest car at the best price at that moment. Drivers might sign up with multiple services, and take rides that will offer them the highest pay at any given time. Aggregation services like Kayak might even spring up, allowing riders to instantly compare the prices and wait times on offer.

Note that this question assumes that the basic Uber business model will prevail: that car-sharing services, ordered from phones and charged automatically, will become more and more common around the world, overcoming resistance by local authorities and the taxi industry, and expanding the aggregate taxi market.

The task facing Uber is not just to overcome the hurdles and make ride-sharing a multibillion dollar industry. It’s to try to entrench the advantages it has from being first: continually refining its offerings to have the best possible user experience, the best data analytics to ensure that people can get a car when they need one, and not to be greedy with regard to its commission, lest it be all the more inviting a target for rivals. It’s no easy job, but nobody said building a company worth $18 billion is.

The Upshot provides news, analysis and graphics about politics, policy and everyday life. Follow us on Facebook and Twitter.

 

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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