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Does Uber Benefit from Network Effects? Part II

27052019_uber

Does Uber Benefit from Network Effects? Part II

In a previous post I discussed what network effects are, and subsequently posed the question to readers as to whether Uber (NYSE: UBER) benefited from network effects and followed Metcalfe’s law. The answer may surprise you.

While it’s easy to surmise that Uber is a platform business and thus benefits from network effects, this thinking is specious. The truth is that (i) network effects are dynamic, and may change in nature over time; and (ii) not all network effects are created equally. With this said, Uber at a point greatly benefited from network effects –which by definition is the value of its network increasing as more users were added –but this value curve has since become asymptotic, reaching a plateau.

Let’s consider Uber when the platform was in its infancy. As more drivers were added to Uber’s network this led to greater coverage and reduced wait times for users, which led to more users joining and incentivised more drivers to join. In other words, driver supply reinforced user supply, and vice versa. By adding more drivers to the platform, Uber could reduce wait times from say 20 minutes to sub-five minutes.

While this is a genuine network effect, it is not one that can continue unrestrained. At a certain point the wait times are short enough such that any additional drivers joining the platform add minimal incremental value to existing Uber users. Uber’s scale after a point has rapidly diminishing marginal returns, and highlights the point that the nature of network effects typically changes over time as the platform develops.

Screen Shot 2019-05-23 at 3.11.45 pm

Source: Andreesen Horowitz

One of the difficulties for Uber is that its supply (i.e., drivers) is commoditised. This, combined with the low switching costs for users to defect to competing ride-hailing platforms that have also reached sufficient levels of platform liquidity (i.e., can replicate Uber’s sub-five-minute wait times), has important implications for the economics of the business, in particular Uber’s long-run earnings power. If you were to remove any branding from the vehicle, could you really tell the difference between an Uber vehicle, and one from Lyft? The issue is that once multiple ride-hailing platforms reach an adequate level of liquidity it becomes more difficult to retain users, and the specific platform becomes less important to users.

Compare this to a platform business such as Facebook (Nasdaq: FB) that has highly differentiated supply (its users supply unique content that is extremely difficult/impossible for other platforms to replicate). It is worth remembering that not all network effects are created equally, and investors should be cautioned to not blindly equate the presence of network effects with long-run business defensibility.

The Montgomery Global Fund and Montaka own shares in Facebook. This article was prepared 23 May with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Facebook you should seek financial advice.

It’s easy to surmise that Uber is a platform business and thus benefits from network effects, although is this really the case? Click To Tweet
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George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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