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Lyft: It Keeps Getting Worse

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About: Lyft, Inc. (LYFT), Includes: DOORD, UBER
by: Stone Fox Capital
Summary

California continues to move forward on AB 5 that will turn contractors into employees.

Lyft already has a slim profit margin.

Avoid the stock until the company formulates a business model around generating solid operating margins.

My previous work already focused on the lack of a margin of safety in Lyft (LYFT) and the news continues to get worse. The company faces legislative issues pressuring the gig work concept while the business growth is apparently decelerating at a very fast clip. The stock doesn't appear to have reached a low yet.

California Problem

The biggest problem with the ride-sharing model is that the main companies have yet to solve the probability picture. Neither Lyft or Uber (UBER) have figured out how to make money on a model that improves the transportation of consumers around the globe.

Image source: Lyft website

The ride-sharing model requires heavy technology and sales/marketing spending to attract riders and drivers. The better transportation service offered by these companies are still capped on pricing due to traditional transportation models such as public transportation, taxis and car ownership.

While Lyft has all of these problems turning a good concept into a great business model, the California State Assembly recently passed AB 5, essentially moving ride-sharing drivers from contract workers to employees.

The law establishes three criteria for employers to use to identify a worker as an independent contractor:

  • Must be free from the employer’s “control and direction” in carrying out duties.
  • Must perform a job outside the employer’s usual line of work.
  • Must regularly do the same type of work as will be done for the employer.

The biggest test that Uber and Lyft drivers fail is the second test of performing a job out the employer's usual line of work. The other two tests probably have some leeway for argument.

Uber was clear on how the changes would impact the business and drivers via a recent blog post on Medium. The company suggests fewer drivers and more control over employees including a substantial reduction in work flexibility.

We would likely have to exert more control over drivers, telling them where to work, how to work, and who they can work for. Uber would likely hire far fewer drivers than we currently support, and we’d likely have to require a minimum number of hours per week. Scheduling and rigid shifts would become the norm, and Uber would likely prevent drivers from working for other rideshare companies.

The company has a proposal to provide gig workers with a minimum income, access to benefits and bargaining power. The guaranteed income of $21 per hour when in the process of transporting riders sounds expensive, but the details might suggest that drivers regularly spend considerable amounts of time idle.

Either way, costs in California are going to rise and the quality of service will likely decline. Lyft has to provide a framework where costs are declining, service is improving or fares are rising in order to justify any investment in the stock with the company already upside down on profits.

Lyft, Uber and Doordash (DOORD) wouldn't have paid $90 million to fight AB 5 if this wasn't the case. The California Department of Labor believes that worker misclassification has cost the state $7 billion in payroll taxes so one has to believe the new rules get passed into law. California's Governor might be open to discussions, but either way the costs to operate in the state and others are likely to rise starting Jan. 1.

Impacts

On top of the gig worker issue, Lyft faces a potential slowdown in revenue growth. Analyst Andy Hargreaves of KeyBanc has ride-share spending growing just 29% quarter to date.

Investors need to consider that analysts have revenues growing over 55% this quarter and over 40% in Q4. The growth rates are set to decelerate at a fast clip heading into 2020 with Lyft only growing revenues around 25% by Q2/Q3 next year.

The system just isn't built for higher costs when only about 30% of bookings reaches the revenues bucket due to substantial driver costs. On top of that, the contribution margin for actual revenue is only 46%.

The end result is that somewhere below $1.50 of every $10.00 booked on the Lyft platform is what most generally view as gross profit. Instead of a software company having 85% margins, the ride-sharing companies have generated low margin businesses with still high costs.

AB 5 has the potential to substantially erase all of this profit margin. Under a business model where drivers become employees, bookings would theoretically become revenues with the cost of drivers shifted into the cost of revenues. One has consider that the current $7 cost for each $10 of bookings (future revenues) would easily rise by 10%-20% whereas a 20% increase in costs would equate to $1.40 in additional costs. BBC News reports estimates for costs increases of 30%. The existing contribution of $1.50 is completely wiped up in this cost equation.

In addition, Lyft already spends 72% of revenues on operating expenses. A company can't just break even on rides with this large expense buckets.

Source: Lyft Q2'19 presentation

Takeaway

The key investor takeaway is that investors are quickly running into the problems of being invested in a business with no margin of safety. Under any scenario where a legal decision goes against the business model of Lyft, the company is further in the hole.

Avoid the stock on the quick blip higher as California is only the first state and easily not the last to attack an already weak business model.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.