Brett Caughran

@FundamentEdge

29 Tweets • 2023-02-04 •  See on Twitter

rattibha.com 

UNIT ECONOMICS

"Unit economics" is an important tool in the tool box

for the buy-side analyst that, surprisingly, is not
discussed often by the sell-side outside of businesses
that explicitly report enough data to calculate LTV (life-
time value) and

CAC (customer acquisition cost), two important, but

incomplete metrics in understanding the totality of unit
level profitability.

Honestly, when I joined a hedge fund and heard other

analysts talking about unit economics, I was lost. I hit
the google machine and looked through
my finance textbooks, but came up empty. I eventually
had to ask a senior analyst, sheepishly, to walk me
through the concept. So I'll do my best to pay that
kindness forward here.

WHAT ARE UNIT ECONOMICS

"Unit economics" is a concept that looks at the key

fundamental metrics

of a business expressed on a per unit level.

Specifically, we are looking at unit level operating
profitability and FCF generation.

The mindset: if a business works on a unit level, it can

scale and create a strong aggregate profit.

If it doesn't ("broken unit economics"),

scaling those unit economics is unwise. Seems silly to
say that, right? You'd be SHOCKED how many large,
scaled businesses, in their current state, have unit
economics that look like the proverbial "selling dollar
bills for 80c".

Particularly in the "blitzscaling" VC-backed,

fed-induced liquidity bubble of the last decade, this

has become incredibly common. The playbook for
many businesses: get to volume scale and squeeze
out the competition with subsidized (i.e. weak) unit
economics, then hope to improve that unit level
profitability in the future.
Some will, many won't.

Do you know that, on an aggregate level, Uber loses

60c on every ride?

Do you know that NFLX, despite massive scale, only

makes 11c per member per month?

And that TSLA was losing money on every car as

recently as 2019?

The challenge. Stocks are priced on collective future

expectations of decades of FCFs. In buying some of
these stocks, whether you know it or now, you are
making a bet on the future trajectory of unit
economics.
So as an analyst, understanding the current strength
of unit economics, and critically which levers can be
pulled to influence the forward trajectory, is very
important.

Let me walk you through a hypothetical.

If I am looking at a Pizza shop, I will first look at the

cost
breakdown of the business. What are the key line
items on the P&L? I like to then express revenue and
the cost items on a per unit basis. My first check -
what is aggregate unit level profitability in current
state? Is this a "unit economics improvement story" or
are we just
maintaining and scaling strong unit economics that are
currently present in the P&L. This distinction is
important.

I will then try to think through, if I sell one incremental

unit, what happens? For a pizza, I have the $4.50
food/packaging cost, but the other costs are either
fixed or semi-fixed in direct relation to volume, with
with 70% GM and 70% "incremental margin) I have
strong unit level economics here of $10.50 GP per
pizza.

If the business is already doing strong levels of

profitability in aggregate and on a per unit basis, your
job in

analyzing unit economics is easy (and you may move

on to using other analyst tools to diligence the stock).

But it's not always so straight forward.

A pizza biz may have strong underlying unit

economics, but simply be early in the life cycle of the
business and not at volume
breakeven. This requires more teasing out of
underlying unit economics and determining what % of
the opex base can be leveraged as volumes grow. A
trickier proposition, for sure (with a higher risk
profile...but the bet that unit economics are good/will
improve when the market
is skeptical can be explosive for stock prices...see
TSLA in a moment).

The risk here is that our pizza shop in question raised

a huge VC round and VC's want revenue growth! (I
like to pick on VC's. It's fun, and pretty easy). So let's
grow! I'll sell my pizzas for $5
with $5 food COGS and this is such an excellent value
proposition that customers will love it!

This is why you could get $15 Ubers and

$1,000/month WeWork offices over the last decade.
These are the equivalent of $5 pizzas.

But this is an incredibly risky bet. You are betting

as the business that you can hook your customer then

normalize pricing or reduce sales & marketing.

Directionally, businesses are able to do this.

Mastercard in 2006 spent $1bn on marketing with 19%
margins. By 2021 then spent only $900m, despite
revenues up 5x. Margins (and the
stock) soared! The majority of businesses will invest in
the early stages of their life cycle in attempt to
normalize profitability at scale. This is natural. But
many companies have done this to an extreme.
UNIT ECONOMICS & UBER

Uber has many characteristics of an interesting stock:

huge TAM, fast growing revenue, transformational
product with a great value proposition.

But the business has been a cash incinerator and the

stock has been a dog. Why?
Let's analyze to unit economics to see. I will go to the
10-K and pull all of the aggregate metrics into a table
to look at aggregate unit level fundamentals.

What is see is not pretty. Despite gross bookings of

$14.20 per trip, Uber keeps only $2.74 (19% take
rate), makes $1.27 of GP/trip and loses 60c on every
trip, in aggregate.
Should I stop there and chalk this up to Uber having a
"broken" business model with broken unit economics.
Not necessarily, as the company is working hard to
improve these economics.
Ultimately, what will matter is not where the business
has been, but where it is going. At this stage, I like to
think through ever line item and see what a possible
future looks like.

Can Uber go from losing 60c to making 45c ever ride?

Growing rides, Uber would be making
$5bn of OP in that instance (and be an interesting
stock). Is this possible with the competitive intensity
from LYFT? Who knows. But for me, as the analyst
(who candidly knows extremely little about Uber), this
exercise is very important in framing the key research
questions for
Uber. For the stock to work, some combo of take rate
improvement and sales & marketing reduction is key.
If the business can't achieve this, the unit economics
will not scale.

CONT'D

CURRENT STATE, FUTURE STATE

In analyzing unit economics, it's important to

remember that the "future state" is what matters.
Often, but not always, the current fundamentals of the
business are reflected in the stock price (this isn't
1960 and we aren't Warren Buffett reading a
10-K, seeing some key metrics, and buying the
stock...the game has changed).

What ultimately matters is a combination of a vision for

the future and asymmetry in the odds embedded in
the current price.

$TSLA, in 2019, had really bad unit economics! They

were making, on a GP
basis, $12k per car and spending $12k per car. And
Elon decided to cut the price via mix! Risky!

Guess what. It worked. COGS declined 25%+ per car

and GP per car expanded from $12k to $16k.
Operating Margins expanded.

This isn't a call on TSLA, and where TSLA goes in the

future on a fundamental basis was deterministic to the
stock. But TSLA, very simply, was a unit economics
improvement story. They hit it, and the stock worked.

HOPE THAT'S HELPFUL!

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