Pando

The truth about Uber in China

By Sarah Lacy , written on August 31, 2015

From The Travis Shrugged Desk

I’ve spent a good part of my summer digging into Uber’s business in China.

There’s no more important story for Uber right now: China will absolutely be the largest ride sharing market in the world, with high smartphone penetration, low car ownership, six mega-cities with greater than ten million people and 160 cities with a population of more than 1 million people.

While in China this past June raising capital, Uber CEO Travis Kalanick said Uber was doing 1 million rides a day there, and that China could easily eclipse the US as Uber’s largest market by the end of the year.

The fact that Uber is doing so “well” in China despite having only 11% of the market shows why the combative CEO has no choice but to win there… or at least carve out a respectable market share. Everything he’s achieved in the US is peanuts compared to China’s potential. And Kalanick has never considered himself a man who deals in peanuts.

But that single vanity number of daily rides has come at an unsustainably high cost. Uber has told investors it will spend more than $1 billion this year in China, mostly in runaway subsidies trying to buy market share. Some Chinese press and analysts have reported that that $1 billion won’t even last the year if Uber maintains current subsidies it’s been paying. And that’s before you consider that Uber plans to expand from 16 to 100 cities in China by next year.

Uber has raised a lot of money by Silicon Valley standards-- $7 billion to date. But even Uber can’t continue to subsidize this level of losses. Enter the subsidiary Uber China, which needs money fast if this house of cards is going to stay up.

In the last week, Uber China appears to have closed a $1.4 billion round of fundraising which is a wild “oversubscribed” success if you read Business Insider… and a tough sell that Chinese institutions mostly passed on if you read Bloomberg or the Financial Times. Late last week, it became clear why a round that had dragged on for more than two months suddenly became “oversubscribed”: Uber itself had ponied up one-third of the round as a show of support for the “viability” of the business.

Uber has now publicly committed at least $1.5 billion to winning China-- a decent chunk of its total fundraising to date. Trying to even gain modest market share in China is the biggest single financial gamble of Uber’s life as a company so far, and it may well be Travis Kalanick’s Waterloo. Exactly one number looks fantastic when you look at it half a world away: Total rides per day. Dig underneath that and it’s an unsustainable mess with an all-but-inevitable shut down by the Chinese government looming at some point.

No scandal has made a dent in Uber’s growth in the US, and yet in China little has gone the company’s way. Just when it appeared to be driving a wedge in the market, its two biggest competitors merged into a massive goliath called Didi Kuaidi, backed by Softbank, Alibaba, and Tencent.

Thanks to that merger, Uber has found itself fighting… a company very much like itself. Didi has far deeper pockets, a massive lead with some 78% market share, a greater advantage to bend the local government in its favor, and plays just as much hardball as Uber. A month after the two merged, Uber found itself blocked on Tencent’s WeChat: An essential channel for reaching customers in China. Next might be Uber’s Chinese payment platform Alipay.

Another Didi backer? The state-owned Beijing Automotive Group. It’s just one of several partnerships we’ve heard about between the government and Didi. The Chinese government not only has a nationalistic and national security incentive to ban Uber, it appears to have a financial incentive too.

As we’ve been reporting for weeks, in China, Uber is getting Uber’d.

But that’s only the beginning. Dig deeper into the Chinese ride sharing market, and you’ll find that Uber’s problems are even bigger than the ones we’ve already reported. I’ve spent weeks trying to get to the bottom of these problems, well reported in the Chinese press and covered by a handful of US financial press with strong Chinese bureaus: Rampant fraud, even less reliable driver background checks, wildly conflicting accounts of fundraising for Uber China, Uber China’s lack of any local management or leadership, and the impact that’s having on the Uber rider experience in China.

Across a dozen interviews over the last few weeks, I’ve come up with more questions than answers. But the picture emerging is almost antithetical to the Uber we know in the US.

Say what you will about Uber US, the company is usually tactically brilliant. But in China, Uber is a house of cards that could fall at any point -- if either the private capital markets dry up or the government decides to shut it down. Sources say that senior management is concerned enough that a six-person China committee chaired by Kalanick himself meets three times a week (presumably in “the war room”) to navigate the mess.

Uber has played a risky game: Raising money at escalating valuations by showing up-and-to-the-right hockey stick growth, painting a story of all-but-certain global domination. But it’s becoming clear that Uber simply can’t win the world’s largest ridesharing market, despite already committing more than one seventh of all the funding it has ever raised to chasing it.

“[It] would be great if they could crack China, but I would be shocked if their best days are not already behind them between the regulatory and competitive environment,” said Bill Bishop, a well known investor, writer, and expat who up until a few weeks ago had lived in China for nearly twenty years. He was one of many I’ve asked in recent weeks if things on the ground looked as bad for Uber as I was hearing from other sources, some of which are connected to Uber’s local and international competition.

Bishop confirmed an even worse picture than I’d imagined. A sad repeat of how most Valley companies try (and fail) to win China:

They appear to have pulled out all the stops to pump up the numbers. Crazy subsidies. Blind eye to driver fraud. Was great for a few months, good service, really solved a problem, but something changed around late July and, by the time I left, driver and service quality had fallen off a cliff. They do fill a need but they are competing against a local monster backed by ‘baba and Tencent. Baidu is not nearly as strong a partner as they would like people to think, and the Uber China management team is not nearly as local as they would like you to think. And American-born Chinese do not count as anything like local in China.

Not-so-coincidentally, late July was when Uber was raising its latest $1 billion funding round, at a reported $50 billion valuation, and the only metric that mattered out of China was showing daily ride growth. It was a handy top line vanity number that spread like wildfire throughout US media along with the narrative that Uber was “crushing it” in China.

This is a narrative the Valley desperately wants to believe, as Asian tech giants are becoming bigger players-- and threats-- on the international technology stage. How Uber achieved this brag-worthy single metric was-- by the most charitable accounts-- by offering wildly unsustainable subsidies to grab market share. By less charitable accounts, it was on the back of as much as 40% driver fraud to which the company turned a temporary blind eye.

China is the closest Uber has ever come to an existential threat, and the only place it’s ever faced real competition.

Let’s unpack some of the deeper, conflicting, and less-reported issues Uber is facing there.

FINANCING

Uber is one of the most well-funded private companies in Valley history. But even for Uber, spending $1 billion a year to buy a market clearly isn’t sustainable. So it’s crucial that it raise even more money.

Uber has separated its Chinese business into a subsidiary called “Uber China”-- not totally uncommon for US companies looking to do business in China, but arguably also a handy way to contain this escalating mess from destroying Uber global’s balance sheet and cap table.

This summer, Uber global just raised another $1 billion in capital at even higher valuations, while Uber China seemed to be struggling to raise $1 billion necessary to keep buying its daily ride growth.

From The Financial Times:

Is investing in Uber — the ride-sharing app, which has had two of its managers arrested, drivers’ cars torched and equity valued at 125 times trailing revenues — just a little too tame? Welcome to Uber China.

That probably is not the pitch that Uber and its bankers at Goldman Sachs are employing. But the fundraising for Uber’s China subsidiary (rumoured to be $1bn, although Uber has not confirmed the size), has been going on for a longer-than-expected two months. It is not for the faint of heart.

Uber, which has a valuation of $50bn, is going all guns blazing into the world’s most populous market and it needs more ammunition. It is already spending more than $1bn a year in China in an effort to recruit drivers and customers. It has claimed early success, with a fast-growing presence in 11 cities and more than 1m trips a day — although even Uber acknowledges that some of those are fraudulent. 

Last week, wildly conflicting press reports starting coming out about this round.

As descriptions like the one above in The Financial Times started to make the two-month old unclosed round look like a shopped house still sitting on the market, a puzzling story in Reuters reported that “sources” confirmed Uber China’s $1 billion was already closed. In the opening graphs, the article cited two strong Chinese financial companies as major parts of the round: Ping An Group’s investment arm and Hillhouse Capital, which also invested in Uber global.

A whole forty-eight hours later Reuters had to update the story with a spokesperson from Ping An flat denying it was investing in Uber China and a source close to Hillhouse denying it was taking part either. Both Ping An and Hillhouse are investors in Didi, Uber’s competitor in China.

Had the Reuters reporter been following the story of this fundraising in China, they would have known that already. The exact same rumors went around in the Chinese media more than a month ago, and a Ping An spokesperson denied it then too.

There were reports of at least one other institution in Uber China’s round, Citic-CP Asset Management. But the group appeared to be peddling the investment to wealthy Chinese individuals, according to a term sheet obtained by the Financial Times and Bloomberg, rather than investing themselves. In the FT, Uber said it had not authorized selling the stock to individuals, rather it was targeting institutions. From the FT: “It will have to emerge from this with a big list of them to fuel the quest for China domination. Some have already demurred.”

Bloomberg -- which has covered the story of Uber China more consistently than nearly any other US outlet-- confirmed the FT’s account with a story about that same private placement for wealthy Chinese, only Bloomberg’s account made it sound tactical on Uber’s part, not unauthorized.

The sales pitch was bullish: Offering a 109% return for wealthy Chinese to invest in Uber China-- a “company” that planned to go public on the Hong Kong or mainland Chinese exchange in five years. To sweeten the pot, the deal would also give investors shares in Uber global. From Bloomberg:

“Dangling estimated returns of as high as 109 percent, the “Project U” offer would put at least 80 percent of the money into shares of closely held Uber before an expected initial public offering in 1 1/2 to 2 years, while the remainder would go into stakes of the company’s separate China arm, according to the document.”

There was no mention that such an offer to individuals was unauthorized. Indeed, if part of the deal was bonus shares in Uber, presumably it couldn’t have been.

Bloomberg included this caveat for investors too:

“And if Uber China doesn’t list, investors would be able to sell their shares back for cash, plus compounded interest, or convert their holdings into stakes in Uber’s global company, according to the document.”

Doesn’t exactly read like a hot deal.

Indeed, Pando spoke with at least one individual who had the opportunity to invest, and passed, even with such incentives. Why? This person’s sources in the Chinese investor market said as much as 40% of Uber’s reported rides are fraudulent, and the competitive and regulatory dynamics are just too tough for the company to succeed. Uber has said that number is much lower, around 10%. But whether true or not, it was the word on the street and enough to convince this person to pass.

And then, finally, at the end of the week we got this from Bloomberg about Uber’s “oversubscribed” round in China: News that Uber itself was investing some $300 million to $500 million “as a show of confidence in the viability of the unit.”

It’s amazing how taking one-third of a round yourself suddenly makes it oversubscribed after two months of unsuccessful fundraising.

The only other institutions the article listed were that same group doing the private placement and existing Uber investor Baidu. It’s no wonder the same “rumors” about Ping An and Hillhouse keep getting floated by anonymous sources.

Uber appears to be doing what Uber does well: Confuse the hell out of everyone about what is actually going on here.

But by Uber’s own comment in these various articles it initially was targeting only institutions, not individuals. Two months later the biggest institutional investor appears to be Uber itself, with Baidu second and a private placement arranged by an institution as the only other one ever even rumored that wasn’t flatly denied.

Let’s be clear what Uber was really pitching here: Invest in a “company” that has no CEO, is losing at least $1 billion a year, is blocked by WeChat with a risk to be blocked by Alipay, and has barely cracked 10% market share. At the still-heady valuation of $7 billion, it’s not a mystery why the round had to later be reconstructed to target wealthy individuals, shares in Uber global, and other guarantees in case Uber China never goes public.

NATIONAL SECURITY

Those are the financial risks, before you consider the geopolitical ramifications. Famously libertarian Uber has morphed from an organization that disdained all government bodies to one that wants to harness big government to its advantage. From a place that mistrusted all politicians and statesmen to one that employs them.

Uber has used its app to encourage political action, whether it’s adding an anti-de Blasio tab to its app in New York or warning its drivers to stay away from political protests in China (at least those in support of Didi Kuaidi.) Uber has become a political tool as much as a transportation tool, and one run by former senior members of American defense and intelligence.

More troubling: Uber has shown in the US, that it’s willing to cross all sorts of lines of what’s appropriate in mining user data, prompting Senator Al Franken - chairman of the subcommittee on Privacy, Technology, and the Law - to formally demand an explanation from the company.

In fact, the leader in Uber China’s fundraising is Emil Michael-- who you may remember from the time BuzzFeed reported that he’d threatened to “go after” my family in retaliation for Pando’s reporting. But more relevant is that Michael was previously special assistant to former Secretary of Defense (and former CIA head) Robert Gates. The very same Robert Gates who now works for... Uber, chairing the advisory board of a division called Uber Military.

Concerns about the financials aside, can you imagine American retail investors lining up to fund a Chinese company that was going to take over the transportation grids of our largest US cities, with a history of abusing user data and organizing political rallies, run by former top members of the Chinese defense and intelligence agencies? Can you imagine the US government being OK with that? That’s exactly the pitch Michael has been making to Chinese institutions and wealthy Chinese all summer long.

The Chinese government was worried about people being able to Google “Tiananmen Square.” Hell, just last week Baidu blocked certain search results about China’s stock market crash, lest it inflame political tensions. Does anyone believe the Chinese government is going to allow an American company whose senior figures include the former head of the CIA to take over urban transportation and create a network of potential protesters? Especially given the uncertain backdrop of the Chinese economy right now? Especially when there is a local alternative that already has some 80% market share, is backed by two Chinese companies clearly willing to cooperate with the government, and at least one state-owned body itself?

The fact that Uber has chosen Michael -- a former defense department employee who still works as an advisor to the Pentagon -- to lead this effort boggles the mind as much as Uber’s refusal to fire him after his threats against journalists made international news. It shows either the same lack of respect or lack of understanding for what it means to do business in China that has tripped up so many US Internet companies before Uber.

No wonder this round had to be passed from institutions to individuals, include such obvious sweeteners, and still took another half a billion from Uber to close. Meantime, Didi has just closed $2 billion and is reportedly looking to raise more. As a show of just how much cash it has, Didi itself invested in a fellow Uber competitor, Singapore-based GrabTaxi, last month.

FRAUD

Let’s look at where all that capital would go: Subsidies. It’s Uber’s only choice if it wants to compete with the entrenched Didi is to offer huge subsidies for riders and drivers. It’s the only thing that has helped Uber and hurt Didi. And it’s a playbook Uber knows. This is how Uber has grown and hobbled competition in the US, but it’s never done subsidies at this kind of scale. And it’s never done them from a position of weakness in the market.

In the US, Uber has used subsidies to bleed out competitors who simply can’t match Uber’s financial health or fundraising ability. In China, it’s the opposite. It’s a desperation play to gain market share against a competitor with even deeper pockets.

Still, in China, the result for Uber has been a dramatic growth in rides. So much so that Kalanick says it could be the largest market for Uber by year end. But the problem, according to sources, is Uber is only judging its city managers on that single metric.

And that’s given rise to an absolute breeding ground of driver fraud. Said analyst Zhang Xu to Bloomberg: “[Uber’s number of rides] is definitely exaggerated. It is well known that Uber has the problem of false bookings.”

Throughout Chinese media-- and the Bloomberg article above-- there are reports of drivers hacking the system to get extra subsidies without driving anyone anyplace at all. For a while, Uber would match drivers and riders based on proximity. So, Pando is told, gaming the system was as simple as requesting a ride with one phone, accepting it with the other, and driving around to record fares. More sophisticated schemes advertised on Taobao involve software that hacks a phone’s GPS such that driving around isn’t even necessary.

In recent weeks, I’m told that Uber has made some effort to combat the fraud, for instance, changing the algorithm so that it doesn’t immediately match the closest rider with closest driver. But because the fraud was so rampant, sources tell me this has created a user experience mess. Fake riders request a ride, a real driver picks it up, and it gets cancelled immediately when the driver trying to game the system doesn’t get his own ride as expected. It’s hard to know whether that experience is widespread or just anecdotal.

More disturbing is a different kind of fraud: Buying and selling Uber driver accounts online. Like most countries where Uber operates (including the US) there are disturbing accounts of weak background checks at Uber, and last week we saw the first reported account of sexual assault by a driver out of Uber China.

For months the Chinese media has detailed just how easy getting an Uber driver account is-- you pretty much need a license, an email address, and a computer to watch a 17 minute training video. But even the most solid background checks are meaningless if thousands of driver accounts are being bought and sold for a dollar each on Taobao.

Absolutely no one is denying that the subsidies have encouraged substantial fraud. Uber has told Bloomberg this fraud is around 10% and it plans to get that down to a “sustainable” less than 1% “in short order,” but various Chinese media reports peg it closer to 30%-40%.

The closest an outsider can get to witnessing some of the scale is to search for “Uber account” and “Uber simulation” on Taobao and look at the number of listings and sales in the past 30 days. There are hundreds of listings, with some having completed thousands of transactions over a month’s time. The listings include driver accounts, manuals to teach fraud, GPS simulation software, and pre-programmed phones to simulate rides. The Chinese press has detailed all of these techniques and just how easy and widespread these transactions are.

Does that all add up to 10% of activity or something greater? With a reported million rides a day, only Uber knows for sure. But it’s clear there’s a very open and easy-to-navigate black market which makes US drivers’ attempts to turn off phones to provoke surge pricing seem cute by comparison. The company has not detailed how it plans to decrease fraud to less than 1% “in short order.”

Only Uber knows how much of that $1 billion is actually acquiring legit drivers and riders and how much is simply being siphoned off in exchange for giving Uber management its vanity number. Either works in Uber’s interest, but the latter arguably only works in Uber’s short term interest.

It’s one thing to spend $1 billion in venture capital buying growth. It’s another thing to spend $1 billion and have a huge chunk of that get lost to fraud.

MANAGEMENT VOID

Astoundingly, Uber China -- a company that has reportedly just closed a $1.4 billion round at a $7 billion valuation with a promise to go public in five years-- has no CEO. Individual city heads are reporting to Travis Kalanick, according to our sources.

This is similar to what was revealed about Uber Delhi, after a woman was allegedly sexually assaulted by an Uber driver late last year. The Uber Delhi team was just a handful of workers operating out of hotel rooms.

Uber appears to take a “lean” approach to operations globally so it can focus its spending on subsidies.

* * * *

One thing is certain: Uber China bears little resemblance to Uber, aside from a logo. Uber may not always be the most ethically appealing business, but it’s a brilliant one, as all of its cleverly leaked documents’ soaring top line revenues and skyrocketing valuations have shown.

Consider:

Uber global spends heavily to grab market share, but in the US it doesn’t do so recklessly. It has a dominant market position, a huge trove of investor cash, and a seeming ability to raise more at the snap of its fingers.

Uber China is the market underdog with an upside-down business model. It has spent unsustainably to grab 11% market share in 16 cities and says it’s expanding to 100 next year. Even with the reportedly-closed $1.4 billion round, this spending can’t continue indefinitely. And given the cold shoulder institutions already gave Uber China, it’s hard to know how much capital is out there for round two.

Uber global has one of the most brutally pugnacious and effective CEOs the startup world has seen in Travis Kalanick.

Uber China has no CEO.

Uber global is strengthened by its close ties to the government and ability to mobilize its drivers as a grassroots political force.

Uber China is weakened by its lack of inroads with the Chinese government, which doesn’t smile on grassroots agitation with foreign backers.

Uber global has major Chinese financial institutions behind it.

Uber China is trying to raise funds from wealthy Chinese individuals, using financial institutions as a conduit.

Uber has been plagued with issues around its background checks, but maintains it’s safer than taxis.

Uber China is populated with an unknown number of drivers buying accounts for $1 on Taobao.

Uber global’s investor Chris Sacca mocked Carl Icahn for investing in Lyft, saying he didn’t believe there’d even be a second player of any meaningful size in the US.

Uber China better hope potential investors don’t listen to the logic of Chris Sacca.

Fortunately for Uber China, the separation between the two entities is hopelessly muddied-- even by the reported terms of their own fundraising. Some number of investors will see this as the “bargain Uber” or a way to get into Uber global. Emil Michael appears to have pulled this fundraising off, even if it took Uber itself “leading” the round. Uber China may still find a brilliant CEO. It may be able to buy itself a few more market share points. It may even be able to hold onto some meaningful minority position once it eases back on subsidies and combats fraud to save its user experience. And that may be enough to make this gamble worthwhile, given the size of the Chinese market. But Uber China will never be anything like Uber in the US.

And that means that Uber-- the giant of Silicon Valley, the dominant player in the on-demand economy that has spawned so many other copycats, the company considered the “Facebook” of the iPhone era-- may not be destined to become the largest ridesharing company in the world, a role all but considered its birthright until this fight. That stark reality puts into perspective just how sophisticated the Chinese startup market has become. It’s not only a harsh pill for Uber to swallow-- but for all of Silicon Valley.  

It’s only when you look at it through this lens that you start to understand why Uber is taking on such an expensive and ultimately doomed battle. It has to try, and right now, capital is cheap enough that it can.