SMBs Are Worst Customers Ever, Which Is Why Uber Will Replace POS, Payments, Then Merchants

There are many bright-eyed founders who read ReformingRetail. They take a look at the brick and mortar landscape and come to two conclusions pretty quickly:

1. The solution they’ve built delivers massive ROI to brick and mortar merchants
2. The total addressable market (TAM) for brick and mortar is huge, so they’ll be a billion-dollar company in no time

They reach out, humming with optimism, and then we burst their bubble. (This is not limited to founders, by the way – private equity funds and venture capitalist also look at TAM, the objective ROI of solutions for merchants, and believe there to be a missed opportunity.)

In some regard these parties aren’t wrong: brick and mortar is a huge market and the merchants themselves are run so poorly that “innovation” from the 1600’s would be a massive improvement from their current state of affairs.

But brick and mortar, or SMB as we’ll call it, is massively irrational. The people who make decisions in SMB aren’t the people you’d seek if you needed objective advice. Like if someone came to you with the idea to slash the prices of your items or services by 50%, give 50% of the new revenue to a third party, and target customers who will never return (and you won’t collect any contact information from) you’d tell them they were batshit crazy.

Yet SMB merchants just couldn’t get enough of Groupon no matter what the rational, objective math told them.

This is the same conclusion Bellcurve, a marketing agency that works with startups, came to when examining the potential performance of their customers. By looking at the end customer the startup focused on, Bellcurve analyzed which companies would be financially solvent the quickest. Turns out the startups that focus on SMB (… drumroll…) were the least profitable. And since investors actually care about profitability and cash flow, what do you think that does for the appetite of innovations targeting the SMB market?

This moat is what makes Uber (via UberEats) so dominant – and dangerous – in SMB. While investors are turning over every rock to figure out how the SMB startup they invested in is going to reach $10M in profitable revenues so they can exit as quickly as possible, Uber is able to convince merchants that they should be handing over 30% on every order. 30%! Let’s put the math another way.

Payment processors sodomize merchants for 1% of gross revenues. If a merchant does $1M in annual revenue their payment processor is scarfing up $10,000 in gross margin (because the COGS of payments processing is basically $0).

Uber, on the other hand, has the potential to be much, much more profitable. Imagine the same $1M merchant does 10% of his total revenue – $100,000 – via UberEats. Uber takes 30% of that, or $30,000. If Uber can find gross margins of 33% ($10,000), then it’s making the same gross profit as the merchant acquirer.

But unlike payments processing which is massively commoditized and competitive (i.e. when a merchant’s processing rates get too high they switch to a different provider with the exact same offering), Uber offers access to customers, which Groupon has already demonstrated SMB will throw money at blindly. This is why online delivery is expected to grow to $79B of restaurant revenues by 2022: unsophisticated merchants, desperate for a panacea, will encourage consumer convenience no matter how detrimental it is to their own business model. Uber, therefore, is penetrating SMB merchants faster than any POS or payments processor ever could.

In addition to dominating distribution, the real Achilles Heel of SMB, imagine Uber capturing 20% or 30% of merchant revenue with an additional kicker of automation that simultaneously drives gross margins upward. You end up with the below table:

If you’re looking at this math and thinking the entire model is unsustainable you’re 100% right. SMB merchants are lucky to eke out 5% profit margins, and per the above table it’s not hard to envision a future where Uber is earning higher gross profits than a merchant is net income. In other words the merchant is losing money as all their profits flow to Uber.

Uber knows this, and they will make a business model change.

Before we go any further we need to add some context. Uber is going to IPO at a roughly $100B market cap. The markets expect public companies to grow on the order of 10% a year. This means Uber needs to be adding more than $10B (depending on Uber’s valuation multiples this requires adding another $500M-$1B in EBITDA) to its market cap every year – a massive number. When companies get above a certain size the only achievable way they can hit 10% growth is by acquiring other companies.

The business model limitations made clear in the table, and the nature of being a public company, mean Uber will take two actions in time:

1. Replace POS and payments companies
2. Replace the merchants themselves

The first action is the more imminent of the two. We’ve already demonstrated how Uber could earn more money than payments processors, and payments processing earns substantially more than POS companies. And neither POS nor payments industries have shown any willingness to materially improve their position by creating new, defensible products off the underlying transaction data.

All Uber needs are reasonable payments processing and POS offerings and they can leverage their exiting SMB relationships to start moving these products. Further, Uber is not shy about using data, and as we’ve pointed out years ago they recognized the significant limitations of existing POS and payments products as it relates to helping merchants run their businesses, so we’d expect their products to come with higher ROI than incumbent options. Unlike POS and payments companies, Uber has a massive balance sheet and they can heavily subsidize the POS and payments products they bring to market, too.

If you thought venture capital investors and payment processing perverted SMB, just wait.

The second action already has precedence in history. Suppliers make a lot of money relative to retailers: Proctor and Gamble has net margins of roughly 15% while Walmart has net margins of 3%. In 1993 Walmart decided to use its own sales data to create Great Value, a Walmart brand of products offered at much lower prices. At the risk of sounding cliché, history repeats itself; what do you think Amazon has been doing with its Basics product lines? They’ve been quietly analyzing their own sales data to understand where they can or should compete with new product initiatives. If the market is compelling enough – and it needs to be compelling when you’re looking to add billions in revenue annually – Amazon jumps into it with both feet.

Uber is working out the same math as it relates to the restaurant industry.

The restaurant industry is large, racking up over $700B in US sales in 2018. Even penetrating a fraction of the restaurant market gets Uber the 10% growth it needs as a public company. For those of you arguing that Uber would be devaluing itself by getting into the restaurant vertical, where financial multiples are not as high as they are in technology, think again. Yes, technology companies command higher enterprise value to EBITDA (EV/EBITDA) ratios than just about every other industry. But if you take a closer look, EV/EBITDA multiples for restaurants are not horribly far off, especially when comparing the new, sexy restaurant brands. Look at Shake Shake as an example, with an EV/EBITDA of nearly 25. That’s significantly higher than what Facebook commands at 14:

To get here all Uber has to do is analyze the sales data it’s been collecting across its millions of online orders and deliveries. This data gives Uber some compelling advantages:

1. Uber knows who its customers are. They have their addresses, names, and payment information. Merchants could have this data but the card networks and acquirers don’t openly share it or bother building compelling products because they’re too focused on processing revenues
2. Uber knows exactly what its customers order. They have access to item-level (SKU) data. This data has traditionally been limited to POS companies.
3. Uber knows how much a customer is paying or willing to pay for an item. Uber gathers all the pricing information for orders
4. Uber knows the velocity of items. This is critical. Uber knows how popular chicken parmesan in Denver, Colorado is on a Friday night. Restaurants only have visibility into their own sales but not item level sales of competitors
5. Uber knows what customers want. Through its search interface Uber knows what customers are looking for and when they come up empty handed
6. But perhaps Uber’s greatest strength is that it is not run by restaurant people. They have no aversion to data and technology and make decisions on objective ROI (what a concept!). They’re willing to aggressively invest in R&D to win market share. This is a total 180 from their competition – we know from first hand experience

All of this means Uber can create their own restaurants (which other delivery companies have already done, and Uber is secretly trying). They know what to put on the menu, at what price points, and whom to target with their advertising. Additionally Uber has the benefit of leveraging technology in the restaurant without needing to reformat an existing footprint. Uber can do the math to determine where to stick the restaurant, how big it should be, and pump out 100% delivery, shrinking the costs associated with a restaurant that caters to patrons with a front of house.

If this seems so farfetched, why don’t we look at what Uber’s ousted founder, Travis Kalanick, is doing with his billions of dollars and spare time: he’s building ghost restaurants. Just maybe the former Uber CEO has an inside track as to where Uber must go if it’s to successfully grow beyond a $100B company. Travis could put his money into any number of initiatives but we’re betting that he’s taking the risk on ghost restaurants because he knows Uber has to get into the space to grow its business. And as we mentioned earlier, larger companies become acquisitive when needing to find 10% annual growth.

All of this is predicated on data. While POS and payments industries are playing checkers via payments bundling and rate ratcheting, Uber is over here thinking about the data needed to execute the check mate. Uber will continue its foray into payments and POS to get the data requisite for their larger, longer term play.

It’s time the industry saw the forest from the trees.