September 14, 2019
Deep Dive into WeWork’s IPO
The We company, or more commonly known as WeWork is IPOing in the US in September 2019. The company is hoping to raise $3 billion to $4 billion through public offering at a valuation of approximately $25 billion (half of what it was planning on doing just a week ago!).
WeWork and the Industry overview
WeWork provides its members flexible access to office spaces. At a high level, its business model is somewhat comparable to Amazon’s AWS. As service providers, both AWS and WeWork provide their customers access to infrastructure for a recurring fee, turning customers’ fixed costs into variable costs. However, instead of cloud compute infrastructure, WeWork leases out office space, giving its users access to beautifully designed spaces. Flexible access to office spaces can lead to lower cost per employee (~57% in savings), less monthly expenses on rent, and make it easier for customers to expand geographically. As a result, the flexible office space rental industry is poised to grow. According to CBRE, the world’s largest real estate company, flexible office space currently makes up just under 2% of leased office space in the US and could grow to 10% of leased space in top office buildings by 2028. The following is taken from its S-1.
Figure 1:Cost Per Employee, WeWork Versus Standard Lease. Data taken from its S-1
WeWork is the largest player in this space
Present in 528 locations in 111 cities across 29 countries, WeWork has been been expanding globally at an unprecedented rate. The company now offers it’s “space-as-a-service” model to more than 527,000 customers, up from 400,000 a year ago (end of 2018). WeWork’s revenue has been growing 100% year on year for four consecutive years, to US $1.5 billion in 2019. To further expand its offerings, the company has used its ample cash reserves to acquire startups in the similar and adjacent space. One of its more recent acquisitions was Spacious, a startup that makes use of underutilized restaurant space. Its fast paced revenue growth is accompanied by a rapid growth in expenses. Expenses grew from US $1.4 billion to US $2.9 billion in just one year, pegging losses for the first half of 2019 (up to June 2019) at US $1.34 billion (a number that would make even Uber blush). Data taken from the S-1.
Figure 2: WeWork’s Revenue, Expenses and Losses from Operations. Data taken from its S-1 2018 FH= First Half of 2018, 2018 SH= Second Half of 2018, 2019 FH= First Half of 2019
Concerns Around WeWork
Concern #1: Increasing CAC
Ok, so the company is fast-growing, with extremely high losses and aggressive expansion plans in order to achieve large scale. Normally, large scale comes with many benefits for businesses: network effects, lower costs, higher margins, or lower customer acquisition costs (CAC). It is unclear that any of these are true for WeWork. Unlike marketplace companies (in these marketplace businesses, the more providers available on the platform, the more benefit for the customers) such as Uber, AirBnB, Lyft, there are no network effects achieved with achieving larger scale for WeWork. For some businesses, larger scale means more margin. In the case of AWS, building one data center to serve one customer is significantly more expensive than building one data center to serve millions; not to mention the fact that server capacity can be served at almost zero marginal cost via the internet. Again, this is not the characteristic of WeWork’s business. For WeWork, opening more locations in one part of the world does not necessarily benefit operations in the other parts of the world. So that leaves the question of CAC. Does customer acquisition cost (CAC) become lower with more scale?
Unfortunately, the company does not disclose its cost of acquiring customers. Nonetheless, we can estimate this figure from the Sales and Marketing expenses (SG&A). CAC is the money that the firm spends upfront to acquire customers in the hope of receiving revenue in the future. In the first half of 2019, WeWork added 127,000 new customers. In this time period, the company spent US $320 million in the SG&A. This implies an estimated CAC of US $2,539. This figure is 40% higher than the preceding six months, where the company added 133,000 customers with US $240 million in SG&A spend, which implies an estimated CAC of US $1,804.
Figure 3: Estimated CAC for WeWork based on Customer Growth and SG&A spend. Data taken from the S-1.
In general, increasing CAC over time is expected and is not necessarily a bad thing, as long as revenue and margins continue to grow accordingly. This does seem to be the case with WeWork. Figure 4 plots WeWork’s Gross Margin along with the estimated CAC since 2016. As you can see, the company’s gross margin increased from 11% to 15%, or a 36% increase over from second half of 2018 to first half of 2019. This is a positive sign for the business. Nonetheless, the company faces significant risk of running out of cash. Gross margins represent unit profitability. Gross margin does not take into account the general administrative expenses, depreciation and amortization of its assets, SG&A, and costs of opening new locations. If you take into account these expenses, the net margin for the second half of 2018 to first half of 2019 are both at -89%. Therefore, if WeWork continues to burn cash upfront to acquire customers, without improving margins or revenue at the same pace, they run the risk of running out of cash (since the time period to recoup the upfront spending period gets longer and longer).
Figure 4: Estimated Customer Acquisition Cost and Gross Margins for WeWork based on Revenue and Total Operating Expenses. Data taken from the S-1. Gross margin = Revenue – (location operating + other operational expenses ). CAC = new subscribers add / SG&A spending.
Concern #2: Recession Risk: Long Term Liabilities vs Short Term Revenue Commitment
WeWork operates a business model where they take out long term liabilities while offering short term contracts. The average lease that WeWork signs with real estate owners and developers is 15 years, whereas the company’s customers’ average lease is only 15 months (up from 9 months in 2017). The increase in average lease is likely due to WeWork signing more and more enterprise clients, who typically sign longer leases than smaller companies. If the company were to lose a lot of customers, say in a recession, it would still have to make payments on the longer leases. This mismatch between short term revenue and long term liabilities is a huge risk for the business. In fact, the company has US $24.1 billion in liabilities (which is 71% of its operating lease obligations) that is due on 2024 and beyond.
By comparison, WeWork’s closest competitor, Industrious, pivoted to an alternate model that is similar to the hotel industry, where owners hand off management of their properties to brands such as Hilton and Marriott. Instead of entering into long term leases, Industrious has adopted a “partnership only” approach where they enter into management contracts with the landlords.
Industrious then provides its workspace services to the landlord’s tenants, allowing the landlord to charge a premium for the property. By doing so, Industrious enjoys 3 times higher profit margins. Furthermore, by partnering with landlords, Industrious is able to eliminate long term liabilities and minimize the recession risks. But this approach comes at the cost of relatively slower growth and smaller turnover. Nevertheless, the benefits of this asset-light model is very attractive. As a result, WeWork is trying to enter this segment by introducing its “Powered by We” services.
Concern #3: Questionable Corporate Governance
WeWork’s founder, Adam Neumann, has invited a lot of controversy with his behavior. A few months before the IPO, he cashed out nearly US $700 million. The large amount signaled to external investors that Neumann does not have confidence in the company.
Neumann also charged WeWork US $5.9 million for using the “WE” trademark, which he previously owned. After some controversy, he recently returned the money. Nonetheless, this incident further raise concerns whether his decision making is in the best interest of the company.
The massive losses and controversies around the business has led the company to slash its IPO valuation by 40% to a range of $20 billion to $30 billion, a range that is far below the $47 billion valuation the company enjoyed in January. Despite this devaluation, WeWork still has a valuation that is 6x higher than IWG, a comparable competitor (Figure 5 shows the comparison between the two companies).
Figure 5: Comparison of WeWork and IWG’s (a publicly listed company) financial figures. Data taken from Vox.com.
Overall, WeWork’s S-1 is very convoluted. The company’s organization structure is unclear, with a complex structure of holding companies. The company is burning a lot of cash and is aggressively expanding, with no clear benefits of expansion and with little clarity around geographical contributions towards revenue and profits. It also has high exposure to the risk of recession, and its numbers suggest that its customer acquisition cost is increasing far more rapidly than the margins. All these issues around the business is exacerbated by the drama around the IPO: the recent slashing in WeWork’s valuation and Neumann’s margin call on the company’s stock (Neumann has given the banks the right to liquidate his ownership position in WeWork as collateral against his $500 million personal loan. If the stock price tanks substantially, the banks can dump Neumann’s shares to protect their own capital, which will cause the stock price to fall even further) have made WeWork’s IPO a very unusual one (to say the least).
Thanks for reading!
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