Unraveling of the WeWork IPO – The most ridiculous IPO of 2019

WeWork IPO

In this blog, we will discuss about the WeWork IPO as it is moving towards its offering date, why there is so much curiosity on the IPO, credibility that We Work has built in past few years and how quickly they can lose the credibility if the markets lose faith.
I have written a previous post on We Work Valuation and whether their valuation at $47 Billion holds any sense.The link to the article is here
The biggest loser in this entire valuation cut is Softbank – The biggest investor in We Work story.
While We Work has cut its valuation figure to $10 billion, let us analyse the We Work Business model, their growth strategy and if they can continue to grow as projected.

Understanding WeWork IPO Business Model

• I always feel that the CEO and board should only focus on running business efficiently to deliver superior returns to shareholders, provide good career and growth to employees and add value to customers rather than delivering spiritual lessons to society or building their growth story around it.
• There is nothing new in We Work Business model as many real estate companies have explored this business model and abandoned it due to micro and macro economic issues.The difference here is the access to capital that We Work has along with its scaling ambitions to grow aggressively.

Conventional Real estate office business model

• Most businesses need offices to work.The real estate owner acquires the office building, standardise the office space and rent it to companies.
• The huge debt that owner incurs for buying the building along with the operating expenses to maintain the building is recovered by the rent payments received from the companies.
• The real estate is a cyclical industry and gets impacted when there is an economy downturn.Hence to mitigate this risk, the real estate owners buy the building at a time when the rates are low and executes multi year long term rental lease agreements with creditworthy tenants at high prices.This is done to ensure that there is a profitability buffer during the downturn.

Wework IPO Business model vs Conventional Real Estate model

• There is a slight twist in the We Work Business model. Instead of buying office spaces, We Work gets into long term lease agreements with property owners.
• We Work identifies locations (Newyork and London) where there are plentiful businesses and lot of employable talent.Then they upgrade and renovate the office spaces to make it suitable for millennials and according to tech culture.
• We Work charges occupancy by desks or square foot.Then it tries to enter into short term monthly contracts.The plans offered is flexible and caters to freelancers, startups, SME and enterprises.
• Any difference between the rental payments received by We Work and the lease payments spent goes towards renovating and maintenance of office spaces.
• Any amount left goes as profits and as economies of scale kicks in, the profitability increases.

WeWork IPO Value Proposition

• We Work claims that the unique strengths it brings to each stage of the process is what sets it apart from other businesses.This is the reason for its success.
• The company substantiates this argument in its prospectus where it provides data on time taken to signing and filling a location to showing profitability in that location.
• This argument still needs clarity as We Work is providing financial numbers by location and not by building basis.Hence it is difficult to decode the contribution margin for each building along with the renovation and operating expenses spent for each building.

WeWork IPO Model Analysis and Trade off

We work model differentiates itself against other business on three factors.

• First We work provides an unique atmosphere and add flavor to the office spaces to make it look cool and friendly to millenials.We Work is also able to duplicate these features in other buildings quickly and with cost savings.
• Second is the We Work community where the company provides value added services like business networking, consulting services and seminars.
• Third is in providing flexibility options to cater to all types of businesses from freelancers to startups to enterprises by providing short term lease agreements.This is particularly useful for startups who have unpredictable futures and hence do not want to enter into long term rental agreements with property owners.

Weakness in WeWork IPO Business Model

• The biggest weakness in the We Work Business model is that while the firm has locked itself into long term lease agreements with real estate companies with most of these leases spanning a duration of more than 10 years, the rental inflows for We work are mostly short term rental contracts with most of them having annual agreements.
• We work needs to spend an high upfront costs to get locked into lease agreements, but its revenues may have it’s own ebb and flows with majority of its rental agreements not getting renewed during the economy downturn thus resulting in liquidity crunch and heavy losses.

In addition, We Work is further exposed due to the four reasons below:

WeWork IPO issues : Owning vs Leasing

• Owning a property and leasing it is less risky when compared to leasing a property and then sub leasing it.
• Owning a property gives rise to fixed cost.The capital to be raised to buy a property can be a combination of equity and debt.
• When the property prices rise after buying, then the equity price also increases which can inturn reduce the financial leverage.Again the reverse can also hold true where the property prices can dip after buying.

WeWork IPO Explosive growth

• We Work had scaled up its business model and had an explosive growth.The firm that started in 2010 has more than 500 locations in 2019 giving rise to significant lease commitments.
• The lease commitments combined with it’s already existing operating losses exposes it to further risks.

Flexibility in choosing tenants

• The flexibility options provided to tenants exposes it to revenue losses when the young startup would pull back from rental payments during the period of downturn.

Lack of discipline in Cost structure

• Successful companies follow a disciplined cost structures where the fixed cost commitments would be very low and adapting itself to changes in environments.
• We work does not seem to have this discipline as the company has locked itself into huge leasing agreements even when the occupancy rates are still low.

Complexity of WeWork IPO Operations

When we analyse the WeWork prospectus that the company has filed, we find that the company has complex operations which is surprising given that the company is just a decade old in its operations.

WeWork IPO issue 1 –  Operations

• The company has reported a growth in every operating dimensions – Cities, Locations, Tenants and revenues.
• The losses also continue to grow year over year.When we discount the losses before operating lease expenses which includes the debt payments, the losses reduce, but still remain.

Wework IPO issue 2: Exposure to Debt

• We Work business model operates on leasing properties and locking itself to long term lease agreements. This results in significant lease commitments over a longer period which runs into billions of dollars in claims.
• A huge portion of these commitments come in the form of debt which leads to interest payments after covering for operating losses.
• Currently, We Work has reported revenues of $2.6 billion with operating losses of more than $2 billion.In addition, it has outstanding debt of $24 billion.This debt is only going to increase as the model will scale up.
• Debt is the major component of revenue model and only after paying the interest obligations will the remaining earnings be given to shareholders.The company hopes that as it matures, the leasing ages, it will turn profitable.

WeWork IPO issue 3 – Usage of Proceeds

• The company has not still specified how much money it intends to raise in IPO.With the company undergoing a valuation cut, things become even more dicey.
• The company further says that it intends to use the IPO proceeds for Working capital purposes and for Capital expenditures.This indicates that none of its equity investors intend to cash out their investments.

WeWork IPO issue 4 – Corporate Governance

• The company has a complex holding structure and share classes with different voting rights.
• The complexity in holding structures is due to protection from tax considerations and to protect itself from downside effects of its lease growth.
• The voting structure is deplorable with class A shares offered at IPO having 1/20th of the rights of Class B and Class C shares.This means that the entire control is in the hands of its CEO – Adam Neumann.
• The other shareholders might not have the power to oppose and retract any decisions that the CEO takes which they feel is not favorable to the shareholders.

Wework IPO Valuation

There are four components to the We Work Valuation story

WeWork IPO valuation factor 1 – Wework meets an unmet need for flexible office space

• The company meets the large need of small and young companies who are looking at office space but at the same time not willing to get into long term rental agreements due to their uncertain future.
• The enterprises also have a need to set up innovative facility agreements in order to save on capital expenses.
• Hence this demand of flexible office space has potential market demand of close to $900 billion as estimated by We Work.

WeWork IPO valuation factor 2 – Differentiated Offerings

We Work provides differentiated offerings which allows the firm to command premium pricing and higher margins.

WeWork IPO valuation factor 3 -Access to Capital

• The company has access to capital from its Venture Capital investors.Through this capital, the company is able to fund its growth and also able to survive economic shocks.
• This would not be sufficient in the time of distress and recession, where the firm large debt load will expose them to higher distress.

Wework IPO – Key Financial Drivers

Revenue Growth

• The company had a triple digit growth last year.Using past trends, the firm is projected to grow at 50% YoY for next 5 years followed by a stable growth equal to risk free growth rate after year 10.
• This projects We Work revenues at $80 billion in year 2029.

Margin Growth

• The real estate market has an operating margin of 11% in the last five years.
• IWG – The closest competitor to We Work in the terms of operating model has a margin of 12%
• We Work reports that it has a contribution margin of 25% which is before the corporate expenses, stock compensation and capital maintenance expenditures.

Capital Intensive Business

The firm business is capital intensive requiring major reinvestments of its earnings to buy new properties or maintaining its aging properties.

Risks to Wework IPO Operating Model

High Risks of Failure

The firm has high debt loads and in the downturn, the firm will be exposed to a higher distress.Hence there is a 20-30% chance of firm getting bankrupt and if that happens the firm will be liquidated to ~60-70% of the fair market value.

High Debt Loads

The firm has current debt load of $24 billion primarily taken for fulfilling the contractual lease commitments.

Risks in investing in WeWork IPO

• Valuation is generally an intersection of story and numbers.In case of small companies or new age tech companies, it is the story that drives the numbers.
• The bulk of the investment for the company bets on what the company will achieve in the future as against what the company has achieved.
• Most of this value is driven by the vision and passion of the CEO – Adam Neumann who had projected We Work as a social community to help small companies by renting out office spaces so that they can compete against biggies.This vision has driven Softbank and other investors to inject capital.
• The success story will remain intact till the CEO credibility is safeguarded. The moment, the market doubts his integrity, then it will start to dissect the actual numbers which can plunge the company to a big fall.

Conclusion

• Looking at the latest events including a cut in its valuation, there is every chance that the WeWork IPO could be pulled by its CEO and Softbank from a public offering.
• As We Work pulls from the IPO, the investors may need to inject additional funds for We Work to survive.This will be difficult for the investors as it will not be sure about the return on investments given there are so many flaws in the model.