- Signal from Noise
I work. You work. Does WE work? Hard to say – WE offers strong growth, an asset light and disruptive concept – But profits could take a while; ownership convoluted – Overly complex financials, with governance, related-party red flags The We Company (WE) recently filed an S-1 registration statement for an IPO to be priced next month. Sans price, analyzing WE stock is like working the high wire without a net. Still, it’s going to be an interesting IPO, and here’s my take on the high and low lights of the S-1. WE sports impressive triple-digit percentage growth but little prospect of a profit in the foreseeable future. The many risks WE faces makes me think that, at best, it will ultimately appeal to a narrow range of investors. While it’s a disrupter, contrary to WE’s claims, it is not a tech company. There are plenty of things to like, but there’s at least one negative for every positive. WE is a holding company for the brand We Work and a real estate company that itself doesn’t own much real estate but applies technology to the use of its leased real estate in novel ways. WE had 527,000 members at June 30, with 604,000 workstations, and an average member lease commitment that has about doubled to 15 months from 8. Members get more flexible terms than a traditional commercial rental agreement might offer and can can range from a one person graphics design firm to companies with 500 employees or more. WE offers customized service for “enterprise members,” that is, companies with lots of employees and more complicated needs than the typical freelancer that many associate with We Work. About 40% of of its membership are companies with organizations with over 500 workers. Here’s what I like about WE: robust growth, with both revenue and membership growing at a 100% run rate. If the real estate trend of independent workforces with flexible solutions is sustainable, WE has a substantial first mover advantage. It posted $1.54 billion 1H19revenue and operates in 29 countries and 111 cities. Another competitor will find scaling up to WE’s global reach a tall order. WE has ambitious global expansion plans. Some 50% of its members are outside the U.S. It’s an asset light company, as WE is a holding company with no material assets other an indirect general partner interest and indirect limited partner interest in the in the We Company Partnership. WCP “is owned by certain direct and indirect subsidiaries of WE and certain members of management and related entities.” WE generally controls the affairs of the WCP. (See graphic below.) The negative here is that the ownership structure is convoluted. A Rubik’s cube is easier to solve. More on this below. There is also scarcity value to a publicly-traded WE. The London-traded, Swiss-based International Workplace Group (IWG) has a similar business model. In the S-1, depending on the measure used, WE claims a total addresseable market of $1.6 trillion to $3 trillion. Moreover, it says it can go from its current 111 cities, and a potential 149 million members, to 280 cities and a potential 255 million members. I’m not particularly phased by the lack of prospective profits and I’m not overly concerned that it currently spends faster than revenue grows. While not attractive in most stocks, these could be forgiven in a fast-growing company that has something new to offer and a moat. Nevertheless, this story stock is still marred by several significant issues, which together give me pause. WE’s class A shares have one vote, but class B and C shares, owned by CEO Adam Neumann and management, are endowed with 20 votes each. Neumann will control the company. If you have faith in him, great, but you will be powerless to effect change as a shareholder. Some investors don’t care about that. But I find it a red flag. WE is also afflicted with a Byzantine and shareholder unfriendly ownership structure. It’s fraught with legal complexity and opaque governance, as well as less-than-transparent related party dealings. Suffice it to say that reading the S-1’s complex litany of various general partners, holding companies, limited partners, special subsidiaries and legal entities made me blanch. There is more related party transaction risk than I’m comfortable with. Here’s an example: besides being the controlling shareholder of WE, CEO Neumann has ownership interests in companies that own office properties and buildings that are leased to WE, which then subleases to its members. The potential conflicts, particularly if things go south or there’s a recession, could be substantial. Ironically this puts WE in the unusual position of being in a much less flexible economic situation than its own customers, whose leases are much shorter than the average 15-year lease that WE itself typical undertakes for the spaces it rents. In a recession, its member could walk away fairly easily but WE cannot. WE has about $47 billion in lease commitments against a $4 billion backlog of rentals from its members. Not much cushion there. WE results aren’t so hot. In a recent analysis, Bespoke Investment Group noted the company spends about 80% of total revenues operating its coworking spaces, with two-thirds of revenues going to expenses related to new office openings. Another 43% of revenues go to other pre-tax expenses. Consequently, the company’s pre-tax margin is –79%, with operating margins of –90%. More worrisome is WE’s use of a customized non-GAAP metric it terms “contribution margin.” I’m always wary of new fangled metrics, particularly in IPOs which claim special circumstances. WE says its “contribution margin,” is its economically relevant performance statistic. It excludes location start-up costs, non-core operating expense, sales and marketing costs, growth/new development investments, general and administrative expense, depreciation and amortization, and all stock-based compensation. (See table.) This is about as close to “earnings before everything” as you can get, Bespoke wrote. I agree. Magically, the 1H19’s $1.37 billion operating loss turns into a $340 million “contribution margin.” When the stock is priced, investors should evaluate the business by more traditional metrics that reflect total costs, growth funding, and liabilities to shareholders. That brings me to IWG again. Admittedly, it’s not a perfect comp, as WE has better spaces, but the older IWG has survived a recession; has a similar number of workstations, and made a profit of $357 million in 1H19. It trades at a forward P/E of 30 times, but I’m guessing WE and its underwriters aim much higher. In the realm of anecdotal, WE is an inveterate user of buzzwords. Here’s an S-1 quote that made me chuckle: “Our mission is to elevate the world’s consciousness” Geez. Just make us some money. Where could I be wrong? Sentiment can drive a stock, so if WE somehow catches the investors zeitgeist, it could have a strong IPO. Bottom Line: Super sales growth eventually will slow, just by the law of large numbers. It’s a company with an interesting concept, but it’s still a real estate company. Treat it as such. I’ve got issues with it and you should too.