After starting with a solitary office in Manhattan eight years ago, shared office space provider WeWork now rents 265,000 desks in 287 buildings around the world.
As quickly as its business has grown, though, its valuation has grown even faster.
In 2017, Japanese firm Softbank, led by Masayoshi Son, committed to providing US$4.4bn of equity funding in return for nearly 20% of WeWork, valuing the whole company at US$20bn. The investment was made both directly by Softbank and indirectly using Softbank’s US$92bn Vision Fund, which is also backed by the sovereign wealth funds of Saudi Arabia and Abu Dhabi.
Softbank steps up again
Now it seems Softbank is in talks to take its WeWork stake to over 50% for a total investment of between US$15bn and US$20bn. The latter figure would almost double the valuation of WeWork to US$40bn.
To put this in perspective, listed flexible office space competitor IWG Plc (LSE: IWG) has almost twice as many desks for rent as WeWork but only trades at less than 15% WeWork’s current valuation.
There’s no doubt WeWork’s revenues are rising quickly as it expands. WeWork’s revenue for the second quarter of calendar 2018 more than doubled, from US$198.3m to US$421.6m, as its memberships (ie customers) surged from 128,000 to 268,000 over the same period.
Even so, costs are rising even more quickly, resulting in the company losing some US$723m in the first half of 2018, nearly five times the US$154m loss recorded in the prior corresponding period.
WeWork argues that a large portion of these losses are due to its rapid expansion: once it enters into a lease over a new floor or building and fits out its space, the company then has to wait a year or two to attract enough tenants to make the new space profitable.
I can’t argue with this logic: our very own shared office space company Servcorp (ASX: SRV) experiences a similar dynamic. Unfortunately, though, this ignores WeWork’s – and Servcorp’s – Achilles heel.
This is the mismatch between the long-term leases WeWork and its competitors sign with building owners and the much shorter subleases they enter into with tenants.
WeWork, Servcorp and IWG lease space off building owners for periods generally ranging from seven to up to 15 years, but then sublease this space to tenants for periods as short as one month.
Unfortunately, demand for office space is highly cyclical, being dependent on changes in the business cycle and its influence on employment levels and the rate of business formation and destruction.
Worse, barriers to entry to the co-working or share-office space are low. Virtually anyone can form a WeWork copycat, enter into a lease with a building owner, fit out its new space and then try to attract tenants.
This is why WeWork competitors are a dime a dozen: you can now choose coworking space designed to look like a hotel lobby, one located in a restaurant and even one designed as a camp site.
Moreover, short-term leases mean it is easy for customers to switch to a competitor should they choose and the barriers to exit are high (as breaking leases with landlords is costly).
So in any downturn, WeWork will likely be stuck with paying ever increasing lease expenses to its landlords (office rents generally rise by predetermined amounts over the lease term) at the same time as its floors’ occupancy rates decline. And that’s without even considering the likelihood that lower demand and pressure from competitors force net rents down too.
The high operating leverage inherent in the flexible office space business is why Servcorp CEO Alf Moufarrige, a veteran of the industry, has amassed a war chest of more than $100m in net cash and liquid investments to help the company survive the next downturn.
Actions speak louder than words
And based on WeWork’s actions, it appears well aware of the risks inherent in its business model.
WeWork is trying to reduce the abovementioned mismatch by requiring larger tenants such as General Electric (NYSE: GE) and KPMG to signs leases for a year or more in return for volume discounts.
Even so, larger companies only make up 25% of WeWork’s membership and I doubt a lease of one or two years will protect WeWork come the next recession. In previous recessions, flexible office space was among the first costs to be cut by companies struggling with the downturn.
Finally, not only is the company setting up special purpose vehicles (SPVs) to protect the parent company should the desks housed within the SPV not make enough money to cover lease costs, but in a recent debt raising presentation WeWork invented the term “community-adjusted EBITDA”. Unsurprisingly, WeWork was profitable using this metric, but only because it excludes essential costs like marketing, administration and design expenses.
Interestingly, around US$1.3bn of Softbank’s original US$4.4bn investment went to paying out existing investors in WeWork. Yet even insiders taking money off the table hasn’t stopped Masayoshi Son upping the ante.
Softbank famously lost 99% of its value during the tech bust around the turn of the millennium and perhaps this is one reason Softbank executives have questioned Son’s obsession with WeWork.
But Son overruled them.
While time will tell, I suspect he will ultimately regret doing so.