WeWork's high-risk model undermines $20b valuation

WeWork photo: Shutterstock Chrispictures

Why does Softbank say that it will spend $15-20 billion on acquiring control of a company that is projected to lose $1.5 billion in 2018?

Global Japanese giant Softbank is so enthusiastic about co-workspace company WeWork that in addition to the $4.4 billion that it invested in WeWork last year, it is preparing to acquire control of the company for $15-20 billion, according to a report in "The Wall Street Journal." The management of Softbank, the biggest investor in WeWork, believes that within a year, WeWork's value will reach $35 billion, and "it will be a $100 billion company."

These figures put the company started by Israeli Adam Neumann on the list of the world's largest private companies - a source of great pride. Several unanswered questions, however, are liable to detract from this value. Does Softbank want to acquire the company in order to hide it from the public? Is this the value of WeWork's activity, or the value of the company?

The value of WeWork's assets is $18 billion. The company has 270,000 tenants. It posted a $723 million loss on $421.6 million in revenue in the first half of 2018.

Old model in new packaging

WeWork is an amazing company - an income-producing real estate company that has succeeded in branding itself as a revolutionary startup. Its simple model is not new: it rents a property on a long-term lease, renovates it, adapts it, organizes it into offices and co-workspaces, and rents the offices and spaces out to tenants.

This model is designed to generate a high return, but it is very risky. The return on the business results from the ability to rent large properties at low cost. The cost is low because the company rents the property under a long-term lease, and because of the size of the offices. The owners are willing to rent out offices to WeWork at a discount if the office is large, especially when a long-term lease is involved.

In essence, WeWork rents the offices for long periods (many years, even decades). Because the leases are for very long periods, from an accounting standpoint, WeWork is in effect buying these properties, and therefore reports them as properties against liabilities for these properties (future rent).

The model of WeWork, the world's largest co-workspace company, depends on renting out spaces under short-term subleases at higher rents than those paid by WeWork, which means that the return that it receives from renting out properties exceeds the rent that it pays. They are real estate agents and financiers, but they are financiers with a difference - they are selling an experience, a brand, and an image, including a large package of pleasant conditions. The parties renting from WeWork have no other expenses. They receive coffee and refreshments, shared breakfasts, and young, lively, and fashionably furnished quarters. They receive… friends. Yes, this basic need is the focus of WeWork's business model - otherwise, why should anyone rent such a place, instead of a room in an ordinary office building?

Large revenue, even large expenses

Concealed under the young wrapping, however, lies a very old model of returns and interest rate games that can collapse overnight. The big risk is that in preserving an occupancy rate high enough to make revenue exceed expenses, the company will incur additional expenses, particularly sales and marketing expenses, in order to reinforce its tenants mechanism (a large proportion of whom stay for only a short time).

Another problem is competition. Tel Aviv, for example, is awash with young attractive co-workspaces at competitive prices. Opening such spaces poses no real problem; entry barriers in this sector are almost nonexistent. WeWork is also feeling this elsewhere in the world.

WeWork is the largest company in the sector, but it is also losing the most money. The value of its properties is around $18 billion, a huge amount for a company planning to revolutionize the global offices market. These offices are sublet to over 250,000 people, generating over $1.5 billion in revenue, double the revenue from the preceding year.

This rate of revenue, which is based on the first half of 2018, is projected to rise each quarter - the company is growing. Expenses are also growing rapidly, and WeWork's bottom line is a big loss. The rate of losses, based on the first half of 2018, is $1.5 billion, compared with over $900 million in all of 2017.

Company value versus activity value

What we have here is a company with properties worth $18 billion (it has probably grown since the company volunteered to publish the information), $1.5 billion in revenue, and a $1.5 billion loss.

How much is this company worth? First of all, an important distinction - the value of a company includes its debt, while the value of activity is the value of a company's activity, regardless of its debt (and other items pertaining to its business).

WeWork does not publish financial statements. Every so often, figures are leaked to the US media, but the company itself conceals the information. It is true that WeWork has bonds traded on Wall Street, but where transparency and information are concerned, it provides the minimum required.

We therefore do not really know what its balance sheet looks like - how many actual debts it has, what its equity is, or whether it has an equity deficit (this is likely, but not definite).

In any case, if we classify debts from leasing/rental payments as a financial liability, there is a wide gap here between the company's value and that of its activity. For the sake of argument, say that the properties are worth $18 billion, and the liabilities total $18 billion. The company's properties will then reflect the operational items, which total $18 billion. On the other hand, the company's value, which takes debts into account, is zero.

The truth is that zero is more likely than the $20 billion that Softbank plans to pay (I may be very wrong), so it is possible that Softbank is simply talking about making an acquisition at a $20 billion value for the activity - but this does not appear to be the case. Nevertheless, there are accepted semantics in valuation, and here it appears that $20 billion refers to the company value, not the activity value.

Hiding WeWork

How is it possible for Softbank to take this value seriously? Maybe it is not possible, or maybe it has some great visionaries. Maybe it is just a show - it may be that Softbank is trying to conceal a failure - it has already invested $4.4 billion (and $1 billion more later), and realizes that it will have to make additional investments. If this is the case, it might be worthwhile keeping WeWork away from the critical public eye.

In this way, it fixes a high value, and does not have to deal with adjustments and writing off value. As the owner, it can set whatever value it wants to. The paper absorbs everything. The value is not in the financial statements; it is on spreadsheets, and the potential is really enormous.

Besides, no one really understands how the money will be paid (if at all). Will it be an owners' loan? Convertible bonds? A capital investment? Each option has major consequences for the value. Injecting money as a loan, for example, does not affect or reflect value.

The ostensible value of WeWork is contradicted to some extent by the return on its bonds. Six months ago, the company raised bonds on Wall Street. The return on the bond is around 8%, a return that reflects a big risk. Investors are concerned about the company's ability to repay its debts. The company has a high cash flow, but this does not necessarily indicate business potential and value. It is definitely stands out, however, that a company whose cash flow and ability to repay debt fall short of stunning has such a high value.

This only reinforces WeWork's dependence on financing. This company, with backing from Softbank, can be a tremendous success, but first it will lose a lot of money and burn billions. If there is no financial backing, its value could even be zero. If it has backing, the value is determined by what the owner (the party providing the money) determines. It can inject $2 billion, $10 billion, or even $20 billion, and set the value at whatever it wants.

The big competitor is worth $4 billion

WeWork is not alone in the market, and has not invented anything new. It has put it into a prettier package than anyone else, and has leveraged it into a global project. Workspaces, however, have existed for years, and this sector is drawing in developers, financiers, and real estate people setting up workspaces in important cities all over the world.

The biggest company in the sector is Regus, which is listed in London as part of the IWG holding company. The holding company's market cap is $2 billion, but Regus is valued at $4 billion (given that the holding company has liabilities, other holdings, etc.). Regus is bigger than WeWork in revenue, and it makes a profit, although its growth rate is less and it lacks WeWork's chic. It has other advantages, however - profits and cash flow. The obvious comparison between the two companies raises a major question about WeWork's $20 billion value.

The author is a lecturer in accounting, analysis of financial statements, and valuation, and is a consultant in these areas. This article should not be regarded as advice and/or a recommendation to buy or sell any security. Anyone relying on the article and/or its content bears sole responsibility for any resulting damage and/or loss suffered.

Published by Globes [online], Israel business news - en.globes.co.il - on October 14, 2018

© Copyright of Globes Publisher Itonut (1983) Ltd. 2018

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WeWork photo: Shutterstock Chrispictures
WeWork photo: Shutterstock Chrispictures
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