Tuesday, April 20, 2021

The 'WeSPAC' Is Here

By Berna Barshay

Following a high-profile false start, the one-time king of the unicorns is going public after all...

In late March, it was announced that special purpose acquisition company ("SPAC") BowX Acquisition (BOWX) had entered into an agreement to merge with co-working space operator WeWork, once the poster child for the "sharing economy" and for a time the most valuable startup in the world.

WeWork had planned an initial public offering ("IPO") in late 2019. I remember salivating while reading its prospectus... WeWork seemed like a short idea that was too good to be true.

It actually was. 

Despite a mountain of spin, investors saw through the cagey "adjusted" metrics the company put forth – trying to create the impression it was profitable when it wasn't even close. 

But unprofitable companies with big top-line growth go public all the time... Red ink alone probably wouldn't have been enough to kill the deal had investor due diligence not turned up a slew of bad behavior, conflicts of interest, and just boneheaded moves by co-founder and CEO Adam Neumann (who was later forced out of the company).

Among the sins were a series of investments completely unrelated to WeWork's core business.

Does anybody remember the unfortunately named "WeGrow," the new age elementary school that was the pet project of the CEO's wife, Rebekah Paltrow Neumann? The school featured yoga, meditation, and weekly farms visits... presumably not to a cannabis farm, but you could have fooled me with that name.

Or perhaps you remember the strategic investment into Wavegarden, a wave pool company?

The old WeWork was a lesson in poor corporate governance, which you can learn all about in the recently released and highly entertaining Hulu documentary, WeWork: Or the Making and Breaking of a $47 Billion Unicorn.

► The good news is that WeWork has seriously cleaned itself up...

After the IPO was pulled, the company had a brush with near bankruptcy. But then WeWork and its venture capital sponsors got to work cleaning the place up. 

Neumann was replaced by real estate veteran Sandeep Mathrani, who had previously served as CEO at leading real estate investment trust ("REIT") Brookfield Property (BPYU) and major mall REIT General Growth Properties.

Under Mathrani's leadership, WeWork slashed the budget for sales, marketing, and general and administrative expenses. The workforce was cut by more than 60%. Many high-cost leases were dumped, as were non-core investments into other companies.

Mathrani heads a professional team with legitimate credentials... The adults are now running the show at WeWork. 

The team at SPAC BowX is equally impressive and led by Vivek Ranadivé, who founded TIBCO Software – which was sold to private equity for $4 billion back in 2014. Ranadivé is also the co-owner and chairman of the NBA's Sacramento Kings, after previously being a co-owner of the Golden State Warriors.

Ranadivé is the real deal, but I would have loved to get behind this wildly successful tech entrepreneur and investor doing a tech deal, not a real estate one...

WeWork famously tried to pass itself off as a tech business during its failed run at an IPO. This time, the company is owning up to its real estate identity.

It's good to see WeWork come clean about its business model and own the fact it's a real estate company... But it's also impossible not to notice that this is a terrible time to be a real estate company specializing in offices. 

Just yesterday, I wrote about how tough the office tower market is for landlords, with Deutsche Bank (DB) recently predicting that we could see permanent demand reduction for office real estate of between 10% and 30%. 

The COVID-19-induced work-from-home experiment basically showed employers that most folks can be as productive – or even more productive – at home. And most employees like the freedom to skip the office.

Most office REITs haven't seen earnings plummet because office leases are long, typically five or 10 years in duration. Office REIT stocks have fallen and haven't recovered because investors are worried about the future, not the present.

But at WeWork, leases can be as short as a month... so the drop in demand very much affects results in the present. Occupancy at WeWork dropped to just 47% at the end of 2020, from 72% the year before, as people decided they didn't want to be crammed shoulder-to-shoulder at small desks during a pandemic.

While WeWork strives to obfuscate results, deep on page 46 of its investor presentation the company disclosed that it lost $3.2 billion in 2020, excluding results at its recently sold China business, which lost an additional $610 million. While the $3.2 billion is an improvement from the $3.5 billion it lost in 2019, excluding China, WeWork remains a deeply unprofitable company... even after all the cost cuts. 

In 2020, WeWork lost $3.2 billion on revenue of $3.2 billion, for a net margin of a cool negative 100%.

The results are bleak, but WeWork is trying to pitch itself as a reopening story complete with a sharp revenue rebound and operating leverage.

The company's projections have a lot of hope built into them considering the current period of unprecedented uncertainty...

In the short term, WeWork is calling for a sharp second-half recovery in occupancy, forecasting year-end occupancy to come in at 70% versus its current level of 47%. Since demand hasn't yet begun to bounce back, this is an entirely speculative prediction. 

Longer term, projections are even more aggressive. WeWork expects that memberships will triple in three years and turn a sea of red ink into a highly profitable business. Take a look at the details from the company's investor presentation...

 Source: WeWork

The 22% compound annual growth rate for revenue implied here seems aggressive – as do the margin projections – but recall that SPACs are much less regulated than companies pursuing an IPO, which are forbidden from giving forecasts. You can see how steep WeWork's revenue forecasts are for 2022 to 2024 in this chart from the Wall Street Journal...

Source: Wall Street Journal

The revenue rebound relies on occupancy rising to 90% by late 2022 and hitting 95% in 2024. Considering that occupancy has never been this high before at the company, these are aggressive targets. WeWork also plans to achieve this high occupancy while growing capacity by 50% over the next four years. 

Turning to the calculation of profits, the adjustments that WeWork makes to calculate earnings before interest, taxes, depreciation, and amortization ("EBITDA") are nearly inscrutable. Of course, the company has a history of playing fast and loose with disclosures, as the Wall Street Journal reminded readers in a recent article... 

In the run-up to the IPO, the Securities and Exchange Commission told WeWork to change certain profit and growth measures that it was using. The recent investor presentation by BowX has "echoes of the company's approach in 2019," said Minor Myers, a law professor at the University of Connecticut who specializes in corporate finance. "The SEC could push back hard again," he said, unless WeWork tones down these claims in its official filings with regulators, expected later this month.

My main gripe with WeWork was always the mismatch between assets and liabilities...

WeWork commits to long-term office leases and then slices and dices the space into smaller pieces that it rents out on shorter leases. In doing so, the company bears a lot of risk for demand changes impacting occupancy and pricing. 

This is a particularly large risk when it sells the month-to-month leases that it's most well-known for, which to WeWork's credit now only account for 10% of revenue. 

The company has also done a great job moving its customer base from primarily small and medium-sized businesses ("SMBs") to larger, enterprise ones, which now comprise 50% of revenue. The average lease duration of a WeWork tenant is now 15 months, which probably contributed to WeWork's topline being far more resilient than I would have expected during 2020. 

But market conditions will eventually catch up with the company... And conditions in the office space are in the gutter right now. With most office towers looking like ghost towns, it's a funny time to bring a speculative office real estate company to the public markets. 

The great uncertainty arises from the growth of "hybrid" and fully remote work during the pandemic. WeWork spins this as an opportunity, as large employers that cut office space may go purchase co-working space for employees who lack a good work-from-home set up.

But it's so early in the post-COVID real estate assessment cycle for enterprises... There's just an exceptional lack of visibility into the demand environment for co-working office space. 

WeWork could certainly see a surge in demand for meeting space from companies that have drastically reduced their own footprint. But you could also see a lot of enterprises that have too much space go ahead and cancel their WeWork contracts because these are the shortest-duration leases they have.

Counterbalancing the work-from-home headwinds, we have a strong economy... And new business starts tend to be strong coming out of a recession, as many recently laid off workers get entrepreneurial. But this argument may not hold water this time around after the very particular and very brief COVID-19-induced recession. The people who lost jobs in this recession tended to be lower income and not likely future entrepreneurs. 

And finally, there's the elephant in the room... The thing that made occupancy plummet in the first place: COVID-19. Even after the risk passes, the PTSD may linger for many people – including those in large WeWork markets like New York and London, which were hit hard by the pandemic.

A selling point of co-working spaces pre-COVID was that they were a revolving door with tons of smart people passing through from different companies. But having random people in close quarters is what we have desperately spent the past year trying to avoid... Habits may die hard.

Bottom line: Stay away from BOWX shares...

The $9 billion enterprise value the deal puts on WeWork is way too high. This amount may seem like a deal because WeWork raised capital from Japan-based lead investor SoftBank (9984.T) at a $47 billion valuation back in January 2019... But it's not.

Last May, SoftBank valued WeWork at just $2.9 billion, leaving the tech investment giant way underwater on its investment – having sunk more than $11 billion into WeWork so far. 

While many private companies have seen their value soar during the pandemic, the gainers have generally been digitally driven companies that saw user growth and engagement soar. 

Performance metrics at WeWork are going the wrong way, which makes a tripling of value over the past year suspect on a high level.

Assuming the company can get to its targeted $7 billion in 2024 sales – and I doubt it can – based on historical performance and the current cost base, I could see the company generating maybe $500 million in EBITDA, versus the $2 billion it is projecting. At 15 times EBITDA, I would get a target price of around $8 per share, and that's my best case. BOWX shares currently change hands at around $11. 

In my worst case, the stock is worth zero. The company will have about $2.3 billion in liquidity after it merges into the SPAC. Last year, WeWork burned $2.3 billion in cash. In 2019, it burned $3.9 billion.

If demand bounces back slower than WeWork expects because of a glut of office space, current enterprise tenants not renewing leases, or worker post-pandemic wariness of working in close quarters with strangers, the company could be wiped out. 

And stepping back to the 30,000-foot level... This is a company that leases long then re-rents short. And the leases that it signed... When did it sign them? Right before office rental rates collapsed, as much as 20% in some markets. Costs are locked in high. Revenue will likely float with overall market conditions.

Sure, $9 billion may be cheaper than $47 billion... But WeWork is no bargain. Stay away!

Finally, a quick programming note...

I'm taking a much-needed mini vacation beginning tomorrow. Look for guest essays the rest of the week, and I'll be back writing on Monday.

In the mailbag, readers react to the piece on the 'Four Horseman' of the bull market, and a reader catches something I missed... 

Has anyone worked in a WeWork space... And if so, how did you like it? If your employer offered to get you a co-working space instead of coming to the office, would you want it? Or would you just prefer to work from home in that scenario? Has the COVID-19 experience changed your appetite for co-working? Share your thoughts in an e-mail to [email protected].

► "Very odd. Enrique recommended an NFT on Wednesday." – Gary F.

Berna comment: Not as odd as you would think, Gary! While Enrique, Whitney, and I agree on many things, we don't agree on everything. Diverse opinions are healthy for our subscribers. 

Enrique is indeed bulled up on NFTs, whereas I'm more cautious on them right now. 

Enrique authors the Empire SPAC Investor newsletter on his own, with his team of analysts. Whitney and I don't influence his picks at all for that product. There are other products, like the Empire Investment Report, that we work on together and where we come to consensus on ideas. 

► "GameStop (GME) is a meme stonk, sure, but it's also going to be a huge short and gamma squeeze; shorts have mostly not covered and there are 100s of millions of synthetic shares out there. At some point shorts will have to cover and/or be margin called and then it will 'go to the moon' as they say on Wall Street Bets" – Jeffrey S.

► "Started with $300. When the price of bitcoin goes up $3000, I sell $100. When it goes down $3000 after a buy or sell, I buy $200. At the current time I have none of my money in the game and my account stands at $700. My total investment in the market is $15,000 and I have of done all of this in less than 5 months. I call that a killing." – Dave R.

► "Hi Berna, I like your emails and am a lifetime subscriber to Empire. Best money I've spent this year! I never thought I'd be an apologist for Walmart (WMT), but I'm writing to correct something in your last email: their minimum pay is $11 per hour. Still meaningfully below Amazon, but 50% higher than the federal minimum." – Nicholas C. 

Berna comment: Nicholas, you are 100% right. I had forgotten that Walmart raised its minimum wage to $11 per hour in the wake of the corporate tax rate cut in 2017. Before that, its minimum wage was $9 per hour – still above federal minimum wage. Good catch!

In mid-March, Walmart raised wages again, such that the average pay for hourly workers should exceed $15.25. The bump was to digital fulfillment workers, who will all be paid at least $13 per hour to start, and most will make between $15 and $19. These workers tend to be on the East and West Coasts in higher-cost areas. Walmart is raising the wage to stay competitive with its peers.


Berna Barshay
April 20, 2021