Why WeWork Is the Most Ridiculous IPO of 2019

WeWork – now rebranded as The We Company (WE) – filed its initial S-1 on August 14, and the company reportedly plans to go public in September. There isn’t official pricing information, but the company’s most recent funding round – a $2 billion investment from SoftBank in January – valued the co-working company at $47 billion. At this valuation, WeWork would be the 2nd largest IPO of 2019, trailing only Uber (UBER)…

WeWork might not be the largest IPO of 2019, but it is easily the most ridiculous, and the most dangerous. At least, Uber and other recent big-money IPO’s offered some legitimate innovation in their business models even if their valuations were far too high. WeWork has copied an old business model, i.e. office leasing, slapped some tech lingo on it, and suckered venture capital investors into valuing the firm at more than 10x its nearest competitor. The company also burns tons of cash, carries huge risk factors in a recession, and sports some of the worst corporate governance practices I’ve ever seen. WeWork (WE) is in the Danger Zone.

No Innovation in the Business Model – Just More Risk

WeWork was founded in 2010 in the SoHo district of New York City to provide co-working space, primarily for freelancers and small startups. In the nine years since its founding, the company has grown rapidly and consists of 528 locations in 111 cities and 29 countries.

While WeWork is growing rapidly, the service it offers is not new. The Belgian company IWG, which operates under the brand name Regus and a variety of other, smaller brands, utilizes the same business model of leasing office space, refurbishing it, and sub-leasing it under shorter terms to tenants.

IWG has more square feet of office space than WeWork, earns more revenue, and actually earns a profit. However, IWG has a market cap of just $3.7 billion, less than 10% of WeWork’s most recent valuation. The primary difference between the two is that WeWork describes its business model in the faux-tech lingo of “space-as-a-service” and its mission as “elevating the world’s consciousness.”

Figure 1: WeWork vs. IWG – Which Would you Buy

* Market cap for WE estimated using valuation in latest funding round

Another difference is that WeWork operates with a much higher degree of risk by taking on significantly more operating lease commitments with longer terms and more geographic concentration.

WeWork has ~20% less usable square feet of office space than IWG, but almost five times as many operating lease obligations at the end of 2018. Two main factors account for WeWork’s massive amount of operating lease obligations compared to IWG:

  1. Geographic Concentration: IWG’s locations are spread across over 1,000 cities all over the world. WeWork, on the other hand, operates in just 111 cities, and its S-1 reveals that the majority of its revenue comes from New York (where it is the largest office tenant in the city), San Francisco, Los Angeles, Seattle, Washington D.C., Boston, and London. WeWork’s concentration in high-priced cities means it pays significantly more per square foot than IWG.
  2. Longer Lease Terms: WeWork’s average lease term is 15 years. As Figure 2 shows, 71% ($24.1 billion) of its operating lease obligations are due in 2024 and beyond. IWG does not disclose its average lease term, but just 37% of its lease obligations ($2.5 billion) are due in 2024 or later. Taking on longer leases allows WeWork to get cheaper annual rents and offer premium office space at competitive prices. However, this long duration raises the risk that, during a downturn, WeWork will be locked into expensive leases and unable to able to find sub-tenants to cover its rental expense.

Figure 2: WeWork vs. IWG Business Model Carries More Risk and Leverage

* Market cap for WE estimated using valuation in latest funding round

Making matters worse, the company currently uses an extremely high discount rate of 8.2% to calculate the present value of its operating leases on its balance sheet. This high discount rate allows the company to understate this liability, and it signals that the company faces a significant risk of default in a recession.

For comparison, IWG uses a discount rate of just 3.7%. The difference between the two company’s discount rates shows how aggressively WeWork has taken on extra risk to fuel its rapid growth.

Massive Recession Risk

WeWork’s business, essentially, aims to capture the spread between long-term and short-term rental costs. Landlords want stability and guaranteed cash flows, so they’re willing to lease office space at lower rates if a tenant is willing to make a long-term commitment, as WeWork does. Companies, on the other hand, want the flexibility of short-term leases that allow them to quickly grow, shrink, or move their office space in response to personnel needs. As a result, they’re willing to pay higher rents for this flexibility.

WeWork adds value to its office spaces in other ways – through renovations, technological support, and enhanced amenities – but the spread between long-term and short-term rents is at the core of its business model.

However, this model only works during times of economic expansion. When the economy enters a recession, companies lay off workers and reduce their office space. In this situation, short-term rents can decline to the point where they no longer cover the long-term rental expense.

IWG has managed to survive this recession risk by not locking itself into extremely long leases, diversifying its business geographically, and inserting provisions into many of its leases that allow for early termination, reduced rates, or other loss-minimizing provisions in the case of a downturn. WeWork, on the other hand…

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