WeWork's IPO Tanks: The Market Is Far From Euphoria

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About: The We Company (WE), Includes: QQQ, SPY, UBER
by: Ian Bezek
Summary

WeWork has faced increasing media scrutiny and dimming valuation prospects recently.

On Monday, reports surfaced that backer SoftBank wants the IPO shelved.

Tech and momentum shares got slammed Monday as investors digested the news.

Make no mistake; WeWork's failure is a healthy sign for overall market conditions, not a harbinger of doom.

It's been a rough month for the co-working (shared office space) company WeWork aka The We Company (WE). The company has seen its valuation plummet. The updated valuation is now said to be at most $20 billion with rumors of even lower figures. There's claims that SoftBank wants the IPO stopped so that it doesn't suffer embarrassing losses in its funds:

In any case, it's a big disappointment for WeWork, which was supposed to IPO at as much as a $60 billion valuation.

It probably shouldn't come as a surprise, however. The media has absolutely savaged the proposed IPO, with everyone piling on since the company filed its IPO prospectus. To be fair, the company gave analysts plenty of reasons to mock them, starting with this bit from the opening page:

Source: We S-1 filing

WeWork's CEO has drawn plenty of criticism for not being a credible leader and this sort of commentary in their prospectus helps you understand why folks are nervous.

Anyway, here at Seeking Alpha, even before the company starts trading, folks are lining up to label this one of the year's worst IPOs - in fact every author recently is coming in "very bearish" on the company:

The bear case on WeWork is so widely accepted that I actually had to do some digging to find people bullish on the company. Again, remember we're talking about a $20 billion company (and one that theoretically was worth $50bn+ recently) and hardly anyone is defending it in public. You have companies that have clear operational issues and questionable CEO decision-making - like Tesla (NASDAQ:TSLA) - that still have no shortage of backers. Yet WeWork is almost universally panned.

The Bull Case For WeWork

To be clear, I'm not bullish on WeWork. At minimum, the company would need a more trustworthy CEO before I would ever consider investing. Adam Neumann tried to charge his company $5.9 million to use the name "We" along with hiring family members to key roles and giving himself low-interest loans. There's bad optics there. That said, it's worth taking a look at the potential upside in the business for a second. A business with $4 billion in committed revenue backlog and a huge growth rate is worth at least a brief look - I'm not convinced the business model is as bad as some folks are saying.

The bull case I'm presenting below is based on commentary from Sandy Kory - of Horizon Partners - who defended the firm on Bloomberg's Odd Lots podcast. Bloomberg's hosts were quite skeptical of WeWork as well, and they didn't let Kory off with easy questions.

For example, they asked about WeWork's invented accounting metrics, including things such as its "community-adjusted EBITDA". Kory defended this, comparing new accounting metrics today to the cable industry in the 1970s. Remember that John Malone, the cable industry legend, created EBITDA and was broadly scolded back in the day. Noted investors, including Warren Buffett, have bashed EBITDA for being a misleading look at a company's well-being. Regardless, Malone's company became extraordinarily successful despite looking poor on traditional accounting metrics during much of its rise. Amazon (AMZN), as well, intentionally ignored accounting earnings as it took over retail, and value investors that decried the company for not earning money missed the ride.

Do I give WeWork a pass for making up a seemingly silly metric like community-adjusted EBITDA? No, I don't. The things it excludes from this EBITDA calculation, such as rent, make up the largest category of its expenses. Once you subtract enough stuff from your earnings, it's barely different from your revenues. That said, WeWork has a nice argument based on revenues - nearly four billion in revenues growing at a massive rate. That's far more than you can say for most of the late 1990s dot com companies.

Also, we don't know if the company is inherently as unprofitable as it appears to be. Remember that WeWork is still in hyper-growth right now, opening new properties and markets left and right. Its older established facilities and markets, such as San Francisco, are probably profitable or at least close to it. The public markets have no problem with companies that have a profitable core business while losing money on new locations/product lines/markets. If WeWork is losing gobs of money even in its oldest markets, that'd be a major problem. But, as far as we know, the core business model isn't inherently hugely loss-making.

There's also the mismatched liabilities versus income. The bears love this point, but I think they overstate their case. In brief, WeWork rents buildings from landlords for long terms, think 15 or 20 years. In turn, it re-rents these spaces out to workers on a monthly basis. This exposes WeWork to a great deal of risk in a recession, where it is stuck with long-term leases while its clients go bust or rental rates decline sharply.

But, things could go right. The world's Central Banks are trying to drive up asset prices, and if they succeed, it should lift rents as well. This would be great news for WeWork. Remember that they have their locations locked up for many years at fixed prices. Meanwhile, they can raise prices on their tenants every few months or year. Hotels have great economics during inflationary periods because they can raise prices quickly - WeWork would have a similar salutary leveraged effect during a rising inflation/asset price market.

Remember that companies have built their entire success on duration mismatch. Think ESPN agreeing to pay huge fixed prices for sports broadcast contracts, betting that advertising rates would go up enough over the years to justify the upfront expense. ESPN would have lost a fortune if they'd bet wrong or a big economic downturn hit. But things turned out well and it turned ESPN into a cash cow (until recently, at least). Bears are focused on what happens if a recession hits, downplaying the real possibility that WeWork could make a killing if rents rise sharply while their real estate costs are fixed.

Also, it's unclear how much of WeWork's business would disappear in a recession. It could be a disaster, particularly if many small tech/freelancing sorts of businesses go under. On the other hand, WeWork has already been operating in Sao Paulo. Brazil had its worst recession in its economic history a couple of years ago and yet coworking spaces performed relatively well during that. As such, while we don't have enough data to judge yet, it's presumptive to assume their clients will all disappear in a recession. The flexibility of short-term leases might actually bring in more tenants who don't want to commit to a long-term arrangement when the economy is in a slump.

If This Were A Bull Market Top, People Would Be Loving WeWork

Again, I'm not going to invest in WeWork anytime soon. Their CEO alone is enough to dissuade me. But it's a sign that markets are far from frothy when WeWork's deal is going so badly (despite Goldman underwriting it) that it may get canceled altogether. Other Softbank-backed giants including Uber (UBER) and Alibaba (BABA) IPOed successfully despite various accounting concerns. As I demonstrated, you can make a decent case for WeWork eventually succeeding, particularly if they got more capable leadership to run the company. Yet the market is so negative that the company may not even be able to sell stock at any reasonable price.

Speaking of Uber, it - and many other recent IPOs, are struggling. It's been a terrible summer for the recent crop of tech offerings, in fact:

Chart Data by YCharts

The people predicting an imminent market crash due to low-quality tech companies IPOing either have short memories or weren't around in 1999. Then, you had companies with no revenues and no coherent business plan besides amassing "eyeballs" going up 500% in days after they IPOed.

Now, by contrast, you have very real - if money-losing - operations like Uber and Slack getting absolutely pounded by the public markets. Highly valuable consumer platforms like Spotify (SPOT) attract little investor interest despite supplanting the traditional music industry. And now, even in SaaS - formerly the market's hottest sector, things are starting to show some real strain:

Chart Data by YCharts

This looks nothing like late 1999 or early 2000, when ordinary folks were frothing at the mouth to buy low-quality stocks. Instead, it looks more like portions of 1996 and 1998, when the IPO window generally closed and people running small tech companies feared that they'd be unable to offer their stock to the general public before the moment passed.

People are now proclaiming that WeWork's failure is a sign of trouble ahead. But it's when the market is booming and people lose touch with reality that markets can crash. WeWork's failure is an indicator that markets are still rational and operating efficiently at the moment.

With the Fed now easing aggressively again, expect more irrationality and higher prices over the next 12-24 months - I'm staying long stocks - but we aren't there yet. If you remember 1999, you know how sedate things are in 2019 by contrast. We'll see much more vigorous optimism before the market tops.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.