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Circle of Competence Issue #77

QUOTE OF THE WEEK

"Creating long term liabilities and short term assets... every other time in history when they create this, the results are predictable. Why is this time any different?" - Sam Zell, on WeWork IPO

FOOD FOR THOUGHT

Runaway story or meltdown in motion? The unraveling of the WeWork IPO (Aswath Damodaran)

Sam Zell weighs in on WeWork's business model (CNBC)

WeWork's new potential valuation could be as low as $20B in an IPO, a much lower valuation than its latest valuation in the private markets. All of the concerns I raised a month ago have been validated now that the rubber is meeting the road in the pre-IPO process:

I simply can't understand the massive multi-billion dollar valuation (on-paper) assigned to what is essentially a real estate leasing company that *used* to be capital-light when it was *only* subleasing office buildings on a short term basis but then *pivoted* into actually *owning* the buildings. Isn't it morphing into an actual real estate company? They trade for far lower multiples than WeWork. Community adjusted EBITDA? Hmm. The CEO owns buildings that are being leased back to the company? Fishy. The CEO is cashing out almost three quarters of a billion dollars prior to the IPO? Huge red flag. Competitors are beginning to emerge in other markets? The bells are tolling.

I found the above interview with Sam Zell fascinating, especially given that he invested in a similar business model in 1956 and was burned. The two largest risks to WeWork's business are leverage and a mismatch in assets and liabilities. Their financials involves leverage upon leverage: the first level of leverage is leasing long term assets and the second level of leverage is the debt applied to the business model. The key financial piece to understand here is that they are matching long term liabilities (leases) with short term assets (subleasing space). Their entire business model is predicated on the thesis that they can gather significantly higher rents per square foot than what they pay to the landlords per square foot, collecting a spread based on the higher short term rent potential. But as Zell points out, they are the marginal player in this space, and marginal players get walloped in the bad times. One has to wonder, if they aren’t profitable in one of the strongest economic periods globally in the last 10 years, what will be the catalyst for their success going forward?