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?

GameStop releases 2nd quarter earnings (GameStop)

I've been following brick and mortar retail's demise for years now and $GME is an excellent case study for value investors. Buffett once bought a shoe retailer for what he believed to be a wonderful multiple, but it turned out to be an absolute dog based on the inherent difficulties and competitiveness of the brick and mortar retail industry. Fast forward to the internet era, where everything can be bought and sold online, and it isn't hard to see how a company which produced hundreds of millions in consistent free cash flow by selling physical games is now barely treading water.

I wanted desperately to buy stock in this beaten down retailer a year or two ago based on then-current multiples but couldn't get comfortable with the disruption occurring in brick and mortar retail. While it is currently trading at less than the cash on its balance sheet (!), I am uncertain of the prospects of GME as a going concern, and we've seen how it worked out for other investors who bought into value traps for the assets on the balance sheet. Interestingly, Dr. Michael Burry, the investor known for his 2008 housing short, recently bought a large block and wrote a letter to the board encouraging them to buy back even more shares. I'm unconvinced that this will solve their long term structural problems.

WRITTEN WORD

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

The iPhone and Apple's service strategy (Stratechery)

Flying taxi maker lands $50M as the battle for the skies takes off (PitchBook)

The global landscape of online program companies (Inside Higher Ed)

California passes law reclassifying 'gig workers' as employees, threatening Uber's business model (Vox)

Leon Cooperman calls private equity a scam fueled by low interest rates (Bloomberg)

Great tweet storm on momentum vs. value investing and the shift that occurred this past week in markets (Robin Wigglesworth)

Duty, democracy, and the threat of tribalism (General Jim Mattis, WSJ Op-Ed)

Meet the HyperLoop's deepest devotees (Jalopnik)

SPOKEN WORD

TOP LISTEN: How to build your company to last with Exor's John Elkann (Masters of Scale)

A conversation with Marty Fridson, the Dean of high yield (Grant's Current Yield Podcast)

Jocko Willink and the way of the violent intellectual w/ Eric Weinstein (The Portal)

Joe Rogan and Nick Bostrom on artificial intelligence (Joe Rogan Experience)

Deep Basin Capital on earning alpha in the energy sector (Invest like the Best)

Mark & Tamiel Kenney's multifamily syndication journey from 15 units to over 5,000 (BiggerPockets)