Is WeWork Fixable?

Over the past year, WeWork has experienced roller-coaster-like valuations, messy legal battles, and executive turnover like no company ever before. It became a household name for attempting to scale its coworking platform globally before its well-documented rise and fall. This piece is a follow up to our original piece detailing the factors that led to WeWork’s rise and fall. I teamed up with Neil O’Donnell along with the Capital Technologies Quant team to explore how the market currently is discounting its future prospects (through curent bond issue pricing) and what it will ultimately take to turn the business around. For those less familiar with the back story, let’s explore a few pertinent details before diving into the business model and our recommendations for turning the business around.

WeWork – The Back Story

- In 2010, Adam Neumann and Miguel McKelvey started WeWork after Neumann departed from his baby-clothing startup, Krawlers (now known as Egg Baby).

- In 2017, WeWork’s valuation rose to $17 billion after SoftBank invested $300 million in the firm.

- In early 2019, the company was valued at over $47 billion after a follow-on investment led by Softbank. Its initial public offering (IPO) was among the most highly anticipated of all the unicorns minted over the decade. In the second half of 2019, however, WeWork began to stumble as investors began to take a closer look. In April 2019, WeWork confidentially filed to go public with the SEC and began preparing its Form S-1 to complete an IPO. In August 2019, The We Company (WeWork’s corporate parent) filed the S-1 to go public. The disclosures in the S-1 revealed that the company had huge, growing losses.

- In the third quarter of 2019, WeWork lost $1.25 billion on just $934 million in revenue and its occupancy dipped to 79%. While these losses were to some extent anticipated, the disclosures also raised several questions regarding the entity’s corporate governance and finances. WeWork had paid Neumann more than $5.9M in preferred stock after Neumann incorporated the “We” trademark and transferred it to the company. In addition to this inside dealing, Neumann also owned several properties that were leased back to WeWork.

- Overall, the financial statements disclosed in the S-1 were opaque. WeWork did not report its company-wide cost of revenue expenses and relied on several non-GAAP metrics to present its financial results in a more favorable light. As the Wall Street Journal noted these financial statements initially contained very significant inaccuracies:

“[h]ow many new workstations did We deliver in the first half of the year? The prospectus filed in August said 273,000. Barely a month later, an amended version said 106,000. What was the total gross cost? In August We said $1.3 billion. In September: $800 million.”

- In September 2019, as a result of the increasingly negative investor sentiment, WeWork elected to postpone until the end of 2019.

- At the end of September 2019, Adam Neumann was ousted as the company’s CEO, and he surrendered his voting control of the company. As WeWork began to encounter liquidity issues, it shelved its plans to go public indefinitely and withdrew its S-1 filing.

- In October 2019, SoftBank extended $5 billion in debt financing to keep WeWork afloat and maintain sufficient liquidity to operate. In addition to the debt financing, SoftBank also proposed to accelerate the conversion of $1.5 billion of warrants that were scheduled to convert to equity in April 2020.

- In April 2020, however, SoftBank balked at the purchase of WeWork’s stock from its employees and other shareholders for $3 billion. As grounds for refusing to consummate the transaction, SoftBank cited criminal and civil probes into WeWork, the company’s failure to restructure a joint venture in China, its failure to meet closing conditions under the stock purchase agreement and the impact of the pandemic as a material adverse cause under the agreement.

- In February 2020, Sandeep Mathrani was selected as the new CEO of WeWork. Mathrani is a real estate veteran who previously helped to turn around General Growth Properties as its CEO as the company exited from Chapter 11 bankruptcy until it was purchased by Brookfield Property in 2018. Mathrani has stated that WeWork will continue opening new locations, but at a much slower pace, and continued spinning off, selling and closing unprofitable, non-core divisions of the company (which had commenced based on pressure from SoftBank after Neumann’s departure).

- In August 2020, WeWork reported a $1.1B infusion from Softbank and ended Q2 with $4.1B in cash on hand.

WeWork – The Yield Curve Arbitrage Business Model

We wrote extensively about the real estate industry’s inverted yield curve and WeWork’s business model in our previous piece, but will repeat a small section here to help set the stage for our recommendations in the ‘turnaround section’ below:

“The yield curve for real estate assets is naturally inverted. Short-term leases provide higher monthly rents than those of long-term leases because they are preferred by renters and disfavored by property owners. Short-term leases provide greater optionality as renters have the discretion to find a new property at the end of the lease term. Conversely, property owners need to negotiate new leases and must risk their property sitting vacant at the end of the lease. As a result, a property with a longer leasehold interest has a more dependable rent role which is more valuable and can accommodate greater leverage…

WeWork’s business model represents the flipside of the yield curve arbitrage model tailormade to profit from the inverted yield curve inherent to the real estate industry... From its beginning, WeWork relied on long term leases (typically 10 years) while permitting everyone from entrepreneurs to small businesses to big corporations to rent month-to-month at a higher per square foot monthly rate. This inverted YCA model harvests the optionality premium by deriving profit from the spread between higher-rate, short-term leases and lower-rate, long-term leases much like SIVs harvested the liquidity premium by investing in higher-rate, long-term loans.”

WeWork – The Turnaround

In our exploration of what is required for WeWork to turn its business around, we relied on fundamental data from the S-1 to explore what levers can be pulled to achieve enterprise sustainability as well as the market prices of certain WeWork bonds in comparison to several other publicly traded REITs to gauge markets’ sentiment on WeWork’s future prospects (which can be quite circumstantial and myopic from both a macro and microeconomic standpoint).

At a high level, WeWork’s business centers around four things:

1) Identify markets and locations within those markets to lease (new market growth)

2) Lease office space from landlords (leverage in the form of a right-to-use asset and corresponding lease liability) or purchase office properties (using a combination of debt and equity)

3) Build out the space for its members (capital expenditures)

4) Operate the space (market the space, operate its membership platform, and G&A)

As you can see below, WeWork’s astounding growth was funded in large part by its profligate spending on leasing, marketing, and opening new spaces. There is little doubt that the explosive growth of WeWork’s coworking model also revealed the demand of both individual entrepreneurs as well as enterprises for more flexibility around their workspace arrangements. WeWork reported 612,000 members at the end of Q2 in 2020, 48% of which were ‘enterprise’ customers with over 500 employees. Given the strong demand for coworking arrangements combined with the inherent leverage in the coworking model (long-term liabilities matched with short-term assets), we propose that the problem with WeWork’s business does not stem from its business model, but rather from its inappropriate capital allocation.

A business’s value is determined by its discounted future cash flows, and the best way to gauge this is by digging into the cash flows from operations and capital expenditures. We can see from WeWork’s statement of cash flows in the S-1 that their high marketing and new development expenses (negative operating cash flows) and the expansive capital expenditures (investing activities) all added up to significant negative cash flows which required constant infusions of new financing in the form of debt and equity (cash provided by financing activities).

WeWork may have largely ignored its cash burn until the filing of its S-1 because of its reliance on easy private funding and use of uncommon profitability metrics such as “community-adjusted EBITDA.” This metric, for example, added back not only interest taxes, depreciation and amortization but also marketing and development costs. The use of this metric was meant to persuade investors that the upfront costs fueling its growth would not impact the company’s ability to generate cash over the long term.

The largest part of WeWork’s capital expenditures are tenant space buildouts. Tenant improvement capex spending represented ~$1.3B in 2018 and was on pace for over $1.6B in 2019.

The main lever in the operating side of the business that we recommend pulling is simply to slow the pace of new location openings and close locations with little prospect of profitability. This will have two main effects on the company’s cash flows:

1) Decrease pre-opening, new market growth, and marketing expenses (operating cash flows)

2) Decrease tenant improvement capital expenditures (investing cash flows)

The effect of this strategy shift would allow WeWork to pull back on capex, and drive operating cashflows higher through expense reduction (or at least less negative), resulting in a lower cash burn rate and thus a longer runway for the business. If the coworking model is indeed sustainable at the individual property level (publicly traded IWG has proven this model can be sustainable), then slowing or pausing new location openings will go far in reducing the cash burn rate and allowing current operating locations to lease up to a higher, more profitable level of occupancy (~89% according to the S-1).

But what does the bond market think of WeWork’s prospects? The picture is bleak both for WE as well as some of the more traditional retail REITs. The Covid-lead economic slowdown forced a substantial increase in remote-work and dealt a body blow to co-working space as layoffs skyrocketed and companies cut back on expenses. WeWork's bonds currently trade at about 70 cents on the dollar, double their lows in March, thanks to SoftBank’s recently reaffirmed pledge to provide $1.1b in secured debt.

For comparison purposes, we gathered a sample of pricing for bond issuances that have similar maturities from retail (WPG, CBL), office (BXP, ARE), and hotel (HST, GLPI) real estate investment trusts to reflect the market’s differentiated views between sub-asset classes. WeWork doesn’t neatly fit into any of those categories, although its model of matching short term assets (member leases) to long term liabilities (leases and debt) is most similar to a hotel’s in the sense that hotels rent by the night and have fixed obligations (debts) for each property. Notably, HST and GLPI traded down by roughly 15% during the first few weeks of the pandemic lockdown as hotel revenues were down 70+% month over month, while WeWork’s 7.825% 2025 bonds traded to roughly 40 cents on the dollar! HST and GLPI’s issues have recovered significantly despite weak fundamental demand in the hospitality sector, while WeWork’s 2025 issue continues to languish. Indeed, WeWork’s bonds trade more in line with retail property groups Washington Prime Group and CBL than they do relative to office and hotel REITs. The similarity between WPG, CBL, and WE? At face value, it seems to be leverage prior to the pandemic.

Debt to Equity ratios for each REIT as of Q4 2019:

HST (Hotel) – 77% Debt to Equity

ARE (Office) – 85% Debt to Equity

BXP (Office) – 133% Debt to Equity

GLPI (Hotel & Casino) – 280% Debt to Equity

CBL (Retail) – 410% Debt to Equity

WPG (Retail) – 336% Debt to Equity

WeWork (CoWorking) – N/A (equity deficit at S-1)

While we were not able to extract any data about its nearest competitor, IWG plc, it is worth noting that IWG’s stock is down ~40% from its pre-covid high and was down as much as 65% when the pandemic first broke out on a global scale. Despite IWG’s multiple decades of experience in financing and operating coworking spaces, its business was also greatly affected due to covid-19. See its latest filing for more details.

The market's pricing of WeWork’s bonds indicates its view that (i) the company will not have sufficient cash flows to service its debts and (ii) leverage (including leverage through leases) needs to be trimmed by at least 30% from its current levels for the company to satisfy its debts. If the operational changes detailed above can be successfully implemented to extend the runway for the business and prove financial viability at a property level, we would strongly recommend a substantial equity raise in an equity for debt swap from SoftBank that is large enough to give the company a 20-30% equity cushion and right size the company's debt structure. This would be highly dilutive to current equity holders but would give the enterprise a fighting chance to survive the current pandemic-driven downturn. Fortunately, WeWork's primary equity holder SoftBank, has emerged relatively strongly from the covid-19 crisis as its technology bets have rebounded and it has restructured its business. As a result, the investment firm continues to take measures to support the company to protect its nearly $13B investment. Going forward, equity levels should equate to roughly 30-35% of the NPV of lease amounts to be paid plus long-term debt. This is in line with debt to equity ratios common among its traditional office and coworking competitors.

When we published our first piece on WeWork in late 2019, their cash on hand was roughly 10% of their long-term liabilities (leases and long-term debt) and their net equity balance was zero. As of Q1 2020, the company had $3.9B in cash remaining on the books and burned $500MM from Q4 2019 to Q1 2020, although cash burn was reduced by 60%. In the second quarter, company revenue dipped below the $1B mark to $882M due to Covid-19 impacts, and cash burn increased to $671M. Including SoftBank’s new $1.1B in debt financing, the company closed Q2 with $4.1B in cash. At a $500M/quarter cash burn clip, WeWork has only 8 quarters of runway to prove viability or raise more capital.

Ultimately, the survival of WeWork boils down to 1) demonstrating a path to profitability relatively quickly to extend the business’s runway and 2) raising capital in an equity for debt swap to shore up the balance sheet. In the short term, swapping equity for debt will dilute current shareholders, but lucky enough for WeWork, their largest shareholder is a technology conglomerate with extremely deep pockets and an ability to cope with losses in the short term. Survival is more than possible, but it will be painful. Time will tell how the saga plays out, but the main lesson remains timeless: leverage amplifies underlying business outcomes, both positive and negative.