WeWork (or the We Company), the biggest co-working space company in the world, was last valued at $47bn. In comparison, the company is set to generate revenue of "meager" $3bn in 2019, with operating losses nearing -$3bn for the year. Can such a lofty valuation be justified by this type of financial metrics? To explore this question, we analysed its IPO filings as well as its business model, both of which bear a striking resemblance to a truly great business, Amazon. But, some context is required to truly appreciate the strange situation interested investors may find themselves in regards to WeWork's IPO prospects.
Some Characteristics of a Great Business
WeWork indeed has built a business with some great characteristics like economies of scale and brand habit. For example, having a large scale could allow it to acquire leases more cheaply by being able to lease multiple floors, or even the entire building, more easily than the competition. Having more buildings and workspace options available in a given city also makes it more valuable to tenants who may have to keep moving as they grow. Scale also allows the company to acquire new tenants more efficiently than its peers by building a huge brand name while spreading out its marketing cost over a larger base. While the business model itself doesn't exhibit a hard lock-in effect that prevents its customers from leaving, its net customer retention rate of 119% indicates a decently high level of stickiness in its customer base. All of these are tell-tale signs of "flywheel effect" that is prominent in most great businesses.
Examples of Flywheel Effect
But Low Margin Requires Immense Scale, Like Amazon
However, the We Company's filing clearly shows that it is a low margin business that requires an immense scale to be profitable. One of the most famous examples of this business model is perhaps Amazon. As Amazon competed by offering low prices and terrific customer service, investors questioned whether the e-commerce giant could ever become profitable. In fact, Amazon's revenue had to grow by almost 2,600% from $148mn in 1997 to $3.9bn in 2002 before it produced its first operating profit margin of 1.6%.
The problem with WeWork is that the company is already quite large, but still massively unprofitable. As we mentioned earlier, its revenue is already set to exceed $3bn this year in 2019 with around a -90% operating profit margin; even Amazon was close to breakeven at this size. Even if the company were to achieve its long-term target of 30% contribution margin (excluding non-cash GAAP straight-line lease cost), all of its other expenses like sales & marketing and general & administrative costs are so large that they still account for over 100% of its revenue. In fact, the company may have to grow its business by 10-20x before it starts to generate some profit as Amazon has done in the past.
Tricky Addressable Market
Then, how quickly can WeWork grow into a $30-60bn revenue business? To put this into perspective, Amazon took almost a decade to grow its revenue from $3bn to a $30bn, with a business model and customer market that is arguably easier to scale than WeWork's. Not only that, WeWork's addressable market, i.e. commercial real estate, is a very sticky and fragmented market filled with long-term leases and an eclectic mix of customer demands; not every company can or wants to host their office inside of a WeWork. For example, a stable small-to-medium business could find it to be more costly to move out of its current location and into a co-sharing space.
WeWork's penetration in New York, its oldest market, is still just at 1.2% despite already having 62 buildings. While one way to look at this may be that WeWork still has a lot of room to grow, another (perhaps more accurate) way to look at the same thing is that WeWork's addressable market may be smaller and more difficult for the company to penetrate than some give it credit for. Could WeWork really account for 5-10% of all office space in a given city, and how long will it take for the company to get there?
WeWork's Market Penetration by City
Is $47bn the Right Number Right Now? What Does Softbank's Existence Mean for Investors?
While WeWork has some potential to grow into such a scale over the long run, its current valuation of $47bn implies that the market is practically certain that WeWork will achieve such size in the foreseeable future, which seems quite premature and highly speculative. In fact, WeWork's Enterprise Value including its debt obligations and preferred shares is over $70bn, representing a 20x its 2019 revenue, which rivals valuations of some of the hottest software companies like Slack and Zoom that possess entirely different (i.e. superior) profit structures. To even come close to justifying this valuation, WeWork needs to scale smoothly and quickly in the face of numerous factors that are still extremely uncertain and could go wrong. Competition from smaller and regional players could hit up, making it more difficult for WeWork to have pricing power on its tenants or landlords. The global economy could have a downturn. Its addressable market could be smaller than expected due to the fact that not all jobs and companies seek out an environment like a high-end co-sharing space. The company may even run out of money, which means it will require numerous rounds of additional financing that could significantly dilute its shareholders.
It's worth briefly discussing Softbank on this last point. That WeWork has the support of Softbank's seemingly limitless funding is definitely going to be a huge advantage for the company as it keeps growing while suffering losses. However, this also means that WeWork could be heavily reliant on Softbank without much leverage; there aren't that many entities in the world that can write a check in billions for a single investment. Without a strong negotiating position, the rest of WeWork's investors who buy the stock previously could face heavy dilution in the future if and when the company needs to raise additional capital to keep the party going.