WeWork and the Voodoo Economics of Silicon Valley

Almost every day in my email inbox arrive offering memoranda for new high yield bond issues. Mostly, these come from investment banks that are seeking to arrange financing for a public company or a private equity firm trying to finance a leveraged buyout. Yesterday, something unusual caught my eye. An offering memorandum arrived for a bond issue by WeWork, the operator of fashionable co-working spaces in major cities. The company is hoping to borrow $500m for seven years. The company was founded in 2010 by Adam Neumann in New York and has since expanded to 73 cities. The business model involves the company itself leasing properties in popular commercial locations on a long-term basis and then sub-leasing these on a short-term flexible basis to individuals and small businesses.

This is not a particularly innovative business model: there are already at least two companies doing this that are listed on the London Stock Exchange (Workspace Group plc and IWG plc). Despite this apparent lack of innovation, WeWork has attracted leading Silicon Valley venture capital firms as investors (eg Benchmark) and media reports suggest that the company was valued at $20bn at the time of its last funding round in March 2017.

In its own words, WeWork writes: “We see ourselves as a leader in flexible workspaces as the first company to program real estate and the first global lifestyle brand centered around working and living.” This has certainly led to rapid growth: in 2017 revenue increased ~100% from 2016. Perhaps a co-working lifestyle brand has truly inspired people? Or maybe the company is simply providing its services below cost? A business model of selling £20 notes for £15 would probably also generate rapid revenue growth. A quick review of the financials suggests this is exactly the business model. In 2017 the company earned $886m of revenue. However, “community operating expense” ie. the costs required to operate an open member community location on a day-to-day basis was $814m. This leaves a gross profit of $72m. You’ll have already spotted that $72m is quite a small gross profit for a company that is valued at $20bn. But wait, there are lots of other costs of running a business. These include: the cost of attracting and retaining customers (sales & marketing cost), on which the company spent $143m in 2017; the cost of running the WeWork headquarters and management team (general & administrative cost), on which the company spent $183m in 2017. WeWork also spent a further $131m on pre-opening expenses, $110m on “growth and new market development”, and an additional $295m to compensate its staff by issuing equity.

I don’t need to add these numbers up to show that we’re now quite significantly into negative territory. But wait. WeWork isn’t just growing quickly by leasing office space to customers at loss-making rates, it is first spending heavily to improve those leased buildings in order to help attract those customers. In 2017 the company spent just over $1bn on property and equipment, almost all of which is classified as “leasehold improvements”. In a nutshell, the company spends money to improve properties it doesn’t own, which it then leases to tenants at a loss.

As high yield bond investors, we can clearly identify two different tribes within the broad universe of Silicon Valley darlings: ‘Cash Machines’ and ‘Cash Incinerators’. The first tribe, ‘Cash Machines’, is composed of those companies operating with cutting edge technologies, primarily in the digital world, that have created brand new markets for their products and services. They are growing rapidly, but also generating more cash than they can possibly reinvest. This group includes Apple, Google/Alphabet, and Facebook[1]. Those that have borrowed – Apple and Google – have high quality investment grade credit ratings. Apple is rated Aa1 by Moody’s and Google is rated Aa2.

The second tribe, ‘Cash Incinerators’, is composed of businesses that are trying to apply technology to industries that already exist in the physical world. They too are growing rapidly, but to compete against incumbents they are required to deploy enormous amounts of capital, far in excess of what they can generate internally. This tribe includes Netflix and Tesla, both of which borrow in the high yield bond market in order to finance their cash-burning business models. Netflix is rated Ba3 by Moody’s and Tesla Caa1. A brief review of WeWork’s financials leads us to conclude it is most likely a member of the ‘Cash Incinerator’ tribe. The Voodoo Economics will only work as long as there are speculators willing to fund these losses. This will unlikely be for an indefinite period.

 

[1] You’ll note I’ve not included amazon.com. amazon.com is almost unique in having spent almost exactly its internal cash flow generation on new investments. In recent years the company has become cash generative as Amazon Web Services has grown.

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Netflix has no time to chill

On this week exactly a year ago, our co-Head of Fixed Income Adrian Hull wrote about Netflix’s debut issuance (Netflix launches Billions) into the euro bond market, when it printed €1bn of 10-year maturity bonds. One year on and Netflix has just priced its first issuance of 2018, this time in US dollars. Having initially targeted raising $1.5bn through senior bond issuance, the company ended up printing almost $2bn. Pricing at 5.875% for a 10.5 year maturity, this bullet bond proved to be another successful bond issue for Netflix. So what has changed for the business in the last year?

Netflix continues to surpass expectations for subscriber and EBITDA (earnings before interest, taxes, depreciation and amortization) growth. Both US and overseas segments saw net additions to subscribers well above company expectations. On top of this, Netflix successfully passed through its planned subscription price increase without significant churn in either its US or overseas base. Last year, US profits meaningfully supported overseas expansion; one year on, international improvements are offsetting margin declines in the US market.

The proceeds for the new bond have been earmarked for ‘general corporate purposes’, which is likely to mean a significant portion will be used to fund Netflix’s anticipated $3-4bn cash flow burn in 2018. We think Netflix will have to keep tapping the debt market in the near term as it burns through its cash pile in its quest to create new content.

On that basis we’re not taking a “Daredevil” approach to this bond issue, and will instead continue to focus our efforts on finding companies with secure and stable cash flows, and of course sustainable returns for our clients.

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