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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Ball Tampering

Being the token Aussie within Kames multi-national bond team, I need not have feared a lack of commentary from my colleagues on the topic of the Australian Cricket team’s recent ball-tampering scandal. Regrettably, this format does not allow for a full examination of Scottish, Bulgarian, or even Spanish perspectives on the concept of fair-play or the deep traditions of the great game. Anyone wishing to read more about the scandal, I do commend you to have a look at the Aussie press, who are covering it with their renowned sense of understatement and proportion.

Anyway, looking to the future of the Australian team I encountered an alarming statistic; some 35% of all Australian test cricket runs since 2013 have been scored by Steve Smith and David Warner, the captain and vice-captain who have been side-lined for a year as a result of the scandal. Their absence will place a great deal of pressure on their replacements to be sure, but more pertinently, on the rest of the batting order who have often had their own performances bailed out by their erstwhile teammates. Time will tell, but you do not need to be a cricket tragic to realise this will prove a significant challenge.

In much the same way, global asset markets are facing a similar challenge. Our superstar players – The Fed, ECB, BoE, and BoJ – have all indicated that the glut of central bank liquidity, which has carried the global economy and asset prices along, may be coming to an end sooner rather than later, with the ‘sooner’ part coming into sharp relief on the back of improving economic data. Markets will have to learn to get along without the soothing realisation that evermore central bank support will be there to float all asset prices higher, much as the Aussie top order can’t rely on ‘Smithy’ to bail them out with yet another effortless century. Thank goodness. In my view, the reawakening of volatility in bond and equity markets we have seen in 2018 is the result of participants belatedly rediscovering asset valuation on factors other than central bank largess.

Part of our core view for 2018 had been for the return of dispersion as idiosyncratic risk came to the fore, as the beta-driven QE trade dissipated. The volatility should be seen for what it is – a process of adjustment rather than the beginning of the end. This environment demands a closer examination of business models, cash flow, and financial resilience for the companies you invest in. Assets with flimsy intrinsic valuation will find this being examined, often brutally (hello Tesla). For the rest of us, this volatility presents an opportunity to add to positions in those firms that set to benefit from what is, remember, an improving global growth story. In navigating this environment, we are convinced that selecting an active manager who has been consciously avoiding areas where we see QE-driven excess, and identifying the overlooked and more attractive parts of the high yield market is the right thing to do.

Failing that, I am sure I can find some sand-paper.

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Making Stuff is Hard

The most valuable lessons in high yield investing are usually delivered using a mix of shock, pain and humiliation. A rare exception to this occurred to me a few years ago; however I suspect more recently, similar lessons are visiting Tesla investors, albeit more painfully.

German company Heidelberger Druckmaschinen (HD) is a precision manufacturer of high quality printing presses. In late 2011 it hit a rocky patch where revenues were down, and the high yield market began to seriously worry about its imminent collapse. The timing was lousy. A European high yield market recovering from the Eurozone crisis was in no mood to tolerate any missteps by a CCC rated issuer, and its bonds were duly hammered.

However, taking a closer look, a few things stood out. For one, its lag was entirely predictable as historically orders ALWAYS dipped before the major industry showcase (‘drupa’) which was held every four years, and 2012 was the next one. In addition, there was a view that HD was at the wrong end of the terminal decline of newspapers (what with the internet n’ all), and to make matters worse, Chinese competition was about to take what was left. This nuanced assessment played well to the ‘gut-feel’ view of the world favoured by a certain type of investor. Except it was wrong. HD had actually disposed of its newsprint business many years prior, instead focussing on the growing need for high quality consumer packaging. Chinese threat? Sure, the lower end of the market had been subject to it, however they seemed to struggle to replicate the most advanced presses. Thematic investing is great, but it’s even better when accompanied by some due diligence.

So how does this relate to Tesla? Making ‘stuff’ is hard. The beta version and constant update model of the software industry works well, as their products can be costlessly tweaked after sale. Not unreasonably, software companies are given high valuations based on this high operating leverage. Applying this to the auto industry is more problematic. Tesla is running into problems scaling up production due to the presence of bottlenecks, labour issues, and even difficulty in welding. If this sounds all terribly 19th century, I apologise but it still matters – it is very difficult to sell a car you can’t make. All of this would be manageable except Tesla’s valuation allows for nothing but a non-stop journey to global domination; not a decades-long on-the-job training programme.

Upon visiting HD’s factory I was struck by the huge amount of accumulated skill, knowledge and expertise amongst its many thousands of employees. Not only ‘had’ it accumulated, it was ‘still’ accumulating. I saw first-hand the factory floor work groups that measure absolutely everything and are constantly refining their process to save 12-mins here, reduce 400g of scrap there. To scale up any advanced manufacturing takes this kind of process which simply cannot be replicated – nor should it be dismissed – overnight. Following the visit I invested in HD, confident that it had a significant embedded competitive advantage and that its ability to earn economic profits – and pay our coupon – was intact. I won’t bore you with the details, but it ended very well for the company and the investors who backed it at the time.

Electric cars are certainly the future, but Tesla’s valuation reminds me that the market can sometimes underappreciate the challenges of operating in the physical world, at scale. This can be a great opportunity, as in the case of HD, or it can lead to risks being under-priced by financial markets, as with Tesla’s recent swoon. It’s our job to recognise these factors and it remains a core focus of the way we do things at Kames.

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Boring is good

In our experience, some of the best high yield bonds reflect those of us who invest in them; low-key, reliable, and often profoundly boring. The ‘monotony’ of a business that reliably posts juicy but safe cash flows? Sign me up! Some of our fondest positions are in glamorous industries such as cardboard boxes, funeral care, tin can making, and the gel-like casings your headache tablets come in. Glitz and a good story is more often found in the equity market, and that’s the way we like it.

A test to this rule came recently when US electric car maker, Tesla, issued its maiden, conventional high yield bond. Tesla is unquestionably an impressive company. Their cars are technological marvels that outperform their peers on almost every metric, and to be sure, our friends in the equity market have certainly not been shy in reflecting such wonder. Tesla’s current share price implies an enterprise value (that is the total value of Tesla’s debt and equity) of some 96x its Earnings Before Interest, Tax, Depreciation and Amortisation.EBITDA is the HY market’s imperfect (but convenient) shorthand for cash flow, and illustrates the cash earnings a firm produces from its assets, stripped of as much accounting chicanery as possible. Now, 96x is a lot. A cynic might suggest that all the good things that have ever or could ever happen to this company are currently ‘in the price’.

By way of reference, BMW is a reasonably well-known car maker that has both a very strong position in conventional premium cars, as well as making significant inroads into electrification of cars via the impressive i3 and i8 models. We would be the first to admit that wherever the auto industry is going, Tesla will be part of it, but so too will BMW. In the meantime, they have a significant and highly profitable conventional car business, as well as decades of embedded know-how in the sector and a cash flow profile that can support significant investment in research and development.

Conveniently, BMW ($61 billion) and Tesla ($60.7b) have almost identical equity market valuations. However in terms of cash flow and scale, they are worlds apart. Last year Tesla produced just over 76,000 vehicles to BMW’s 2,360,000; a factor of some 31:1. Cash flow is where the real difference lies however. BMW’s cash flow is such that the company is valued by the market at only 7.5x the EBITDA it can produce today versus the 96x at Tesla. Clearly, the market believes Tesla ‘should’ grow significantly in the future.

Given Tesla’s ambition currently far exceeds its cash flow, it has turned to the high yield market to plug the gap between what it needs to spend to grow into its valuation, and what it can generate currently. For us, this is the antithesis of what a high yield bond is for. By investing in Tesla bonds you are providing growth equity capital with all the potential downside that entails, but with the upside profile of, well, a bond. Regardless of our admiration for Tesla, we don’t like that risk reward profile and we declined to buy the new deal. We prefer businesses that ‘do’ rather than ‘should’ produce the cash flow we need to pay our coupons and principal back. In the good times it can be easy to have one’s head turned by new and dynamic companies; however at Kames we don’t believe that our clients’ interests are served by such an approach, when indeed the opposite is usually far more rewarding for bondholders. If that makes our presentations a little less electric then so be it.

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