Last week, WeWork, the coworking space now known as The We Company, released its S-1 filing to go public. That spurred numerous concerns about the company’s large valuation ($47 billion at last count), given its hefty losses ($1.6 billion loss on $1.8 billion revenues) and despite its rapid growth (86% year-over-year revenue growth). It also renewed questions about WeWork’s claims of being a tech company (the word “technology” appears 110 times in its prospectus) and about whether it’s worth a tech-type high valuation. Pundits have long argued that it is not a tech company, but a modern-day real estate company – purchasing long term leases from landlords and renting them out as short term leases to tenants. Many have also argued that WeWork does not deserve the large EBITDA-based (earnings before interest, depreciation, and taxes) valuation multiple that is often ascribed to tech companies.
In our opinion, a successful modern tech company can transform whole industries, achieve expansion of scale and scope at breakneck speeds, and make enormous profits, without requiring significant capital investments. It typically has most, if not all, of these five features:
Low variable costs: Google Search, Airbnb, Yelp, Uber, Twitter, and Facebook have scalable virtual models that can be exponentially magnified overnight with little additional costs. So, an additional dollar of revenues comes without commensurate expenses. How much does it cost to make another copy of Windows 10 or service another Google or Facebook customer? Relatively little. Facebook’s gross margins, for instance, run as high as 80%–85%.
This concept does not even remotely apply to WeWork. It is an office rental company, offering free internet, beer, snacks, coffee, and working space to members. Even if it becomes the largest and most successful player in its business, it will have significant operating expenses and, therefore, wafer-thin profit margins. (Think about it: rent, utilities, maintenance, insurance, security, refreshments – these all cost money!)
Low capital investments: Even though a modern tech company may invest in server farms, it will still often remain asset light because of its low requirements for land, buildings, factories, and warehouses. For example, Facebook has just $25 billion of physical assets for its $525 billion valuation.
While WeWork rents real estate, it must develop and furnish it to the highest quality levels to distinguish itself from other office providers. And rented premises are now considered to be capital assets. These facts imply two things. First, WeWork has much higher capital requirements than a typical tech company for the same revenues. So, WeWork would never be able to grow nonlinearly based on its internally generated cash. It would keep approaching capital markets and lenders to fund its ambitious growth plans. More important, the company’s ability to generate free cash flows (the amount left after subtracting capital investment from its profits) is questionable. Contrast this to Facebook, whose revenue growth generates huge profits. And given its low reinvestment requirements to sustain growth, most of those profits are free cash flows, which are potentially payable to investors as dividends.
Second, expenses related to depreciation and wear-and-tear of assets would be a much higher expense for WeWork than for an asset-light tech company. That wear and tear would require commensurate funds for replacement. After all, customers attracted to trendy offices would expect fused neon lights, worn out carpets, and broken chairs and printers to be regularly replaced. As Warren Buffett says, the tooth fairy doesn’t pay for those replacement expenses. Hence, while an above-the-line performance metric, such as EBITDA, might work in the valuation of an asset-light tech company, it is a meaningless concept for WeWork. Other metrics proposed by WeWork, such as community-adjusted EBITDA, that ignore even the most basic costs for providing services, such as lease rentals, are even more ridiculous.
A lot of customer data and customer intimacy: Modern tech companies – think Uber, Amazon, Apple, Google, Yelp, Tesla, and Facebook – collect, store, organize, and analyze years of user data. These data are not only virtual gold for those companies, as they enable targeted ads and sale of tailor-made products, they also increase users’ switching costs as users develop intimacy and get customized solutions in return. It is unclear whether WeWork would collect its coworkers’ data and how it would use that data to develop customer-intimate solutions. Too much monitoring and intrusion in an office location could violate privacy laws.
Network effects: For most modern tech companies, the bigger the network, the more valuable the company, but on an exponential scale. Each new customer joining Facebook, even if remotely located, creates value for an existing customer, because it extends the existing customers’ network potential. Any new customer joining Uber or Amazon improves the value proposition for an existing user by improving the feedback quality, logistics optimization, and number of suppliers addressing the market. But it’s hard to see how a new coworker joining WeWork in Indonesia creates value for an existing coworker in Texas. The coworker doesn’t need WeWork’s network to collaborate globally, because there are bigger and better platforms (e.g., LinkedIn) to serve that purpose.
Ecosystems that boost expansion with little cost: A modern tech company leverages its relationship with customers, and what it knows about their tastes and preferences, to deliver more services. This is achieved at little cost by leveraging ecosystem partners’ assets. Consider Apple’s use of the iPhone and Amazon’s use of Echo devices to cross-sell apps, music, video, stores, and payment services. The companies that control these platforms take a cut from each dollar flowing through the system. WeWork might be able to enter other real-estate businesses, such as apartments or schools, but that will require massive investments and addressing new customers. Contrast that to Uber which can extend to Uber Eats with minimal investments.
In sum, WeWork does not meet any of the qualifications that enable a modern tech company to achieve exponential growth as well as winner-takes-all profits. In contrast, even asset and inventory heavy companies like Amazon, Tesla, and Apple meet three of the above five criteria.
WeWork seems to be a disruptive real estate company, with the goal of changing “how people work, live, and grow.” Some may be impressed by WeWork’s tremendous growth. But this growth has required and will continue to require massive costs and investments. More important, this growth will not exponentially grow profits as it might for a digital firm, for which any revenue growth after breaking even adds to profits and dividend-paying potential.
But we do think that some of the other criticisms being laid against the company and its valuation are addressable. It requires adjusting the price investors are willing to pay for WeWork shares.
Concern about asset-liability duration mismatch. WeWork obtains real estate using long-term contracts (which have long duration of liability) and rents this out on through short-term contracts (which have short duration of revenue-generating assets). This feature is typical of many real estate-based businesses, such as hotels. Duration mismatch is a double-edged sword: it can produce large profits in good times, because the firms will have fixed its leasing costs a long time ago and can now command higher membership fees – but it could also drag WeWork into bankruptcy in bad times, because of its fixed liabilities, which currently stand at $34 billion, would remain payable, come rain or shine. Investors can assign an appropriate discount to valuation to adjust for higher risks.
Concern about public offering of shares that carry lower voting rights than promoters’ shares. Offering multiple-classes of shares is a common feature of many modern public corporations. To ease concern over purchasing shares that don’t have voting rights, shareholders can assign an appropriate discount in exchange for voting rights, as they do with Facebook, Alphabet, and Spotify.
Concern about insider dealings, such as promoters being renters of the company’s real estate. While we oppose any manager-owned vendors becoming preferred suppliers to a public corporation, WeWork has disclosed its insider dealings. Investors can therefore assign a suitable discount for potential value loss due to insider dealings.
In summary, we are reluctant to put WeWork in the same league of “tech” companies such as Apple, Microsoft, Facebook, and Alphabet. It doesn’t have the features that make those companies cash-generating machines, so it also doesn’t warrant a tech-type valuation. We also hope that analysts and managers would use the more holistic framework given here to determine what is truly a tech company. Analysts should be wary of labeling every start up, however disruptive, as a tech company or worthy of a tech valuation, because this label isn’t what determines shareholder value. What ultimately does are profits, return on investments, and dividend-paying potential.