WeWork Bankruptcy is Inevitable: How Long will Softbank Keep Drinking the Kool Aid?
On October 11, In the shadow of its failed IPO, WeWork created an extensive presentation for investors.
It remained largely in the realm of the hypothetical with phrases such as “if we do this” and how we define “contribution margin.”
As they drone on, largely with the same lofty, pie-in-the-sky notions as revealed in the S-!, other than referencing divestitures of non-core business and attendant layoffs.
However, they steered clear of the brutal reality that they are burning cash at a rate of almost twice revenue. Stated differently, WeWork Spends almost $2 for every revenue dollar it generates.
The simple reality is that a 10% increase in “contribution margin” they so proudly champion as their locations mature, is hardly a drop in the bucket of the remaining support expenses —largely marketing, administration, and new market development— that are running at an eye-popping 90% of revenue.
And on top what would appear a roughly $6 billion cash burn run rate, on the last two pages (48 and 49), SoftBank dips its toe in the least obligation death trap.
It indicates that of the $41.8 billion in total obligation, only $6.5 in parent obligation.
But now that Softbank owns 80% of WeWork, would it not seem that they are on the hook for the entire $42 billion?
Real Estate companies are likely salivating at the bargain bin shopping spree they will enjoy as WeWork gets dissected out of bankruptcy.
WeWork Still Pushing Hypothetical Hoop-Di-La to Investors in the Wake of its Failed IPO
Ten days before Softbank’s $9.5 billion bailout, WeWork gave a lengthy (49 page) presentation to investors. Despite investors complete rebuff of much of this same information in the failed IPO just weeks before, WeWork continued to bang the hopeful drum. Their focus remained on the holy grail of margin expansion upon locations reaching maturity, which they express occurs after 24 months of operation.
Hard to say if Softbank had taken much more than a passing glance at WeWorks financials at that juncture, as despite the ouster of the flamboyant CEO Adam Neuman, the Kool Aid was still flowing pretty freely - $9.5 billion freely to be precise.
The focus remained on the magic formula of the system maturation bring contribution margins from 10%-15% up to 20% and in some cases even higher. However these “strategic” aspirations are at best wishful thinking, and at worse complete fallacy. And regardless essentially besides the point.
As our locations mature, occupancy improvements drive location contribution margin expansion.
And not that it really matters -except perhaps to the company’s mindset as to detail focus to financial accuracy— quick eyeballing reveals that if the average 10% margin is $253 per desk, then the 21% target is $531, and not in fact $707.
It seems like a perfectly logical theory that as occupancy rises, the attendant leverage of membership fees over ostensibly fixed costs would improve margins. However, the reality in the numbers the company provided in the October 11 presentation don’t support this theory, at least not across the board. Made even more disturbing in that the company self-selected which seven markets to present, and did not even bother to fact check the numbers and make sure they supported their strategy.
In four of the seven markets, the mature occupancy levels are equal or even lightly below that of the total market. And while the mature margins are in all but one city a few points higher, there is no correlation between margins and occupancy. For example, Chicago posts one of the second lowest mature occupancy, but has by and away the highest margin, almost double that of New York.
Despite WeWork’s silence on the subject, it seems fairly logical that rents play a critical factor in determining a market’s margins, especially for a company that has decreed that is not beholden to the same realities of economics that bound other real estate development firms.
A report posted on realty giant CBRE’s website on flexible office space includes square footage holdings for the major competitors in the industry by US city, clearly demonstrating the dominance of WeWork’s square footage portfolio across the country. The report also includes average annual rent per square foot for each of those cities.
There is no reason to doubt that WeWork is able to —as it states— negotiate better than average deals with landlords due to their scale, as well as for favorable buildout allowances. But its surely no coincidence that Chicago - again on the lower end of occupancy rates - posts the highest margin of the group, given that average rent there is a mere 40% of New York. While we have no ability to gauge how accurately these figures reflect WeWork’s actual average lease terms, it is none-the-less illuminating and reinforces the reality that, unlike space in the cloud, all offices are not created equal.
Mature Building Occupancy Hovers around 90%
Although of late that trend hasn’t been in the right direction
The Far Great Challenge in the WeWork’s Financial Debacle Lies Elsewhere
But this “contribution margin” accounts solely for direct building operating expenses, or essentially gross margin. Whether that ratio is 10% or 20% is virtually irrelevant. On run rate 2019 revenue of roughly $3.3 billion, that translates to a gross profit or “contribution” range in 2019 of roughly $400-$800 million. While $400 million is clearly nothing to sneeze at, it is however inconsequential in the face of the far greater cost storm. WeWork’s infrastructure costs—development, administration, marketing—are running at roughly 90% of revenue: at the current run rate the support expenses alone will total roughly $3.1 billion.
With this cost structure, WeWork must generate $15 billion in revenue just to break even, as at that level its targeted 20% gross profit would yield $3 billion, covering the remaining expense structure. If the company were to continue to double its revenue annually, that revenue target could be achieved in less than 3 years.
The all to obvious problem with this projection, is the massive size of the cash burn to hit this projected break-even revenue target. WeWork is burning $2-$3 billion in cash annually. There is one school of thought that posits that due to Neuman’s flamboyance and over excess that much of these costs will be very easy to shed.
Again, that sounds perfectly sound and logical, but it is hard to get it to play out in the numbers. For even if the company raised its contribution margin to its targeted 20%, and slashed it support expenses in half, back to pre-Softbank ratios to sales, the company is still 120% of revenue (80% operating expenses and 40% support, now from roughly 90% and 90% currently). It’s difficult to project the level of revenue growth those expense levels could support, thus estimating the cash burn Softbank will continue to endure is a bit speculative. But needless to say it will continue.
But Not to Worry - Softbank is on it!
One can only wonder the language that was used around the boardroom table at Softbank when the revelation of WeWork’s financial reality finally sunk in. But nothing to be concerned about here - the keen insight of their management and investment team very quickly synthesized the crux of the problem, which they proudly shared with investors.
And in case anyone was alarmed that Softbank had been stymied by the magnitude of the colossal pending disaster at WeWork, management cleverly created a slide to alleviate any such concerns.
And VOILA!
Remove scary, bad words - replace with arrows- Problem Solved!
It is difficult not to be deeply disturbed at the clear lack of diligence and oversight at accompanied a $9.5 billion bailout. There is clearly massive cost cutting on the horizon at WeWork. But with that reduction in spending, must of necessity come a dramatic slowing of revenue growth. So then they have a lower annual cash burn that would likely extend for many more years.
Has Softbank Diagnosed the Unsolvable Problem Yet?
The slide notably lacking from Softbank’s presentation is the realization that has perhaps yet to dawn on them: they are renting office space for significantly less than it costs them to create and operate it.
WeWork proudly touts the fact that they rent space —sell memberships— for a fraction for what it would cost a company to build it out themselves. While this is of course a fabulous proposition for the tenant, it is not in fact a comparable measure.
And while, yes it would appear that WeWork can produce space less expensively (far right column WeWork, far left competition), those costs dwarf the revenue it is actually generating from the space. WeWork indicates it’s average revenue per member at roughly $7,000 - calculations bring the number to closer to $4,400. And is member even the correct measuring metric, or is it per desk? If the latter, the scenario is even more grim, as WeWork’s tells us their average revenue per desk is merely $2,530 according to their previous slide. Regardless of the exact figure, the simple bottom line is that they are giving money away. In the third quarter, to the tune of $1.25 billion.
But Softbank is truly between a rock and a very, very dark hard place. Tucked way back on the final pages of the WeWork’s October 11 presentation is the admission that their lease commitments total $41.8 billion, with parent obligations a mere $6.5 billion. But Softbank now owns 80% of WeWork, which seemingly means that they are no longer simply the parent company and on the hook for the entirety of the obligations.
The world’s major developers are likely licking their lips waiting for Softbank to wake up and acknowledge the enormous fire sale on its hands. Because WeWork did indeed transform the work place, to the benefit of untold companies and employees worldwide. Sadly, Softbank is not one of them, as it will take more than inspirational graphics to conquer this debacle.
