WeWork's Junk Bond Adventure Raises $18 Billion Question

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(Bloomberg Gadfly) -- The nice thing about being a venture capitalist (from a VC standpoint) is getting to decide that the startup you’re backing is worth pretty much whatever you want. In the case of eight-year-old WeWork Companies Inc., which rents office space to entrepreneurial hipsters, SoftBank Group Corp. thinks that figure is $20 billion, give or take.

What Softbank does with its money is its concern, of course. Debt investors considering whether to buy into the $500 million junk bond issue that WeWork is marketing this week probably won’t care a jot about that dizzy valuation or the company’s highfalutin ambition to deliver "space as a service" to the "We Generation."

What they will be thinking about, however, is whether WeWork will have the capacity to pay coupons and repay the principal when the bond matures in 2025.

WeWork's bond prospectus, obtained by Bloomberg's Jack Sidders and Ellen Huet on Tuesday, offers some pretty mixed signals on that front. Leaving aside the fact that there are "few barriers to entry" in renting office space, WeWork's business model appears to have at least one other glaring potential flaw: a duration mismatch.

Many of the company's 220,000 members can terminate their membership agreements with as little as one month's notice. In an economic downturn, it's reasonable to assume some folks will decide it's cheaper to work from their bedroom. It's not certain that bigger corporate customers, which account for almost one-quarter of the membership, would behave much differently – especially if they go bust. Even in today's relatively buoyant economy, WeWork says it suffers “member churn.” 

Yet as the intermediary between landlord and tenant, WeWork has committed to making a huge $18 billion in lease payments over the next couple of decades, about $5 billion of which fall due in the next five years.

Put simply, there’s a risk that WeWork's rent expenses might significantly exceed its revenue during a downturn. While it could try to sign up new members, the fees they’d be willing to pay would probably be lower, whereas rent expenses would be roughly the same. 

True, these leases are often held by individual special-purpose subsidiaries and are secured by corporate guarantees that might cover only the first year of a 15-year lease. But that doesn't mean WeWork can wriggle out of them without fundamentally damaging its business prospects. The prospectus notes that "our business reputation, financial condition and results of operations depend on our subsidiaries’ ongoing compliance with their leases." 

Another item in the "not exactly reassuring" bucket is the prodigious amount of cash the company is burning through as it grows. On my calculation, free cash flow was negative to the tune of about $775 million dollars last year.

Though revenue doubled in 2017, day-to-day operating expenses to run its locations consumed 92 percent of that (and that's before you add things like pre-opening costs and sales and marketing expenses). Overall it made a $933 million net loss. 

Of course, big losses aren’t necessarily an impediment to long-term success. And the good news is that WeWork’s occupancy rates are high and it’s getting better at kitting out new offices. Its brand power is helping persuade landlords to fund a bigger chunk of property improvements too.

Even so, WeWork's growth partly obscures its ability to generate cash. When it takes out a lease on a new building, landlords often grant WeWork a grace period when it doesn't have to pay as much (or any) rent. Plus it gets a brokerage fee. 

For now WeWork has plenty of cash, but to sustainably improve its earnings, it will need even greater economies of scale -- which almost certainly means adding yet more debt and lease liabilities.

WeWork acknowledges that its expenditures "will make it difficult for us to achieve profitability, and we cannot predict whether we will achieve profitability in the near term or at all." Risk is all part of the game for junk investors, and this one looks like it will be priced to go with a fat yield. But the more prudent will take that caveat seriously. 

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

  1. Defined here as operating cash flow minus outlays for property and equipment.

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