The Capital Markets (We)Work

In a healthy financial system, some IPOs will fail.

John Rekenthaler, CFA 15.10.2019 | 8:59


Artikkel publisert i orginalformatet (amerikansk-engelsk)

Shaky Figures
Founded in 2010, the privately held company WeWork has received more than $10 billion in financing. Its January 2019 investment round, from Japanese giant Softbank (SFTBF) (which also bought into Morningstar (MORN) back in the day), valued the company at $47 billion. Several months later, WeWork filed with the SEC for an initial public offering. That planned IPO collapsed, spectacularly. Many observers now predict the company's bankruptcy.

The concern with WeWork is that while it has gathered plenty of customers, recording $1.5 billion in revenue during the first half of this year, the company has been deeply unprofitable. As WeWork's revenues jumped from $500 million in 2016 to $900 million in 2017, and then to $1.8 billion last year, its operating losses grew proportionately. WeWork predicts that it will lose $2.5 billion in 2019.

None of this would matter if the losses came solely from growth. If that were the case, the company could cut back its expansion, thereby gaining profitability as its newer, high-vacancy office spaces became occupied. However, it's not clear that the company's business model will ever...work. In a March interview with The New York Times, WeWork's president stated, "We can very much, if we chose to, moderate our growth and become profitable." Few outsiders shared his confidence. (This assessment, although more optimistic than most, is guarded.)

One might wonder how a company that might never be profitable could have been valued at almost $50 billion, particularly when its business is familiar. After all, Alphabet (GOOG), Facebook (FB), and Netflix (NFLX) earned their stock market capitalizations by dominating emerging industries. In contrast, WeWork leases office space, an occupation that has existed much longer than any of us. It's difficult to envision how a new entrant could so quickly become worth more than all its rivals--indeed, at January's valuation, more than the next two competitors combined.

The Light Fantastic
The explanation lies with the fantastic. Per lexico.com, that which is fantastic is "of an extraordinary size or degree," but perhaps "more appropriate to the imagination than to reality." Such has been WeWork's marketing. From the beginning, former CEO Adam Neumann--who resigned his position during the IPO debacle--presented himself, and thus the company, as a for-profit version of the Dalai Lama. WeWork wasn't just a business; it fulfilled a greater purpose.

Said Neumann at a 2018 company meeting, "There are 150 million orphans in the world. We want to solve this problem and give them a new family: the WeWork family." (Under no interpretation does that statement make sense.) Another time, Neumann stated that WeWork's monetary value was "much more based on energy and spirituality than it is on a multiple of revenue."

The rhetoric escalated after Softbank's investment. Neumann renamed the business The We Company--receiving, in exchange, a $6 million payment from the newly rebranded firm for its use of the word "we," which Neumann had trademarked (truly a fantastic transaction!)--and wrote that the company's "guiding mission" would be to "elevate the world's consciousness." In the process, "It would unleash every human's superpowers."

It's Personal, Not Business
To be sure, WeWork (to use the company's original name) differentiates itself by more than just words. Unlike traditional real estate providers, the firm furnishes and services its locations (with printers, free coffee, and so forth), offers short-term leases, and quickly accommodates the needs of growing customers. WeWork is not the only member of this new breed; several competitors operate broadly similar businesses. But it is fair to say that no company exactly emulates WeWork.

It is also fair to say that WeWork's prime draw has not been the details of its services, but the personality of its CEO. People invested in WeWork to be with Adam Neumann. Indeed, until very recently, the company and man were inseparable. WeWork's corporate structure gave Neumann majority voting rights, even if he was a minority owner. Effectively, whatever Neumann wished, WeWork would do. He controlled the board of directors lock, stock, and barrel.

(In September, Neumann agreed to relinquish both voting control and his CEO position, moving upstairs as chairman of the board. This announcement was intended to support the IPO by mollifying concerns about WeWork's corporate governance, but the deal collapsed anyway. The reaction was unsurprising: As buying into WeWork was effectively a bet on Neumann, curtailing his power was unlikely to prove appealing.)

Yin and Yang
My take: The WeWork saga represents a resounding victory for the U.S. capital markets. The private marketplace did its job. It identified somebody who had a bold idea, with courage to match, and gave him cash to put his plan into action. Over the years, charismatic entrepreneurs convincing private-market capitalists to part with their cash has served the American economy very well. No other country puts so much venture-capital money to work, with such positive effect.

At the same time, the private marketplaces are imperfect. It's tempting to think of venture capitalists as being the "smart" money, but that's not quite correct. They are the "inside" money. They see things that outsiders do not, by meeting with entrepreneurs and hearing those founders' business plans, long before the public capital markets receive such information. That provides clear advantages. At the same time, the insiders are isolated. They make their decisions largely on their own, bereft of outside opinions. They do not benefit from the wisdom of the crowd.

Softbank--admittedly a public company, but operating as a private investor-- miscalculated when investing in WeWork. It paid too much attention to Neumann the spiritual leader and too little attention to WeWork's numbers. It allocated its capital inefficiently. But when the stakes became larger, with the proposed public offering, the error was corrected. The public markets provided a perspective that the private markets could not--just as during the earlier stage of WeWork's financing, the private markets met a need that the public markets could not.

Although some details of the WeWork saga call into question our species' rationality, the lesson ultimately is positive. Each half of the capital-allocation process fulfilled its role; the two parties complement each other, rather than overlap. What's more, WeWork's IPO stumble is good news for equity owners. Only an overcooked stock market would have accepted that offering under those terms. That the public rejected the proposal doesn't prove that stocks are appropriately priced, but at least the possibility remains that they might be.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: MORN. Find out about Morningstar’s editorial policies.

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SoftBank Group Corp39,47 0,05

Om forfatteren

John Rekenthaler, CFA  John Rekenthaler is Vice President of Research for Morningstar.