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Gross Margins, WeWork, And The Public Comp Question

Morning Markets: Good morning! Let’s do some math about gross margins!

Yesterday WeWork filed to go public, releasing an S-1 document and forcing every business publication in the world to scramble to figure out how its books work. Good luck.

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Now that the initial wave of posts are out (here my first, second, a third by Jason, and a podcast with Kate, in case you want more on the matter), I wanted to ask two questions of the company’s current situation. Here they are:

  • Are WeWork’s gross margins high, or low, for its business category?
  • What do public competitors say regarding WeWork’s implied value at IPO, given what we learned about its gross margins?

The latter question is something that we’ve written about together in the past, so we don’t have to explain it much. We’ll get to it shortly.

The first question might seem a bit odd, so let me explain what I’m aiming for. WeWork as a business likes to emphasize the parts of its business that aren’t the business parts. WeWork’s S-1 is peppered with stuff like “our mission is to elevate the world’s consciousness,” and “philosophically, we believe in bringing comfort and happiness to the workplace.”

Nice sentiments, certainly, but not the sort of thing that you can tot up in an accounting book. Or can you? WeWork also says in its S-1 that it is “committed to providing our members around the world with a better day at work for less.” That’s notable.

On the same theme, the company detailed on page 3 of its IPO filing how much cheaper it is to rent space at once of its facilities compared to building out office space yourself. I agree! But my curiosity then asked if WeWork is charging enough for space. The company certainly offers attractive offices. Does it price the square footage high enough to generate enough gross profit to pay for its business?

Not yet, certainly, but let’s explore the question through the lens of a competitor.

Gross Margins

WeWork has a public competitor, IWG, formerly known as Regus. Happily, as IWG is a public shop we have access to its financial performance.

In its most recent half-year, IWG reported revenue of £1.302 billion and gross profit of £196.3 million. That works out to a gross margin of just over 15 percent. The company also generated operating profit (£50.6 million) in the period and strong net results thanks to a divestiture.

The 15 percent result is useful. Yesterday, during our second look at the WeWork filing, we found that using a line item similar to cost of revenue, we were able to gist out that WeWork’s gross margins a little under 20 percent:

Now that we have a way to calculate gross profit from the company’s buildings, what do the results show us? Observe the following pairings of WeWork revenue, and same-period Location Operating Expenses:

  • WeWork H1 2018 results: Revenue of $763.8 million, Location Operating Expenses of $636.0 million (83.3 percent of revenue consumed by location operating costs)
  • WeWork H1 2019 results: Revenue of $1.54 billion, Location Operating Expenses of $1.23 billion (80.3 percent of revenue consumed by location operating costs)

As you can quickly sum, WeWork’s kinda gross margins work out to 16.7 percent and 19.7 percent for the two half-year periods that started 2018 and 2019. Bear in mind that these are directional numbers, not absolutes. What matters is that WeWork’s nigh-gross margins are close-ish to what IWG itself reports.

We know that our WeWork gross margin estimate is generous. Therefore, WeWork isn’t much more profitable on a gross margin basis than IWG. And since IWG is net profitable, I’d hazard that it will be difficult for WeWork to argue that its revenue is worth more than that of its rival due to fundamentals.

This tells us that when WeWork prices its IPO, it will have to lean on revenue growth, and not revenue quality, as its key valuation lever; the firm won’t be able to say yes we are growing more quickly than IWG, and we generate lots more margin per dollar of revenue.

And that makes the IWG-WeWork comp all the more pertinent. Now let’s pursue our second question.

Multiple This!

IWG reported £1.3 billion in H1 2019 revenue. WeWork reported $1.54 billion in the same time period. Convert IWG’s pounds to American dollars and you wind up with very similar sums. That’s useful for us.

Yahoo Finance pegs IWG’s market cap at $3.67 billion, giving the company about a 2.3x revenue multiple on its H1 2019 top line. Yahoo Finance itself notes that the company’s trailing price/sales multiple is a conservative 1.37x.

But let’s use our somewhat-neat H1 2019 IWG revenue multiple result as it uses the most recent financial grounding for each company. WeWork, at the same 2.3x multiple, is worth a hair over $3.5 billion. That’s about 7.4 percent of its last private market valuation of $47 billion.

Now, WeWork will not go public at that valuation. The firm’s growth rates of over 100 percent will afford it a higher price. However, IWG has profits to report while WeWork is incredibly unprofitable. How far WeWork will be able to extend its revenue multiple thanks to its growth (with scant help from its gross margins) is the big question in front of it.

We’ll know soon enough!

Illustration: Li-Anne Dias.

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