Misleading Financial Metrics

In July of 2018, the FT punched back at WeWork’s valuation. CEO and cofounder Adam Neumann crafted a fantastic narrative to support a lofty $20 billion valuation claiming that WeWork is a “community” and a “state of consciousness” that brings people together to “change the world.” In contrast, the FT reported:

WeWork’s claim to disrupter status in serviced offices also requires scrutiny. The existence of older providers such as IWG is the elephant in the office. Like them, WeWork has a business model underpinned by unglamorous property market arbitrage: leasing offices, fixing them up and renting them out at a higher rate. If the groups are fundamentally the same, it makes no sense to value WeWork at $20bn — more than 10 times expected sales.

IWG is the world’s largest serviced office provider, with more than 10 times the number of offices and a profitable business model. Yet it has an equity value below $4bn. This values IWG at 1.2 times forward sales. If valued at the same multiple, WeWork would be worth around $2.7bn.

The word that should leap off the page is “profitable.” WeWork could not be compared to IWG based on profitability because it was on schedule to lose $1 billion annually at the time of this analysis. Well, not on any standard measure of profitability. Which brings us back to “community adjusted EBITDA,” which the FT skewered.

By stripping out almost every cost — from advertising to those associated with setting up new offices — this figure was positive at $233m last year. [CFO Artie Minson] says he received no pushback from investors. But such flattering bespoke measures of profits remain a red flag for many investors. Online coupon site Groupon abandoned its own individual measure after attracting negative attention. WeWork would be wise to do the same.

Note: This article is a terrific read.

In April of 2018 the WSJ reported that WeWork’s revenues had doubled to $866 million ahead of the company’s proposed bond offering. Co-founder Adam Neumann was creating a fantastic investment narrative and investors had piled into the 8-year-old company providing $6 billion at up to a $20 billion valuation. The challenge facing the company: losses had also doubled to $933 million.

Fortunately, a marketing solution was available in the form of adjusted EBITDA. WeWork would push the envelope on an otherwise common attempt to inflate earnings with words vs. dollars.

It called the fully adjusted number “community adjusted Ebitda,” by which it subtracted not only interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs. Those earnings were $233 million, WeWork said.

“I’ve never seen the phrase ‘community adjusted Ebitda’ in my life,” said Adam Cohen, founder of Covenant Review, a bond research company.

In a Barron’s interview, economist David Rosenberg states that the correlation between GDP and the S&P 500 has dropped to 7% from a historical range of 30% to 70%, and that consequently the “stock market is telling you nothing about the economy anymore.”

As for why the correlation has dropped so significantly:

“We have had $4 trillion of quantitative easing matched perfectly by $4 trillion of corporate share buybacks, to the point where the share count of the S&P 500 is down to its lowest point in two decades. You would normally believe that a powerful bull market in equities would have been reliant on a strong economic backdrop. But that’s far from the case. We have never before seen such a stock-market performance in the face of what has been in the last 11 years the weakest economic expansion of all time. We haven’t even had one year of 3% or better real GDP growth in the U.S. since 2005.”

Rosenberg states that the companies that have raised large sums of debt used the proceeds to buy back shares instead of making capital expenditures to invest in future growth. These purchases have little to do with the economy and create an “illusion of prosperity.”

Click on the link below for an interesting read.

In response to a reported increase in revenue from operating leases at John Deere, Jim Grant noted that the mechanism for this “improved” performance was the company’s willingness to absorb more risk via an increase in the residual values of equipment leased. The challenge, as Grant points out, is that the value is determined when the lease is signed and that this is simply an educated guess.

“The higher the estimated value, the easier it is for the lessor-farmer (a higher residual value means lower monthly payments) and the riskier it becomes for Deere.”

During the 2017 holiday season Toys “R” Us experienced an uptick in sales in response to widespread news of the chain’s chapter 11 filing in September of the same year. Anxious consumers rushed to stores to redeem the value of gift cards that would soon otherwise be worthless. According to the article the company claimed that “Christmas came a bit early” that year, but the reality is that the “best gift cards [from the retailer’s perspective] are those that go unspent.”