More Proof of 'America's New Market Madness'

WeWork's absurd IPO filing... Red flags all over... More proof of 'America's new market madness'... Fairy-tale accounting... The co-working space investment Doc made four years ago... This 'anti-WeWork' is up 125% in that span...

The financial media was salivating like a rabid dog...

And when WeWork, the co-working space startup, opened its books, the talking heads were not disappointed with the meaty bone they were tossed.

To be more specific, the company's recent "Form S-1" filing for an initial public offering ("IPO") showed the company to be in worse shape than I (Matt Weinschenk) or the most skeptical observer imagined.

"Bad" doesn't begin to describe it. WeWork, technically now known as "The We Company," as it stated in its filing, is burning through money at a phenomenal rate.

The company lost almost $1 billion in the first half of this year alone.

When the story of this financial era – of low interest rates and cheap capital – is written, WeWork will be a central character...

Still, investors love to hear about and invest in the next "hot stock" like WeWork... And they ignore investment opportunities that are objectively better on every measure.

In today's Digest, I'll show you an investment that I consider the "anti-WeWork." It's one that has already delivered triple-digit returns to Dr. David "Doc" Eifrig's Retirement Millionaire subscribers. But first, let me show you just what's wrong with WeWork...

I first knew WeWork was in trouble in 2016...

If you're not familiar, WeWork runs co-working spaces.

The company signs long-term leases on large office buildings, renovates them, puts in a bunch of desks in small offices, and rents them to freelancers or small startups on a short-term basis.

In 2016, the company was losing money – as many startups do – and was spending aggressively to grow. It posted losses every quarter, and each dollar it spent in excess of revenue came from investors.

Then, in 2017, news broke that WeWork decided to buy a stake in a wave-pool maker, Wavegarden, for nearly $14 million. Bizarre.

You'd imagine that WeWork CEO Adam Neumann had a business case to justify the acquisition of the wave-pool company. I suppose WeWork planned to put wave pools in offices to attract tenants?

But you also need to know that Neumann likes surfing.

And earlier this year, we learned more...

The Wall Street Journal published an article about Neumann and all the investments WeWork has made as part of his personal interests.

He invested $32 million into a food company started by one of his favorite superstar surfers...

And WeWork started a private elementary school in Manhattan called WeGrow, so the Neumanns could have a place for their children to attend...

From the Journal...

The Neumanns have told WeWork staff they came up with the idea after becoming dissatisfied with school options for their five children, according to people present at the staff meetings. Ms. Neumann pressed Mr. Neumann to quickly get the school off the ground, and Mr. Neumann, after initial skepticism, relented, he told staff.

Here's the lesson... As investors, and in my role as a senior analyst for Doc, we discuss growth, margins, and valuations at great length.

But it's easy to lose focus on what you are really doing when you put your money in a company...

You're handing your capital over to a CEO, board of directors, and management team...

You're tasking them with turning it into more capital...

And you are trusting them to treat your money as if it is their own.

Had a CEO come to you and asked to start an elementary school for his kids since there weren't any good enough in Manhattan, would you have said yes?

The wave pool and the elementary school are big red flags... And WeWork is riddled with them.

WeWork is just one of many Silicon Valley companies that is losing massive amounts of money.

WeWork's pitch is that if it loses money for long enough, it'll capture the entire market and become a highly profitable monopolist. It's the same thing that ride-hailing company Uber (UBER) is trying to do.

Porter wrote about this trend back in April, calling it "America's new market madness." And he's right... It is madness. I wouldn't invest in these unprofitable companies, like the young-adult-focused social network Snap (SNAP).

Yet I have a tough time betting against them.

I'm a natural optimist...

My business card designates me as Stansberry Research's "Permabull-in-Residence."

The most likely case for Uber is that it burns through its cash and its shares collapse... but there's a small chance the company becomes the future of networked transportation.

Will electric-car maker Tesla (TSLA) keep losing money (like the nearly $500 million it has lost over the past year) until it can't keep the lights on? I think so... but it's also possible we'll all be driving Musk-built cars in 20 years.

WeWork is the same kind of bet. It needs to get big and take over a massive chunk of commercial real estate to become profitable.

But I would bet against WeWork succeeding...

And my thesis is not about the office-space market as much as it's the fact that WeWork has so many problems with its corporate governance and executive incentives.

For one, there's "related party" transactions. Let me explain...

WeWork bills itself as "asset light." Rather than spend millions on buying office buildings, the company rents them and then re-rents them.

In WeWork's estimation, this allows it to earn more money on less capital. And besides, WeWork really wants to be considered an innovative tech company, as it showed with a "tech-like" valuation in its IPO paperwork. The S-1 filing says...

Technology is at the foundation of our global platform. Our purpose-built technology and operational expertise has allowed us to scale our core WeWork space-as-a-service offering quickly, while improving the quality of our solutions and decreasing the cost to find, build, fill and run our spaces.

If WeWork just bought buildings and rented them out, it'd be a boring old real estate company.

There's a catch... Neumann has started buying buildings for himself, and renting them out to WeWork. Clearly, this risks a conflict of interest. Neumann could overcharge his company and put the money into his own pockets.

But WeWork insists that the transactions all occur at fair market rates and are approved by the board... the same board that let him buy the wave-pool company.

Red flag.

When the CEO is the company's landlord, it won't end well...

Neumann is a guy running a fledgling, money-losing startup. Generally, that makes a founder rich on paper but his wealth is tied up in his ownership of the company. How did he manage to buy these office buildings?

We don't know for sure, but there are two potential sources...

First, WeWork just disclosed that it had loaned $7 million to Neumann at an interest rate of 0.64% in 2016. He has since paid it back. And there were other loans, too. In April, the company loaned him $362 million at 2.89%.

So Neumann may have borrowed money from WeWork to buy buildings to lease to WeWork.

He has also already cashed out $700 million worth of WeWork stock ahead of the IPO. As the Journal noted in a separate article in July, this is "an unusually large sum given that startup founders typically wait for the IPO to monetize their holdings."

That's another red flag.

But the most egregious offense is the naming fiasco...

In January, WeWork changed its name to The We Company because it said it would become more about office space.

"The We Company's guiding mission will be to elevate the world's consciousness," it said.

That statement alone is quite stupid. But there's more... WeWork had to purchase those naming rights from a company called We Holdings LLC for $5.9 million... and that company was solely owned by Adam Neumann.

The absurdity of this could not be captured better than it was by Bloomberg columnist Matt Levine...

That's unusual! Mark Zuckerberg, it seems silly yet essential to point out, not only invented Facebook, he also named it Facebook. But it did not occur to him to charge à la carte for those services. He does not send Facebook an itemized bill for his services as founder, CEO, name guy, etc...

The... sort of the whole idea of having a company is that the people who work for the company work for the company; at least the senior managers are in some sort of long-term relationship in which they come up with ideas for the business and give them to the business in exchange for a salary or bonus or equity or whatever. They don't auction off every idea for a separate fee.

Just yesterday, WeWork announced Neumann returned the payment after public blowback.

But let's call that another red flag.

Finally, let's look at how WeWork's IPO filing didn't answer the biggest question about its business...

Can it ever be profitable?

WeWork, as a company, takes a building, makes it nice and fancy, and rents it to short-term tenants. By leasing the space, tenants get Internet connections, desks and furniture, free food, and free beer. (However, beer is limited to four per day after the company removed its unlimited beer policy.)

Under this model, WeWork earned $1.5 billion in revenue in the first half of this year and booked a loss of $900 million. But those losses include the money that WeWork is spending to grow by buying and renovating buildings and marketing to tenants.

You really need to know if one mature WeWork location on its own can be a profitable enterprise.

To help with this WeWork previously announced a measure called "community-adjusted EBITDA."

This was a fairy tale of an accounting term that showed earnings before considering interest, taxes, depreciation, amortization, rent and tenancy expenses, Internet, staff salaries, and the cost of building amenities.

Any business can make a profit after costs... if you just ignore all the costs!

Community-adjusted EBITDA was roundly mocked by the financial press, and the IPO filing doesn't mention the measure. It has since been dropped.

On the other hand, WeWork does have 158 locations older than 24 months, so it should be able to tell us how profitable they are. But it doesn't. Another section lists the average revenue per WeWork membership at $6,320 per year and the company's target margin on that of 30%...

But that's the target margin. The actual margin is not supplied.

Put another way, there's a big question about WeWork's business actually working...

WeWork knows that investors want to figure this out... and it is not telling. A review of the company by the Financial Times concludes...

All in all, one gets the sense from WeWork's prospectus that it would rather not tell us how its mature locations are faring. And ahead of its public offering, perhaps above all else, that should be the most worrying thing for investors.

Again, not only do we not know if WeWork can be profitable, we know that management doesn't want to tell us.

When he dug into the numbers last month, our friend Whitney Tilson of Empire Financial Research was so shocked that he thinks the U.S. Securities and Exchange Commission ("SEC") won't even let the stock come to market...

I don't think this IPO happens, even with some of the biggest banks on earth pimping themselves for at least $100 million in fees. If the SEC doesn't nuke this pig, the markets will, as investors finally appear to be rediscovering the concept of risk.

I agree that's what the SEC should do. I'm less convinced that it will.

However, I don't know if investors should "go short" WeWork...

Heavily hyped stocks can rise for a long time. Short interest may be high, making it expensive to borrow shares.

Implied volatility will be high, making put options expensive (though we can mitigate that with the techniques used in our Advanced Options advisory.)

But I do know you can find better choices for your money out there...

For instance, find a business with a boring description, real returns on capital, and competitive advantages. This is what we do each and every day.

Smart investors find folks who they'd trust to manage their business for the investors' interests first, not the CEO. In other words, find the anti-WeWork. That's the path to lasting wealth.

Assuming that sounds appetizing, and you still want to invest in "asset light" office space, we've got an investment for you.

It's one we first recommended to Retirement Millionaire subscribers more than three years ago, when we first looked at the co-working real estate space.

Think of this as WeWork without any of the red flags...

It's a company called CBRE Group (CBRE), which manages commercial, residential, and industrial real estate.

The key is that CBRE doesn't own real estate, it manages it. This is an important difference. Owning real estate takes tons of capital and often debt. You are exposed to much more risk.

But the world is becoming "financialized," if you will. Buildings aren't owned by mom-and-pop operators anymore. And many aren't even owned by real estate companies.

Instead, they're owned by pension funds, private-equity firms, and other institutions that want real estate as an asset class. In 1980, about 2% of institutional assets were in real estate. Today, that number is 10%.

And as a greater number of investors own real estate, they need someone to manage it. That's what CBRE does.

The business plan is clear...

CBRE helps coordinate leases, facilitate sales, and arrange financing for clients. It also consults on valuations and project management. You can also turn over your whole building to CBRE to manage. The company will fill it with tenants, collect rent, and maintain the building.

Now, these tenants aren't the trendy "co-working" type. These are big businesses who sign big-boy leases.

But there's nothing proprietary or technologically advanced about WeWork's business model. Anyone can copy it.

In fact, CBRE launched a flexible space division that will turn an owner's property into a co-working space and manage it for them.

CBRE is profitable, earns healthy returns on capital, and trades for just 0.8 times sales today. Compare that to WeWork's projected 15.6 times sales. (If you're a Retirement Millionaire subscriber, you can read all about CBRE's profitability right here.)

We first recommended CBRE in February 2016. It has returned 125% since then...

CBRE is a public company. We know what it's worth. Private companies like WeWork don't trade every day, but based on funding rounds, it was valued at $15 billion in 2015 and $21 billion in 2017.

In its latest private rounds, WeWork was valued somewhere between $47 billion and $20 billion. Yes, that's a big gap and the figures aren't given in the typical order. That's because there's some strange machinations between WeWork and its biggest investor, SoftBank, that we won't even get into here. We'll find out what WeWork's worth when it goes public.

Until recently, projections called for a $47 billion valuation. But just this morning, news broke that WeWork is cutting its valuation to somewhere between $20 billion and $30 billion. Somehow, this IPO is already losing investors' money.

We doubled our money in CBRE and, over the same period, WeWork grew from $20 billion to maybe $30 billion – a lesser return! And we did it without worrying about the accounting shenanigans or the hype...

What smart investors should do...

Some investors want the shiny new thing.

They are obsessed with growth – without regard for costs or sustainability. They are content to take management's accounting numbers at face value. They chase lottery tickets over steady returns. And they are willing to overlook even the most basic measures of corporate governance to chase those big gains.

That's not how smart investors do well in stocks...

So I say ignore WeWork, aside from using it as a cautionary tale.

Instead, look past the headlines and find a boring, profitable company to deliver you triple-digit returns with much less risk.

If you want to know more about how we do that in Retirement Millionaire, click here to learn more about a subscription. You can give it a try risk-free for 30 days.

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We'd love to hear what you think about WeWork and its pending IPO. As always, you can share your thoughts, comments, and observations with us at feedback@stansberryresearch.com.

Regards,

Matt Weinschenk
Baltimore, Maryland
September 5, 2019