With an economic recession looming, some companies are destined to perform better, while others appear to be on the brink of bankruptcy. And with the Fed raising interest rates, a slowing economy and less liquidity, the latter seems increasingly likely for one of the companies in this article.
Therefore, in this article we make a strong case for why it may be advantageous to go long on Zoom (NASDAQ:ZM) and short on WeWork (NYSE:WE) to realize a very attractive, asymmetric risk-return opportunity for your portfolio.
The Battle Of Business Models
Both WeWork and Zoom operate on similar grounds: providing infrastructure for workers, entrepreneurs and independent professionals to get work done efficiently and effectively. Given the prevailing sentiment, it would be easy to think that WeWork, which offers coworking spaces, would overtake Zoom, which is a work from home company, as the economy picks up and people return to their offices.
And while both companies have similar enterprise values, US$25.23BN for WeWork and US$30.13BN for Zoom, their income statements and balance sheets are vastly different. Zoom’s operating margins, for example, are about 25% compared to WeWork‘s staggering (-75%). This comes at a time when Zoom is experiencing huge tailwinds from digitalization and WeWork is about to experience huge headwinds from rising interest rates and some cracks already starting to show in the housing/mortgage market.
The share price of both companies has completely plummeted over the last 3 years, which in the case of Zoom comes as a surprise to us. While WeWork continued to burn more than US$10BN of cash and Zoom gained more than US$2BN of cash in terms of net income, Zoom has fallen significantly faster than WeWork.
To make matters even crazier, Zoom’s share price has barely moved from its 2019 level before the pandemic, while it has seen its revenue grow from US$622.7M in 2019 to more than nearly US$4.10BN in 2021. They have also managed to grow their EBITDA from just US$29.1M to around US$1.18BN over the past 3 years, and yet the stock has not moved.
But that trend will quickly reverse if Zoom continues to grow while WeWork’s business model fails. And it is already reversing. In the past month, for example, Zoom has seen a gain of 4.75%, compared to the S&P 500 (SPY) down 7.08% and WeWork down 22.14%, reinforcing our thesis to bet on digitalization.
The Insider’s Silent Vote
The buying and selling of shares by insiders is usually a silent voice, but is considered a very strong voice by us. We believe it is difficult to support a high valuation of a company set by its founders, while they are also dumping shares on the flip side. Simply put, why should investors trust c-suit executives if they themselves have no confidence in the company.
Above, you can see the stark difference in trust, both among insiders and institutional investors. In terms of institutions, Zoom has twice as much trust from institutions in percentage terms. The insiders at Zoom also have more than 5 times as much skin in the game in percentage terms as WeWork.
WeWork founder Adam Neumann, about whom we will go into detail later, stepped down in 2019 and is set to receive US$1.7BN in compensation. That included a US$970M value of remaining shares, a whopping US$185M consulting fee and a US$500M line of credit to help repay his loans to JPMorgan Chase. All this despite the fact that WeWork generated no profits whatsoever, leaving the company as a burning vacuum of cash.
Even before the company went public, Neumann had already sold US$700M worth of shares, which itself did not exude much confidence in the business model. Other heavyweights like Morgan Stanley dumped more than 7.65M shares, along with other funds that completely liquidated their hole positions, such as Castle Hook and Long Pond Capital. Perhaps the most important advantage WeWork has is SoftBank’s (OTCPK:SFTBY) immense 46% stake in the company.
With Zoom, some heavyweights pounced on the stock when it collapsed this year. For example, Jim Simons, from Quant hedge fund Renaissance Technologies, doubled their stake and bought over US$270 million worth of shares at the current share price. However, the estimated average price Renaissance paid for its US$750 million stake is closer to US$183 per share.
Other hedge funds have also funneled in hundreds of millions more, with well-known names such as Fisher, Susquehanna, Two Sigma, Ark Invest, Citadel and Deutsche holding significant multi-billion dollar stakes in aggregate. As for insider sales, about a year ago Eric Yuan, Zoom’s founder, transferred about 40% of his stake to family members, such as to his children’s trusts. Moreover, the founder himself exercised his options on a normal and predictable basis, although he stopped doing so in early March.
It is also worth mentioning that according to the SEC, that although Eric only owns 7.6% of the outstanding shares, he still holds approximately 29.8% of the voting rights because he owns a significant amount of Class B common stock. Class B has 10 votes per share compared to Class A, which only receives 1 vote. Those Class B shares will likely be converted to Class A shares about 6 months after he eventually leaves the company.
More Management Concerns
WeWork has an interesting history of financing and insider selling, to say the least. Perhaps the first red flag to be seen was the US$47BN valuation that SoftBank wanted to give WeWork when it first tried to go public. In the end, WeWork went public at a valuation of US$9BN, which is still twice its current market capitalization. Another big red flag involved Adam Neumann, who trademarked the “We” in WeWork, and sold it to his own company for US$5.9M. WeWork, more like “WeTheft”, right?
But he eventually gave back the share fee he had received for the trademark, after massive backlash from the public. Nevertheless, that did not stop him from taking legal action against SoftBank, which he sued after they put more than US$10BN of their own money into the company. That’s because SoftBank tried to withdraw a US$3BN offer they wanted to give Adam Neumann for his shares. Talk about biting the hand that feeds you.
On May 4, 2020, Mr. Neumann filed a complaint captioned Neumann, et al. v. SoftBank Group Corp., et al., C.A. No. 2020-0329-AGB, also asserting claims in relation to SBG’s withdrawal of the 2020 Tender Offer. (SEC, 10-K Note 24)
WeWork itself has faced and continues to face a myriad of lawsuits in the past. Lawsuits ranging from the alleged failure of the Board to “reasonably and diligently oversee our management, policies, practices and internal controls” to marijuana use by company executives, pregnancy discrimination, sexual harassment, breach of contract and more.
WeWork’s Massive Problem
WeWork relies on a business model where it might be able to make a profit if the housing market continues to rise and the economy is strong in the sense of low unemployment. Even though we were in that environment at the end of 2021, WeWork did not even manage to turn a profit at that time.
The problem lies in the business model, where WeWork takes on a lot of long-term debt in the form of capital leases and obtains very short-term income from tenants. This can be a valid business model, although it could very easily collapse in a recession. Even when the economy almost rebounded and unemployment hit record lows, WeWork continued to burn $397 million in operating expenses, which still amounts to $1.59 billion in annual operating losses.
Not to mention the $113 million in interest expense they had in the first quarter as a result of the problematic debt they took on. When you compare that to WeWork’s balance sheet, which shows about $519 million in cash and short-term investments, it’s not hard to see why WeWork will soon be looking for more liquidity.
Obtaining more capital once their current lines of credit expire in a higher interest rate environment will be challenging, to say the least. One of the few reasons WeWork has been able to survive so far is SoftBank, which has pumped over $10 billion into the company in recent years. When SoftBank realizes that WeWork is a lost cause and a defunct business model, it may very well be over-and-out for the company.
Looking at the back end of the business, at the fixed income market, we can also see that a very troubling message is being conveyed. WeWork’s bonds, which mature on January 25, 2025, have a CCC+ rating from S&P, which puts them well below their junk bond status with “substantial risk.” A CCC- rating, for example, would give them a “default imminent, with little prospect for recovery” rating.
The yield on the bond has risen to 20.97%, as the price of the underlying bond has begun to deteriorate in recent months. The original coupon rate is 7.875%, meaning the bond is trading at a significant discount, which is a serious signal for the future. The yield is currently similar to that in Q2/Q3 of 2020, when the economy completely stalled and WeWork saw a significant 30%+ drop in revenues.
The Housing Market
The housing market could use a whole article on its own, but we will highlight just a few of the key elements that are closely followed by the real estate sector. And elements that are usually far overlooked by the media because there is much more action in equities to cover.
But cracks are coming in the housing market, and we think investors should pay close attention. The chart below shows the average 30-year fixed mortgage rate in the US. The first thing to notice is that mortgage rates have shot up in a few months, past 5% and are currently even close to 6%. That’s the highest since 2008.
Even more interesting is the fact that although mortgage rates are close to 6%, the yield on a 30-year Treasury is currently only 3.2%. At one point in June, the spread between 10-year treasuries and mortgages was nearly 300bps. For example, on June 10, after terrible CPI news, the weakest sector already went bust. The Mortgage Backed Security (MBS) went no-bid for some time. There were no buyers for MBS.
This also happened, for example, with Subprime and Jumbos in 2007, and the Fed began to lower interest rates again. However, mortgages then remained above 6%, confusing the Fed. Perhaps the widest spread comparable to today is the 350bp spread in 2008. The current spread probably comes after the Fed has now stopped buying up MBS, which make up 1/3rd of the Fed’s balance sheet, or more than US$2.7T.
With the Fed no longer buying MBS, private players will have to step in to buy them. Although the appetite to do so seems very small. Not to mention that the Fed has indicated in the past that it prefers bonds to MBS on its balance sheet.
All in all, as far as MBS are concerned, a run-off is a lengthy process. But the run-off will mean an increase in supply, and thus likely result in a decrease in demand. That’s on top of already low bond prices. That means yields could continue to rise, putting great pressure on house prices, just as they did in 1979-1982, 1994-1995 and 2008.
Add to that a rising unemployment rate as the Fed raises interest rates, and WeWork could very well go bankrupt very soon, unless SoftBank dares to bail them out again. We could go on for hours about other drastic catalysts popping up in the housing market, but the clue is that the picture doesn’t look too bleak, even in the best of times.
Even the Federal Reserve admitted at their last meeting that new homebuyers may want to wait before jumping into the market, indicating that prices are likely to trend lower. In short, WeWork’s business model may have to be renamed “WeToast” if the housing market continues to show signs of cracking, leading to higher yields and lower home prices.
The Fundamental Picture
The reason we chose Zoom for this trade is that we believe Zoom is perhaps one of the most undervalued companies, if not the most undervalued company in terms of growth and fundamentals.
It is no wonder that Zoom’s current PEG ratio stands at a ridiculously low 0.62. We believe that in times when a recession becomes a very likely scenario, only companies with strong growth and profitability will thrive, and we believe Zoom is among those companies. For comparison, the PEG ratio for Coca-Cola (KO) is about 0.62, for Meta (META) 0.93, Zoom’s indirect competitor Microsoft (MSFT) with a PEG ratio of 0.99 and other companies like Walmart (WMT) at 3.21.
We also resolutely chose a subscription-based software company because subscriptions to highly necessary services are usually the last thing consumers cut back on. In addition, software companies are likely to ride out a recession due to their huge gross margins and ability to cut corners on operating costs quickly in times of recession.
Beyond that, Zoom is backed by a stellar balance sheet with US$5.73BN in cash and cash equivalents alone, which should enable them to weather even the worst of the recession. In the last quarter, Zoom spent about US$625 million on operating expenses, meaning they could survive for about 2.5 years without raising additional capital, and with profits dropping from US$1BN per quarter to an absolute 0.
WeWork, on the other hand, has a tangible book value that is approximately negative US$3.0BN. They have only US$519 million in cash and cash equivalents, and are burning about US$504 million in operating expenses (including interest expense) as of the last quarter. That means they are taking on more and more long-term debt each quarter, which only exacerbates their already disastrous debt problem.
Another important valuation measure that we like to look at when scanning companies is the Enterprise Value to EBITDA. In the case of WeWork, they have never made a profit, so they don’t even have a positive EV/EBITDA that we could calculate.
Zoom currently stands at 24.59x EV/EBITDA, which may be surprising. On the one hand, current growth may not yet be priced into that figure, given the ratio of the TTM is shown. Zoom’s forward-looking EV/EBITDA is actually 17.44.
We also believe that it is a better idea to look at the P/FCF metric since cash flow is ultimately the most important thing, especially when going into a recession. The stunning thing about Zoom is the fact that despite their tremendous growth over the past few years, they were still able to generate US$525.7 million in available free cash flow. On an annualized basis, that would mean they are currently trading at about 16.3x P/FCF.
Even at a TTM price, with US$1.51BN in unlevered FCF, they would still be at a 21.34x P/FCF. That’s still extremely low for a company like Zoom, which has only been around for a few years and is still in the growth phase. For example, Google (GOOG) (GOOGL), one of the most resilient companies, is one of the companies that comes close to Zoom’s P/FCF ratio, at a multiple of 21.38x.
The biggest concern of investors seems to be the slow growth in revenues over the past few quarters. However, we believe that this temporary flattening of growth is quite normal, as a company cannot continue to grow its revenues at a CAGR of 87.43%, as Zoom has done over the past 3 years. And we believe the market is still ripe for growth, as recent surveys show that 37% of employees have never even used videoconferencing.
In other developing countries, Europe and APAC outside the U.S., we also believe there is still a lot of market share to capture. We are betting that Zoom’s user growth may continue to be slower, but investors are also not factoring in Zoom’s ability to grow average revenue per user (ARPU), while increasing margins.
Among competitors, we believe they will also be able to expand. Zoom has been able to maintain steady revenue growth, which was 12% year over year, despite competitors like Microsoft releasing their “Teams Essentials,” which is supposed to compete with Zoom at 1/4th the price. And yet people decide to keep using Zoom because of brand loyalty, usability, features, ecosystem integration among other things. In fact, Zoom even increased the number of enterprise customers in Q1, which should really be Microsoft’s territory.
Looking at growth and profitability below fundamentals, Zoom is almost not even comparable to WeWork, as you can see in the charts below. Zoom delivers on both the top and bottom lines of revenue growth and profitability. The fact that a company can have EBIT growth of 384% over 3 years and no movement in its share price speaks volumes about how unfairly Bearish Wall Street is about this company.
Wall Street is pricing this stock at a terminal growth rate. And that’s when there are no serious signs that it’s going to do so, aside from a few quarters where revenue growth hasn’t been as frenzied as it has been in the 2020-2021 period. It’s not easy to beat revenue growth YoY when the past few years have been exceptional, something that Amazon, for example, has also had to contend with in recent quarters.
There’s just a very broad expansion ahead, while the world is still transitioning to digital. Zoom is primed to take advantage of the productivity that AI will have to offer, and there is probably still a lot of room for improvement when it comes to productivity, according to survey data. They should also benefit from an expanding infrastructure with 5G and higher streaming speeds/better quality, AR/VR, ecosystem integration, and an employee demand for an overall hybrid work environment.
2030 Spread Calculation
Since we focus on long-term investments, our valuation model is primarily focused on where companies are headed over the next 10 years. The chart below shows some of the key assumptions we used in our DCF valuation.
After making multiple 10-year valuations, with different margins, growth rates and outcomes, we believe that a CAGR of 16% is achievable over the next 8 years in Zoom’s growth phase. We believe that after this period, Zoom is likely to have reached terminal growth, which would be priced at a generally accepted standard of 3% for the last 2 years of our 10-year model.
We have not taken into account improvements in the FCF margin and a reduction in the number of shares outstanding as a result of share repurchases. The result could be much higher than our relatively conservative estimate. We believe that the estimates we have established are reasonable and achievable.
|Valuation Metrics||Zoom Parameters||Zoom Assumptions|
|FCF Growth Rate||230% (3Y)||16%|
|Current Share Price||$110|
|Margin Of Safety||10%|
We have used a discount rate of 11%, which is higher than the usual 9% generally used today, and have also added a safety margin of 10%. Based on these parameters and assumptions, we believe that Zoom’s fair value is $19.36 per share, or $17.42 when our margin of safety is applied. This would put Zoom at a share price of $385.10 and $346.51, respectively.
|Zoom Calculations||Zoom Today||Zoom 2030|
|DCF Value Per Share||$5.53||$19.36|
|DCF w/ Magin Of Safety||$5.53||$17.42|
|Shareprice w/ Margin Of Safety||$346.51|
As for WeWork, as much as we would like to give it an “imminent bankruptcy” rating, it would be unjust to assume a 100% chance of bankruptcy. Also, considering that SoftBank has provided billions in funding, and may continue to do so before the plug is finally pulled on this shallow situation.
It is also not possible to provide a valuation based on their tangible book value, as it is effectively negative. Our best approach would be to assume that WeWork’s debt will simply continue to rise, and its share price will continue to fall as a result. Currently, WeWork has approximately US$519M in cash, with some Sr. Secured Notes worth US$550M.
We believe this may be the closest approximation we can become to base our valuation on. If we take WeWork for their liquid assets, a US$1.07BN market cap would be $1.38 in share price. However, that is without taking into account the debt that continues to grow, such as the huge loss from their operations, and the increasing interest expense. Therefore, we think a $1 price target is deemed appropriate.
That implies that investors with this spread could obtain a CAGR of 15.42% when going long on Zoom, and a CAGR of 18.06% when going short on WeWork. However, the 18.06% annualized upside on the WeWork short does not take into account the short loan rate, which varies from day to day. Thus, it is only in the best interest of investors to go short when short borrow rates are lower than the 18.06% annualized decline.
The main advantage of the spread is that it provides a downside in this highly uncertain macroeconomic environment/bear market, where a recession is almost certainly on the horizon at the moment.
When going short, we also strongly believe that there should be wide barriers of safety, such as a temporary exit from the short position when the risk/reward ratio is getting unduly dangerous. Limit orders could be set when WeWork goes above a certain price (e.g., US$7), to avoid risks in terms of a possible short squeeze. That brings us to our next point.
Don’t Ignore The Risks
For WeWork, our main concerns are either a short squeeze on the stock, a complete change in the business model or an “unlimited bailout” by SoftBank.
Given that SoftBank’s Vision Fund had US$100BN AUM and has already put an immense US$17BN into WeWork since its inception, it is possible that CEO Masayoshi Son does not want to let the company walk itself into the abyss. Although it wouldn’t be the first time, since he has the honor of losing the most money in history (about US$70BN) during the dotcom crash, and he could find himself in the same shoes again.
The biggest threat could be a temporary squeeze on the stock itself. The most recent data shows a short interest of about 69M shares, out of a total of 725M shares outstanding. At an average volume (3M) of 6M-7M shares per day, that would take 10 days for shorts to fully cover, assuming no change in volume. If more and more people take a short position against WeWork, it could also become more expensive in terms of short borrow rates.
The most unlikely scenario could be a drastic overnight change in WeWork’s business model, although that would require them to cut huge corners that would drive the company itself into the ground. Right now, as mentioned earlier, if WeWork burns US$1.5BN at an optimistic Q1 annualized rate, that would mean they lose about US$2400 per member per year, since they currently have about 626K physical memberships.
Both companies also have above market average Betas over the last 24 months, with WeWork being the most volatile with a 1.26 Beta. Zoom’s 1.10 Beta shows that it is moving relatively steadily, with a 10% deviation from the market. What stands out, however, is the Altman Z-Score. This is a score by Edward Altman to predict the probability that a company will go bankrupt within two years. A safe company is usually above 3, up to a score of 8 which is universally accepted as a sign that the company has almost no distress.
Zoom is at 23.64 and as mentioned earlier, it is extremely unlikely to go bankrupt, even during a recession. However, a score of less than 1.8 means that the company is most likely headed for bankruptcy. But with lower interest rates and easier borrowing these days, that’s closer to 0. But WeWork has a negative score of 1.14. Altman Z-scores are almost never negative. That’s troubling, to say the least.
For Zoom, competition is our main concern when it comes to risk, although we are convinced that Zoom’s current performance is still impeccable. We believe the CEO speaks volumes when he also affirms that Zoom, which was generally created from scratch, was able to compete and easily captured market share from other major tech giants. And this in a market that is usually seen as a “winner takes all” scenario, where Google, Microsoft, Slack (CRM) are supposed to take the lead.
Another small and especially short-term risk that we believe we should note is FX headwinds, with the U.S. dollar being very strong recently against currencies such as the Euro, the Chinese Yuan and especially the Japanese Yen.
The Bottom Line
Even in a very severe recession, WeWork would deteriorate much faster than Zoom, in our view, based purely on valuation. This scenario is primarily driven by a very strong reversal of the aforementioned fundamentals, which would mean that the spread should still be profitable even in a very detrimental macroeconomic downturn.
Seeking Alpha’s most recent Quant Rating also seems to agree with our thesis, giving it a “strong sell” rating, at 1.05 on a scale of 1 to 5, which is bearish to say the least. Zoom is currently at a “hold” rating by Seeking Alpha’s standards, with it at about a 3 on the scale.
Their main criteria that pulls the score down is Zoom’s high P/S ratio, although that is offset by their high margins, which still results in a low P/FCF ratio. Another factor on which Zoom scores below average is their ROE growth (forward-looking), but we think this is mostly temporary because Zoom is already coming out of an exceptional period of growth.
We also kept an eye on the Fed’s data today, after which we noticed that the Fed had revised its GDPNow forecast to a GDP growth of -2.1%, compared to a slightly positive one a few days ago. This was mainly due to a decline in real personal consumer expenditure growth from 1.7% to 0.8% and a decline in real consumer spending growth from -13.2% to -15.2%. It is important to note that the GDPNow forecast is a purely quantitative model. The Fed can still decide to tweak the data, and present a different story.
The reason why this above forecast is important is that earnings expectations for the end of this year have not yet been revised downward. Despite the fact that the GDPNow model shows negative GDP for the second quarter, which means that there is a good chance that we are already in a recession. At least, if a recession is defined as 2 consecutive quarters of negative GDP growth.
Therefore, investors should focus on investing in companies with strong growth, a low P/FCF ratio, a strong balance sheet, and just overall a good EV/EBITDA multiple. We believe Zoom meets all of these requirements, and WeWork is the opposite of all of these factors.
In short, Zoom is everything WeWork would want it to be. Zoom is a true technology company with a highly profitable and sustainable business model, unlike WeWork, which claims to be a technology company but is really just a money-losing landlord.
We believe that the difference in fundamentals between Zoom and WeWork creates an incredible opportunity, with a highly asymmetric risk-reward structure that is doomed to outperform even in a deteriorating macroeconomic environment with wide margins of safety.