Love The Way You Lie
We have spent a lot of time lately professionalizing, standardizing, and automating (where possible) our internal financial reporting. This process has led to an ongoing conversation about how best to track results across the portfolio. For instance, to get a sense of true earnings power, should we exclude gains or losses on the sale of assets? How should we handle changes in accounting policy (ie. cash to accrual payroll expense recognition) that artificially reduce net income in the period the adjustment is made? Should we exclude one-time expenses? If so, what qualifies as a one-time expense? Ultimately, in addition to a calculation of free cash flow, we have gravitated toward tracking an “adjusted EBITDA” metric to measure operational performance. While we think this metric is defensible, we are also aware that the concept of adjusted earnings can seem a bit like make believe, sort of like a “theoretical” max on our back squat or an “implied” mile time. Sure, it’s possible based on our rep schemes and split times we could hit a 500lb back squat and run a 5-minute mile at some point in the future, but that’s not representative of our fitness today.
There was one particular headline last week that grabbed attention for its, shall we say, more creative approach to financial adjustments. Office-sharing company WeWork came to market with a $700 million, seven-year, 7.875% bond issuance, citing something called “community adjusted” EBITDA in its offering report, which the Wall Street Journal explains further:
“In the offering documents, WeWork went to unusual lengths to show ways in which the company would be profitable. While many companies typically offer ‘adjusted’ earnings, WeWork offered three different layers of adjustments. 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.”
WeWork’s argument is that once they achieve scale, large growth-related expenses, which largely include construction and marketing costs associated with opening new spaces, will taper off, allowing strong unit economics (i.e., high occupancy rates and healthy profit margins) to shine bright like a diamond.
The good people at WeWork put this metric together for investors because, in 2017, the company had $866 million of revenue and lost $933 million. Even savvy growth investors will pause at the magnitude of that loss, especially in comparison to the company’s $20 billion valuation (yes, that is a cool 23x revenue). Of course, the flip side is that WeWork is doubling its business every year. With growth that explosive, current numbers may not reflect true run-rate earnings power and providing adjustments can help tell the story about underlying operational strength.
The question then becomes one of reasonableness. Only time will tell whether or not these numbers reflect reality. The bond offering was significantly oversubscribed and things may be just fine for WeWork as long as future growth doesn’t taper off too drastically and current investments in new facilities perform well. However, the early price action suggests some initial concern that the even community adjusted earnings don’t paint a great picture of the business’s current health. The risk is that the bondholders have found love in a hopeless place. In case you are wondering, it will be a while before Chenmark issues a “tribe adjusted EBITDA”. It will probably happen right around the same time we actually hit that 500lb back squat and run that 5-minute mile.
Have a great week,
Your Chenmark Capital Team
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