Don't Moon the Giant!

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This week the world’s largest flexible-office company announced a strategic business model shift and is looking to accelerate growth through franchising. No I’m not talking about WeWork. I’m talking about Swiss-based IWG which manages office brands Regus, Spaces and No. 18. Until now IWG has leased office space, built it out, furnished it, and sublet the space at a mark up. To most of you this sounds like WeWork, but there are a few big differences between the two models going forward.

First, by moving to a franchise model, IWG should be able to increase growth using OPM (Other People’s Money) rather than using only their own to lease, build out, and furnish spaces. Second, IWG should benefit from much lower capital expenditures than WeWork, since the franchisees will assume that cost. Third, recent accounting changes require companies to carry long-term leases as liabilities on their balance sheet as you would for any mortgage or loan. This means that WeWork will be stuck carrying a ton of debt on its balance sheet, while IWG will be shifting that liability to franchisees. Fourth, IWG is already profitable and has been around long enough to experience what it takes to get through a recession. Being able to continue to achieve growth, even if modest, during a recession while using OPM to fund it should serve them well. Last, WeWork manages about 466,000 desks and was recently valued at $47 billion or $101,000 per desk, while IWG manages 547,344 desks and is valued at a measly $3.24 billion or $5,900 per desk. Do you think that gap will widen or close? To steal a quote from Yamamoto, has WeWork “awakened a sleeping giant and filled it with a terrible resolve?”

Here is one way to look at this coming battle royal. Unprofitable unicorns have been valued predominantly on their revenue growth stories. Don’t get me wrong, growth is important, but it is only one element of the value equation. Eventually, public investors want to see EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) and price-to-earnings growth. However, an often overlooked element in the valuation equation is the cost of growth, or capital intensity.

Take for instance two other companies that continue to battle it out for coffee supremacy, Dunkin and Starbucks. Dunkin sells franchises, while Starbucks’ stores are owned and operated by the company. At the end of 2018 Dunkin’s EBITDA was $0.460 billion which represented a 4.49% increase over the prior year. With CapEx of $0.209 billion, Dunkin’s EBITDA - CapEx was a positive $0.351 billion. Starbuck’s EBITDA for 2018 was $5.1 billion, which represented a decline of 0.24% from the previous year. With CapEx of $5.929 billion, Starbuck’s EBITDA - CapEx was ($0.829) billion! In essence, Starbucks had negative free cash flow once you adjust for CapEx. By the way, Dunkin’s stock was up almost 50% from 2016 to 2018, while Starbuck’s remained range bound for the same period.

This isn’t an argument about who has better java or cooler office space as much as it is about the tyranny of numbers. If you can grow fast and use OPM to do it, all else being constant, you should see the benefits show up in valuation eventually, because business models matter.

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