Description

IWG Investment Thesis

All figures in UK pounds

Summary

IWG is a multi-brand operator of flexible office solutions, shared offices and co-workspaces, across value to premium concepts.

The key tenants of our favorable view of IWG include:

a. Large market with massive growth ahead (15-30% CAGR over the next 10 years)

b. Good business that earns 20% post-tax ROIC over cycles

c. Expected compounding of 35% in FCF/Share from 2021 to 2026 offered at 15-16X P/FCF of depressed earnings 

d. Strong and expanding barriers to success  

e. Extremely attractive risk-reward profile on a 3-year fwd basis:

Base case 2.6x MOI / 35% IRR

Upside case 3.4x MOI / 50% IRR

Downside case 0.8x MOI / (7%) IRR

Massive market opportunity with COVID19 as a structural accelerator

Net takeaway: the flexible office space has been grown at an accelerating rate over the last two decades and will likely expand even faster post COVID19.  Companies are shifting from long-term fixed leases (“fixed”) into short-term office solutions consumed on a variable basis through subscription models (“flex”).  

Evidence of growth in supply:  The following summarizes our findings on the global flex office market (date sources in parenthesis):

a. In 2002 flex office made up around 0.3% of total office space in N.A and EU (Savills)

b. From 2002 to 2010 Flex grew at 10% per year, reaching 0.5% of total office space (JLL)

c. From 2010 to 2019 Flex cagr accelerated to 24% (JLL) and flex made up 2.2% of total Office space

- USA: flex made up 0.3% of total space or 9.5 msqf in 2010 and grew to 85 msqf by 2019 at 28% cagr (CBRE)

- Europe: flex expanded at a 21% cagr from 2010 to 2019 and reached 2.1% penetration (JLL) 

- Asia: flex sqf grew from 2015 to 2019 at 38% cagr (JLL, no info on penetration)

e. Globally, flex space grew at 30% cagr from 2015-2018 (JLL); Flex grew at a 35% cagr over the last five years (The Instant Group)

==> Supply of flex offices grew at ~10% during the decade ending 2010, accelerated to around 20% cagr from 2010 to 2015 and to 30% cagr from 2015 to 2019

Evidence of growth in demand: a key question for flex has been whether supply expanded irrationally.  While we do not have direct data on consumption, we can look at an important proxy – occupancy:

We note that mix affects the occupancy stats we show above, as newer entrants (i.e WeWork)  focused on large city centers. IWG, and to an extent Service Corp, operate in both metro centers and secondary cities and spread their network across co-work and serviced office concepts (that work well at lower occupancy levels than large co-working centers).  

As we will explain ahead occupancy rates at the mid 70%s range allow IWG to generate low-twenties post tax ROIC. Large co-working locations in expensive city centers (i.e. WeWork style) require high 80s occupancy to generate good returns.  We therefore view the above as a good indication that occupancy levels in the industry held up well and that rapid growth in supply was mostly absorbed by demand until the COVID induced crisis. There has not been a collapse in occupancy with supply expansion clipping at 24% cagr since 2010.

==> Demand grew at 20-25% cagr over the last decade and matched supply even as growth rates accelerated to 35% cagrs

What drives the success of flex ? we think it wins over fixed on the following dimensions of competition:

Price – flex renters pay high prices per sqf but take up far less space than they do in a single purpose, fixed leases. They end up paying around one-third less on their total real-estate expenses vs the fixed alternative (WeWork claims savings are two-thirds but we think they exaggerate). Savings also stem from efficient resource optimization of shared areas with other tenants (i.e. one kitchen, conference room and receptionist spread across several customers in a flex office center). Pooling of purchasing power by the flex operator also play a role in its ability to save money for the customer (from purchasing power on leases to buying internet bandwidth or office furniture) 

Flexibility – allows renters to move from commitments of 5-7 years to 1-year, materially reducing operational risk and enhancing optionality 

Capital Efficiency – offloads lease liabilities from customers’ balance sheets

Flex should continue to take share and grow at 15-30% cagr for the next 5 years:

We view COVID19 as an accelerator for the flex concept for two main reasons:

1. In a world with more work-from-home (WFH) corporations still need team members to meet in person. Face to face meetings are required to sustain companies’ cultures and to enable processes, which do not transport well to video conferencing (i.e. ad-hoc creative processes, informal data exchanges, processes where body-language plays an important role such as negotiations, work flows that require continuous supervision, etc. – the list is long).  Instead of relying on central HQ buildings it will be more efficient for some but not all companies to use satellite offices located near their employees’ suburban living areas, facilitated through 3rd party flex networks 

2. The challenge of managing real estate in a world with more uncertainty and complexity will drive outsourcing to third party real estate operators.  If managing buildings post covid will require more health-related safety resources, lower density per employee, and involve increased risk of shutdowns (think next pandemic) then companies should make the logical conclusion that: 1. real-estate and office management is a business process better outsourced to professional firms that make it their core competency (with flex operators as natural choices) and 2. that companies should spread their workforce geographically to maintain redundant locations going forward (i.e. reduce dependency on one large HQ building)

Can we find any evidence that supports this thesis?  Initial indications are positive. In a Survey conducted by CBRE on July 17, 2020 that tapped 126 senior real estate executive at large companies (50% Fortune 500, 10% Fortune 100; 60% global, 20% America), we found the following questions relevant to our discussion:

a. “73% of respondents expect flexible office space will play some role in future strategy” (for reference, per The Instant Group, today 44% of Fortune 100 use flex)

b. “33% expect to use more flexible office space (i.e. serviced office, suites, coworking)”

c. Of those 33%, about 18% (of total surveyed) see both an “increasing” and “significant” role for flex and 15% see an “increasing” and “minimal” role

We can point to additional comments by industry players and to surveys indicating similar outlooks for flex post COVID19.  But we found the CBRE survey as the most current and statistically significant, so we used its findings to try and simulate the funnel of demand over the next 5 years based on intent:

An additional approach is to look at penetration rates and expectation for lift in usage.  On this front we point to a Cushman & Wakefiled survey of 579 corporate real-estate professional:

a. 63% of global organization utilize coworking somewhere across their portfolio

b. Those that use flex, have 3% of workforce in flex setting on a regular basis

c. And they expect to reach 10% utilization in 2 years and 15% in 5 years

d. Those who used flex are very satisfied with it, with 65% having positive/very positive view of flex. Importantly the more these customers used flex, the higher their satisfaction score 

Taking these finding, we tried to construct demand growth based on workforce sizes, current utilization and expectations for lift in usage:

While playing with numbers is easy, we think the above exercise applies conservative assumptions. Importantly the figures suggest that flex is still a tiny piece of the entire office base and directly addressable demand. Therefore, for flex to grow it doesn’t have to fit every company, just enough of them. Given that flex has been adopted by a very wide range of industries and company sizes (around 40% large corporates, 25% mid-sized with the balance in SMB) and taking into account its low penetration today and rapid expansion for the last two decades, we conclude that   

==> Flex should compound at 15-30% volume cagr from 2019 to 2025 

As an additional sanity check to our analysis we looked at what 3rd party RE advisors think: JLL projects that 30% of total office space will be flex by 2030 (reaffirmed as of June 2020); The Instant Group’s projects that 12.5% of total office space will be flex by 2023 (reaffirmed as of July 2020); and CBRE sees flex reaching 13% penetration by 2030 in the USA.  These projections imply volume cagr of 20-35% going forward.

Demand will grow and supply is balanced but is it a good business to be in?

The short answer is yes. We see excellent returns at the single unit level and good returns for large operators that achieve scale.

Single Unit economics at IWG: the following is a breakdown of the IWG mature centers’ p&l and roic:

We take away the following insights from the above analysis of IWG’s developed estate:

1. At maturity the returns for the IWG estate are excellent with or without loading the company’s corporate overhead – growing such an estate generates a lot of value

2. Scale at the network level yields significant advantages: every 10% difference in the size of the footprint, absorbs 1% of corporate overhead. IWG is 50% larger than its closest competitor (WeWork, post it expected restructuring) and >10X bigger than the third largest operator in the market. Furthermore, landlord contributions make up 20% of gross capital spent. A flex operators with a strong brand that is perceived as an anchor tenant drives substantial incremental savings on this front relevant small independent flex providers (landlords make an effort to secure IWG and maybe WeWork as tenants far more that they do the next Joe Shmoe flex provider with one to three centers). We therefore see IWG possessing material cost advantages versus all other competitors in the flex industry.  

3. We estimate that a flex center’s cost base is around 70% fixed in the short-term, and around 45% of its cost base is fixed medium-term.  Given that revenues fall around 20% during downturns, a flex center is an economic unit with very high operational gearing. This dynamic holds several important implications

a. Operators who get their leases, center setup costs (=depreciation) and sg&a bases incorrectly find themselves in a world of hurt during recessions. These pains remain as we exit downturns since operators need to return to peak occupancy to generate returns. Therefore, those who accelerate growth when the market looks strong usually end up with misaligned leases priced at the top. This is the dynamic that creates fast growth before the peak of the market and prolonged restructuring well after the downturn. See WeWork’s situation...

b. The operational gearing and cyclicality are partly the reasons why the flex space is an industry with low barriers to entry but very high barriers to success over the long-term.  It is easy to start a flex business during ebullient periods, but the history of the industry proves that many entered but few flourished.  

c. IWG is an exception to the rule with over 30 years of profitable growth but most importantly operational scaring that shaped its DNA as a very disciplined operator. We view this discipline as a material trait to bank on as equity investors in the space (…akin interestingly enough to the investment management business which is also a domain with low barriers to entry but high barrier to long-term success…).  

d. In industries where discipline and consistent levels of execution determine success, high performing players tend to grow regardless of the actions of new entrants, as most of the later do not survive (in other words new entrants are unable to hold on to share as the high execution operators march on)

IWG is the leader of the flex industry 

Our research points to an industry made up of one large and profitable player (IWG), a second runner-up that is struggling as a consequence of undisciplined growth (WeWork) and a long-tail of small sub-scale operators particularly vulnerable to ceding share post covid-19:

We draw the following takeaways from the stats above:

a. IWG is the only scale player that is cash flow positive, with no debt and a stabilized portfolio

b. Only WeWork was close to attaining scale that would have allowed it to benefit from cost advantages similar to IWG. But WeWork is retrenching since its growth was undisciplined, resulting in a portfolio that is predominantly un-stabilized, cash flow negative and straddled with debt – the logical step for WeWork is therefore to curtail footprint expansion and build occupancy. We think this will mean that IWG will be the only player capable of buying assets at distressed valuations; however, it also induces risk that WeWork will lean into price discounts in the short term to fill space.

c. All the other players are subscale, will likely retrench their footprint and will not become scale players for years to come (if at all). IWG will likely remain the best viable option for corporate customers seeking to deal with fewer providers of flex networks to reduce complexity

==> IWG’s competitive advantage in the industry will expand going forward.  There is risk of pressure on pricing in the medium terms (2-3 years till players build up occupancy rates).  This is the time for IWG to deploy capital at very attractive returns

Past financial performance

We highlight the development of IWG key financial metrics over time:

IWG generated very high FCF per share growth (before growth capex) and has done so at robust returns.  We note that EBITDA – Maintenance CapEx lagged EBITDA growth as the intensity of maintenance capex grew over the last 5 years; however this spend was offset by higher contributions from landlord (known as Partner Contributions in IWG’s terms), which allowed IWG to hold onto strong overall returns.  Finally, FCF and EPS compounded at higher rates than EBITDA-Maint. Capex thanks to IWG’s effort to sell locations to franchisees from 2017 to 2019 (more on this front ahead)

Management 

Mark Dixon, the founder and CEO of IWG owns close to 30% of the company (a stake worth $1B).  We have followed him for many years and found him to be an extremely talented CEO that drills down to every little detail in the business.  Mark knows the details of almost every one of the centers in his 3,300 network, and approves every center opening or closing. We think this attention to detail and intensity are critical in a business with high operational complexity.  Mark views IWG as his life’s achievement and manages IWG for the next 20-30 years.  He is as an aligned CEO to long-term investors as we can find. He has also been through three downcycles in the industry (2001, 2008 and 2020), and has seen competitors come in and out of the space several times as they lacked discipline during industry peaks and found themselves without capital during downturns.  We have heard multiple times from peers and landlords that he is a very tough and able negotiator.  We think that positions him well to allocate capital during the current downturn and expect IWG’s to generate high 20% to low 30% returns on its p800mm of capital available for deployment.  Mark seems to believe in the future of the company as evident by the p91mm investment he put into the shares in April.

Valuation – Base Case 

We approach our base case valuation of IWG by analyzing the free cash flow generation of the mature estate (those centers open for 3 years or more) in a normal year, which we define as 2023.  We then add the value we expect IWG to generate on its free cash flow and incremental debt capacity at 2.5X net debt / ebitda (the company target), and assume this capital’s yield matures by the year 2026, which we discount back to 2023. 

Value of the mature estate in 2023:

The above analysis assumes the following

a. The market returns to normal mid-cycle conditions in 2023

b. Immature centers opened in 2018, 2019 and 2020 stabilize by 2023 

c. IWG closes 5% of its current footprint to drive occupancy up

d. Pricing in the industry reaches 95% of its 2019 level despite normal occupancy 

e. Occupancy of 76.3%, similar to previous mid-cycle levels

f. The company achieves 150mm of cost savings announced in 2020 with no additional efficiencies beyond that

g. The 2019PF results show how the estate would have looked with the immature centers stabilizing 

h. The 2023 results show how we expect the pf estate to do in 2023 with the assumptions described

i. We apply a multiple of 13.5X to the estate FCF generation, implying a 25% discount relative an S&P company to account for the cyclicality of the business

==> We arrive at a price target of 4.6p/share for the exiting IWG estate

Combined with the value we expect IWG to generate from reinvesting its FCF and debt capacity we see the following price target on 2023 numbers:

On the returns on capital deployed we assume

a. IWG cash flow generation of zero, ~180mm and ~350mm in 2020/21/22

b. Debt capacity of 2.5x to EBITDA per management targets at a blended cost of 5.5%

c. Capital is deployed at a 20% return, which is attained in 2026, discounted back to 2023 values at 10% and valued at 13.5x similar to mature estate. 

d. These assumptions yield 3.4p of value per share on capital deployed

==> We see a target price for IWG of 7p / share on 2023 numbers, which implies almost 2.6X the current stock price.  If attained by mid to late 2023 this implies an IRR of ~35%

Valuation – Upside Case in a Franchising Model

Over the last three years IWG began emphasizing a transition to a franchising model.  In 2019 it sold its Japanese footprint and Swiss estate to master franchise operators at 3X revenues. The company was also in advanced discussions to sell its US operations for similar multiples before COVID hit. Mark Dixon wants to push into a franchise model as a capital efficient route to growing the IWG network to 20-30K centers over time. We think franchising most of the estate makes a lot of sense as it will allow IWG to transition into a Marriot/Hilton mode of operation and materially increase shareholder value.  Below we show a case in which IWG can franchise its USA operations at 3X by 2023 plus 10% of additional revenues:

==> Upside case is for 9.2/shr or 3.5X and 50% IRR in 3 years

Downside Case

We envision a scenario with the following assumptions on 2023

a. IWG is forced to shrink its footprint by 10%

b. Occupancy is attained at 72% (4% below previous cycle norms)

c. Price drops 10% relative 2019

d. The mature estate receives a 35% discount to S&P multiples or 11.8x

e. The company is able to deploy cash at 15% returns 

In such a scenario we arrive at the following values

==> Downside case is for 2.2/shr or 20% downside and (7%) IRR in 3 years

Risk

Pricing: we expect the industry to suffer from price pressure in the short-term and possibly in the medium-term (2-3 years) until players build occupancy.  We think the risk of rapid supply growth is low as most players, aside from IWG, are capital constraint.  Therefore, if we are correct about the direction of demand, pricing will stabilize as occupancy returns in the industry to the mid 70% blended rate

Competition from fixed office landlords: while flex is still just over 2% of the total office footprint, it had been absorbing around a third of the market’s growth in recent years.  This rapid absorption does put pressure on some landlords to offer shorter-term leases (of 1-2 years) to meet demand.  Such offerings could absorb the incremental flex customer whose primary driver is the flexibility of a short lease. However, we point out that while flexibility is a key driver for flex users it is not the only driver. Flex also competes well on price, capital efficiency and service: in a recent C&W survey more than 40% of flex users saw it as an effective means to reduce costs, 30% to improve employee retention and 30% as a networking tool.  We therefore think landlords that offer 1-2 year leases will absorb only a portion of the demand for flex. We also see covid19 driving large companies towards outsourcing their real-estate operations to reduce complexity and for some to seek distributed network solutions (where office landlords are not setup well both from a geographical and service model).  Our conclusion is that office landlords switching to shorter term leases could become a directional headwind that slows growth but will not halt or reverse flex’s expansion. 

Competition from new entrants: we see the main risk on this front from the likes of JLL/CBRE deciding to enter the flex space with force. Also, hotel operators are potential entrants as well. As an example, Accor announced pre covid19, its intent to enter flex with the goal of building a network of 1,200 centers. We believe post covid19 all these players will be measured and rational in their growth plans. Ultimately their entrance should benefit IWG as institutional quality operators should drive market acceptance and introduce rationality to the industry during the next market peak.

Macro conditions: if we enter a prolonged depression, and experience unemployment rates akin to 1930s levels (25% unemployment, 15% net corporate bankruptcies), IWG will suffer. But in such an environment the weak operators will be wiped off and enable IWV to accelerate share gains. IWG is already making the necessary adjustments to sustain positive free cash flow in 2020 and certainly in 2021 and is effectively debt free. It can tap its committed shareholder base and raise additional capital (unlike many competitors) so it will survive.  Holding the shares will hurt in the interim but we don’t see capital impairment in this scenario, just lower IRR.

Demand for flex structurally broken: we could be wrong and post covid-19 the flex market retrenches as current customers of flex reverse course and do not renew subscriptions.  Companies move solely to WFH modes.  We think this is a low probability scenario based on both the structural reasons we showcased and recent surveys indicating customer expectations to increase their flex usage.

Management: Mark Dixon is crucial for the success of IWG – he serves as a key facilitator of operational excellence at IWG as well as capital allocator and risk manager.   A different CEO would mean a different IWG and would require a reevaluation of the thesis.

Catalyst

Cyclical recovery in industry

Franchise deal