Investment Thesis

            RGU is the market-leading serviced office space company, operating in an industry whose supply/demand imbalance currently supports strong growth at high returns on capital. Top line growth and margin upside both within its mature portfolio and from new centers as they mature should allow RGU to enjoy total EPS growth of more than 30% per year without the use of financial leverage. Although optically trading at a relatively high P/E multiple, RGU is actually only trading at about 12x the 2014 earnings of its mature centers. In addition, the real estate and economic cycles are depressed in most RGU markets (>80% Gross Profit is in UK, EMEA and Americas) so we are buying off of depressed numbers. RGU therefore presents a suitable margin of safety and attractive asymmetric risk/reward profile.

Company Overview

            The company’s core product is the Business Center, which is an office solution providing a built-out office space to a customer who either does not want to commit to a long-term lease with a traditional landlord or for whom a fixed traditional lease is uneconomic. RGU also offers ancillary services such as conference room rental, IT, parking, catering, and secretaries. RGU also has a Virtual Office product that gives customers the ability to work from anywhere but have a physical mailing address and phone answering solution. Finally, RGU offers a membership card that permits the holder to utilize various RGU spaces on a drop-in basis.

            RGU was founded by CEO Mark Dixon in 1989 and pioneered the serviced office business. Dixon owns 34% of the company (>600mm GBP). Co is HQ’d in Luxembourg. Comp for the CEO and CFO is 28% fixed and 72% variable, with variable tied to EPS and total stock return performance.

Business Model

The basic model is to rent space long-term from landlords, outfit it professionally, and then sell it on a short-term basis with a markup and ancillary services. For the primary business, sales are typically done on a per-workstation basis with initial leases on average of 6-9 months (ultimate average customer life of 18-24 months). ROIC on new centers can reach more than 25% unlevered after tax.

The business has three key performance drivers:

1. Maximizing occupancy and rate for the core fixed location workstation rentals
2. Selling ancillary services to these clients
3. Leveraging the fixed costs of these locations through offerings such as virtual office and global membership cards.

Leases w/ Landlords: 82% of RGU’s leases are either flexible (they expire within two years) or variable (they scale with revenue). In addition, RGU generally uses special purpose entities as signatories on leases, allowing RGU to get out of a problem lease in a worst case scenario by bankrupting the SPE and avoiding any spillover into the rest of the company.

Unit economics are attractive. Returns are supported by an asset-light model in which RGU leases its space, and there is also negative net working capital as the business grows due to the two month deposits received from customers. Management targets a minimum 25% after-tax, unlevered 5 year IRR on new centers. By 4 years RGU has recouped its upfront capital. Importantly, the new centers generate operating losses in years 1 and 2 (which impacts the consolidated EBIT RGU reports).

Company-wide ROIC also supports the notion of strong returns.

Use of Cash: RGU pays ~2% dividend and invests virtually all remaining FCF into new centers, both via acquisition and organic. The company believes FCF will support 15% per year growth in centers. They currently have modest net debt but will end the year at a bit higher debt level as they borrow to support new center growth. 

Market

            The serviced office market has grown 10% per year over the last decade. Growth from SMEs appears to be the result of serviced office becoming recognized as a viable option for SMEs. Customers are coming to serviced office from working from home/Starbucks/hotel lobbies, fixed traditional leases and sublease arrangements. Growth is also coming from large corporations and governments realizing they can more cost-effectively manage remote workers/travelers/satellite sites through serviced office arrangements.

Penetration appears to be low. Serviced office space represents a LSD% (perhaps only ~1%) of total office stock globally. In the UK, by far the most mature and largest market in the world, serviced office represents 2-3% of the total office stock.

Serviced offices exist in over 1,500 cities globally but the 50 biggest markets comprise about half of the total global market. RGU is more heavily weighted to the Americas and APAC and less so to the UK as compared to the global market mix.

Competition

Research we’ve done suggests that RGU has ~20% global market share; however. RGU itself and most others believe RGU’s share is closer to 10%. In any case, RGU is the undisputed market leader and its >1,400 centers are more than 10x larger than the #2 player (the Australian company Servcorp).

It is hard to prove barriers to entry. However, the industry does seem to reward execution and/or scale, as many small players do not make money. RGU’s claim is that its scale and best practices do indeed form a CA, in terms of bargaining with landlords, marketing budget, appeal to multinationals, application of best practices, etc. Competition has increased in recent years, though, and new companies spring up all the time.

            It is possible that it is the asset-light nature of the business and current demand/supply imbalance in the industry that produce high ROIC, rather than a structural CA that RGU possesses. However, due to the low penetration, there should be enough growth in front of us that allows RGU to continue to open new centers at attractive returns for the foreseeable future.

EPS Compounding 2013-2016 & Valuation

            We think RGU can grow EPS at >30% per year in the 2013-2016 timeframe. This is driven by their planned expansion of new centers, low single digit “same-store” growth, and margin lift as the mix of centers transitions from “new” to “mature” and RGU leverages fixed costs as it grows.

            RGU trades at ~17x 2014 EPS. However, the large number of new centers are generating operating losses. Based on only the earnings from its mature centers, RGU trades at ~12x 2014 EPS.