The limitations of owning the market

A WeWork retrospective

Riding a unicorn

What can be said about WeWork that hasn’t already been said? Between the WSJ’s bizarre profile of founder Adam Neumann and some excellent academic literature on the overvaluation of unicorns, much has been said about the one-time darling of the venture capital world. However, what I want to explore is what made the narrative of WeWork and many startups like it so compelling to early investors. While it is easy to dismiss WeWork as a case of rampant optimism and the hype cycle gone wrong, there is something objectively appealing about the scale that WeWork was able to achieve (even if the company may not be around much longer to enjoy it). Underpinning WeWork’s narrative was the assumption that if a company can capture the market, the rest will come.

In order to unpack that assumption, I must make a few assumptions of my own. My assumptions are as follows:

1. Being cash flow positive is the ultimate goal of any company. Although some may disagree here, I stand firm by this assumption. Like anything else, corporations adhere to the law of the jungle. If you don’t eat, you starve.
2. For the purpose of this conversation, market ownership is only relevant in spaces that are not natural monopolies. I’m not talking about Con Edison or Time Warner Cable here.
3. Market share can be won or lost. Market ownership does not necessarily equate to a permanent advantage.
4. Fundamentally, the business model of a company does not change. WeWork makes money via subleases for the foreseeable future.

Assuming the above, there are really only two major ways in which owning a market can achieve the ultimate goal of being cash flow positive: economies of scale and/or by raising prices.

Balancing the scales of economy

The benefits of economies of scale manifest themselves in a variety of ways. The first, most obvious benefit is a distribution of fixed costs over a broader base. This manifests itself in a reduction of unit cost. For WeWork, this would be a reduction in the average cost of a seat in a WeWork space. The second benefit is an ability to use these cost savings to undercut competition. Although this approach effectively trades cost savings for additional market share, this can create a defensive moat that is difficult for new entrants to traverse. The third, arguably most impactful benefit, is access to relationships and alliances that may otherwise be inaccessible as a smaller scale organization. WeWork’s scale has lent it a credibility that has doubtless opened the door for many negotiations with real estate developers.

WeWork’s dominance in the co-working space has no doubt enabled it to negotiate more favorably with building owners and maintain high levels of occupancy throughout their buildings. However, although WeWork’s economies of scale have contributed to its exponential growth (effective doubling of revenue YoY), its losses have grown at proportionate rate. As a part of the whole, WeWork’s fixed costs comprise a small slice of their total expenses. In fact it’s the variable costs, the part of the business the scale up as the business grows, that comprise a much larger chunk of WeWork’s overhead.

In a 2018 offering plan for a corporate bond issuance, WeWork put forth the now-infamous operating metric known as “community adjusted EBITDA.” In this non-GAAP number, WeWork strips out general, administrative, marketing, and design expense positing that these expenses are non-recurring and therefore fixed costs. I find this to be a questionable assumption. Once a space has been designed and fitted, does WeWork expect to never update the design again? Do they stop marketing a space once it has achieved full occupancy? Even WeWork themselves seemed to walk back this rationale with “community adjusted EBITDA” nowhere to be found a few short months later in their S-1 filing for their IPO.

Uber and Lyft have had similar challenges in reining in their variable costs. Setting aside the cost of paying each of the drivers (which can technically be distributed among an increasingly large pool of riders), these companies’ customer acquisition cost continues to remain a drag on margins. Any user of Uber or Lyft can attest to the parade of coupon codes that users receive to incentivize them to pay for more rides. Trading profitability for scale can be strategically-advantageous in the short term, but it is not sustainable as a long-term model for success.

Rising tides lift all prices

“Aha!” you say. “Once you own the market, you can raise prices and then achieve profitability,” you counter. Can you really though? Imagine if Facebook introduced a gated subscription to use Facebook, Instagram, and Whatsapp. Would they lose their user base? Not entirely. However, you can expect that a lot more people are going to be downloading Snapchat or TikTok. Consider that Subway offered the $5 footlong for almost a decade or that Coca Cola sold bottles of Coke for a flat price of five cents for over 70 years. If alternatives exist, consumers tend to be exceptionally resistant to changes in price.

This is to say nothing of the pricing trends for the new unicorns. The price elasticity for users of these start ups has proven to be very high. WeWork operates in the exceptionally competitive (and highly localized) commercial real estate market. Having to cover the difference between what they pay building owners and what subletters pay them, WeWork is already one of the pricier alternatives to traditional office spaces. By offering shorter-term leases (generally a year to five years as compared to the traditional 10 to 30 years), WeWork has effectively lowered the switching cost for moving over to a competitor. If the math doesn’t work for these consumers, it is all-too-easy to find an affordable alternative.

I will concede that raising prices does work under specific circumstances. Take Netflix as an example. They wrote the obituary for the former in-home movie industry leader, Blockbuster, almost a decade ago. Their nearest direct competitor, Hulu, has never managed to muster the level of cultural relevance and user experience as Netflix. Moreover, Amazon Prime has only become a real threat in the past few years (Amazon debuted its first original series in 2015, two full years after Netflix). Due to its market dominance and defensible moat of content, Netflix has been able to raise prices four times in the past five years on its standard subscription. However, even under these ideal conditions, Netflix missed its subscription growth forecasts for the first time this past quarter. Their earnings filing notes that the “missed forecast was across all regions, but slightly more so in regions with price increases.” Moreover, as new entrants such as Disney+, Apple TV+, and HBO Max pour into the streaming marketplace at competitive prices, Netflix will likely lose its ability to raise prices again. Raising prices only lasts as long as the market will allow it. Even under the best market conditions, raising prices is just another short-term strategy.

The myth of market ownership

This is all not to say that the advantages of market ownership are not meaningful. Scales of economies and the ability to raise prices are indeed very real competitive advantages that many companies leverage successfully. Yet, while deal makers look for the next Google, Facebook, or Amazon. They often forget the former market owners that these juggernauts supplanted. They forget the Yahoos, the MySpaces, the Barnes and Nobles. As with all competitive advantages, market ownership is fleeting if it comes at the expense of everything else. That is a lesson that WeWork has learned the hard way.