IWG bull case looks overbought

What comes next remains unclear. After three decades spearheading this change, serviced office space provider IWG (IWG) describes itself as the “leading enabler and beneficiary” of the pivot to hybrid working. Many see it as a Covid winner. But judging by its choppy recovery, we think investors have placed too much faith in the group’s business model and the perennial optimism of founder and chief executive Mark Dixon.

With profits not forecast to recover to pre-pandemic levels until late 2023 and significant long-term commitments to pay rent on its leased office portfolio, the shares’ valuation simply looks too high on 25 times 2023 consensus earnings. The stock is priced for recovery followed by strong growth; although the share price is still cheap compared with analysts’ 345p average target price. While IWG’s strategy may eventually be vindicated, share price decline could come first.

The legacy model…

Until 2016, IWG (short for International Workplace Group) was known as Regus. This remains its main division, alongside fellow co-working brands  such as Spaces (“creative workspaces with a unique entrepreneurial spirit”), HQ (“where real work gets done”) and Signature (“the world’s most exclusive places to work, inspire and impress”). It also makes money from managing conventional office space and commercial real estate brokerages.

Serviced providers such as IWG operate by taking out long-term office leases and then renting the space as small units on shorter and more flexible terms to tenants. Historically, this intermediary role has served two constituents: landlords or sub-lessees in need of secure rental income and tenants whose scale, or business models, leave them with little appetite for long leases.

For IWG, the latter customer base can range from small start-ups to government departments and even massive international corporates keen to offer flexibility to employees. A prime example of the latter case arrived earlier this year when IWG signed a deal giving the 95,000 employees of Standard Chartered (STAN) bank access to 3,500 of its global offices.

There is a sound business model here. Because flexible office space is more expensive – one UK workspace operator pegged it at typically three times the cost per square foot of a 10-year lease – IWG need only maintain good occupancy and service quality levels to generate cash. And because the group does not own the buildings it rents out, the initial layout needed for expansion largely stems from sprucing up new locations. Capital commitments are even lighter in the much-trumpeted franchise model, in which third-parties take on the lease-matching risks and pay for use of the brand name and other services such as tenant hunting.

Until the pandemic hit, operating margins hovered around 7 to 8 per cent. Although free cash flow generation was regularly held back by expansion, capital-light growth turned thin headline profitability into a respectable average return on equity of 17.1 per cent between 2015 and 2018 (see chart). In the decade until the pandemic hit, IWG shares grew fivefold.

…and the current challenge

The arrival of Covid-19 had an immediate and painful effect on IWG’s trading as lockdowns and cratering business confidence smashed demand for flexible office space. By June 2020, the group was forced to tap investors, raising gross proceeds of £320m through the placing of shares priced at 239p. This included a £91m commitment from Dixon, whose owns 28.5 per cent of the group.

Fast forward to March 2021 and rising occupancy levels and “unprecedented demand" for hybrid-working solutions had breathed confidence back into the shares, which rallied to 387p. Writing in the group’s annual report, Dixon spoke of a “massive surge in growth” once social restrictions were lifted and “a developmental leap equivalent to the progress we had anticipated for the next decade”. In April, he told the Financial Times “it looks like the worst is behind us”.

It wasn’t. In June, investors were left blindsided by a trading statement warning that underlying earnings for 2021 would be “well below” 2020 levels. “Overall improvement in occupancy across the whole group has been lower than previously anticipated,” the group added.

Interim results showed the pain in full. Despite some revenue growth between the first and second quarters, the top line fell 10 per cent for the period and signs of recovery in the order book couldn’t prevent a £163m pre-tax reported loss. Worse, this came despite £190m-worth of first-half cost savings that are now being recycled to drive growth.

“The timing of this recovery remains difficult to assess,” wrote analysts at Berenberg in August, as they downgraded earnings expectations for the fifth time in a row and warned that consensus forecasts could yet be “overly optimistic” (see chart below). Another broker, Peel Hunt, called the pace of the rent reductions IWG is obtaining from its own landlords “unconvincing”, flagging that its like-for-like annualised property costs only dipped 6 to 7 per cent in the first half of the year.

The balancing act of IWG's role as both lessor and lessee has involved sharing costs incurred from the opening of new sites with landlords. And IWG’s capacity to renegotiate leases with landlords could now be an opportunity to balance margins. But the timing of existing lease agreements may work against this objective. Despite portfolio rationalisations, Peel Hunt estimates that around 30 per cent of the current network was opened since the end of 2018 on pre-Covid terms. The newness of these agreements could make them harder to revise.

With lease liabilities of £5.5bn, any difficulties in recalibrating rents could prove painful. A further challenge comes from Peel Hunt's estimate that about half of IWG's top line relates to central business districts and metropolitan areas where there is considerable oversupply and therefore more need for IWG to offer discounts to entice flexible-space tenants. 

A big bet

IWG believes that the emerging network will be perfectly placed to service companies’ desire for a blend of homeworking, and a “hub-and-spoke” mix of headquarters and local offices.

Quite how many businesses can (or will) justify this model is hard to say, although demand for hybrid space is clearly on the rise as employers look to switch fixed office costs for variable overheads. But it stands to reason that more workers will work from home more of the time – including staff of legacy IWG clients – and that a glut of office space is likely to persist in cities all around the world. One Dixon line in the annual report – “if you can give a worker two hours of their time back every day, that’s worth more than money” – cuts both ways, especially if the two hours are saved by working from home rather than working from a more local flexible office.

These shaky foundations, coupled with a high valuation, might explain why persistent bid speculation has never converted into a formal offer. This week, shares in the group jumped after Sky News reported Dixon is considering a break-up of the company that could help to double shareholder value. Aside from comparisons with the fantastical valuation of WeWork – itself set to ratchet up the competition when it raises money at IPO later this year – it’s hard to see what the arithmetic involved here is, and banks are yet to be hired.

While corporate actions cannot be ruled out, it’s worth noting that a bid approach by CC Capital earlier this year went nowhere, as did an attempted public auction in 2019.

Is an M&A premium already in the shares? “Don’t ever underestimate them,” says one former executive, who describes IWG’s founder as “incredibly relentless and resourceful”. That may be so, but at some point investor faith needs to be rooted in cash flows and real signs of an earnings recovery.