Chinese co-working prodigy Ucommune hopes to tell a new story about its business to go public. It has to be different from what WeWork touted: an unsteady model which incurred voices of doubt before the company’s near-collapse in Q4 2019.
It is a story that has quickly become a cautionary tale: WeWork has turned from a unicorn that investors wooed into a distressed asset, one that is now valued at USD 8 billion, in a climbdown from a previous figure of USD 47 billion concocted by Japanese backer Softbank. WeWork presented itself as a ‘Space-as-a-Service,’ with members bringing monthly ‘recurring revenue.’ On this unsteady ground the founders gobbled up a giant real estate portfolio and far more investment than the projected merited.
Beijing-based unicorn Ucommune was founded by a real estate veteran, Dr. Mao Daqing, in 2015. Mao previously led Chinese property conglomerate Vanke, where he oversaw historically high sales figures. As Mao takes Ucommune public, the ‘SaaS’ logic of WeWork looks like a toxic pitch on Wall Street. Ucommune (formerly known as URWork, until IP conflicts with WeWork forced a name change) is now in desperate need of reorienting its business before the IPO launch.
What might the new image be?
Chinese tech media Rancaijing (the link is in Chinese) said the target model would be that of Chinese hotel management firm, Huazhu Hotels Group. Apart from that, there are other candidates: for instance, IWG (International Workplace Group). The general consensus is that a steadier approach is needed. These incumbents raise their revenues at a much slower pace compared with ‘disruptors’ like WeWork and Ucommune – if they are indeed competing in the same vein.
In the first half of 2019, IWG increased its revenue by 12% compared to last year, while WeWork’s revenue jumped by 101%. In the first three quarters of 2019, Huazhu’s sales inched upwards by 10% while those of Ucommune rose by 60%. A broadly accepted theory is that investors are paying for future cash flows, so fast growth becomes essential. But that is not the case here. Huazhu has a market cap of USD 11 billion and is now trading at a 6.97X revenue multiple. Will the fast-growing Ucommune eventually be more valuable? Growth is hardly the only metric that investors look at.
Huazhu and Ucommune are providing two different types of service. Hotel rooms are of high purchase frequency and are rented directly to customers, while co-working spaces are rented to businesses long-term, with less purchase frequency. It might be a risk for Ucommune to benchmark itself with Huazhu.
In the wake of WeWork stepping back from its IPO in the face of doubts about its loss-making business, Ucommune filed for an Initial Public Offering on Wednesday, December 11. According to Reuters, Citigroup and Credit Suisse were reportedly set to drop out of the company’s IPO due to its desired valuation.
In the frothy markets, it is easy to convince an array of investors to pour money into a yet-to-be-proven business. An investment may push up valuation, ballooning the bubble – but not creating value. When a bull market ends, the capital becomes a liability; observe how USD 40 billion vanished when WeWork accepted SoftBank’s USD 5 billion rescue package. WeWork’s Chinese rival risks becoming another testament to such over-reaching.
Ucommune once claimed its post-money valuation had reached USD 3 billion (in its Series D round of funding in November 2018). According to its prospectus, the company is valued at USD 843 million, calculated by its 131 million ordinary shares outstanding to date, multiplied by the fair value of USD 45.9 per share as of September 19, 2019.
The subleasing business model counts its losses, while Ucommmune puts more efforts into controlling rising costs
Ucommune had shared workspaces across 41 cities in the Greater China region as of September 30. Thus far, WeWork and Ucommune have been following the same basic strategy: a growth-heavy and loss-heavy scheme. WeWork reported a net loss of over USD 900 million in the first half of 2019, on a revenue of USD 1.5 billion, while Ucommune posted a net loss of CNY 572 million (USD 63.4 million) in the first three quarters of 2019, on a revenue of CNY 874.6 million (USD 122.4 million). Ucommune's revenue in the period grew 209.94%, compared to the first three quarters of 2018 – a fair number that Wall Street investors seem to buy.
But behind the veneer of growth is an acquisition deal. Marketing tech provider Shengguang Zhongshuo was acquired by Ucommune in December 2018, and contributed to the majority of marketing and branding services revenue in 2019 – representing about half of the total revenue. Though boosting the company’s sales and saving the collapsing financial reports for a little bit, this acquisition is difficult to frame as a solid investment. Merely looking at the gross margins – an excellent proxy for full scrutiny when evaluating a company, it is evident that the marketing and branding services generated only 10% gross margin in 2019. A typical Software-as-a-Service business makes a 60%-70% gross margin.
The core business, or so-called workspace membership revenue, involves taking long-term leases and renting out spaces in the short term. This incurred expanding negative margins and burgeoning losses. Ucommune therefore took some control on three major aspects.
Improving operation efficiency
The company’s sales and marketing expenses-to-revenue ratio decreased to 5.5% in 2019 from 15% in 2017 while the general and administrative expenses-to-revenue ratio plummeted to 15% from 56% in 2017.
Slowing scaling
The company only added nine more new spaces in the first three quarters of 2019, compared to 96 in 2018. The company defines mature spaces as those spaces whose lifespan has surpassed 24 months. The occupancy rate of mature spaces achieved 83% in September 30, 2019, higher than the occupancy rate of all spaces of 79%.
Exploring ancillary businesses
In its Dec. 11 prospectus, Ucommune describes itself as using an “asset-light” model in its side business, comprised of two branches. One is the ‘U Brand’ function, whereby the company charges landlords management fees for branding, consulting and operating services. The other is the form of U Brand whereby the company shares revenue with landlords. Though Ucommune claimed to generate operating profit from the model in both 2018 and 2019, there is no clear evidence, other than the square meter number of the managed areas. In 2019, 23% of the managed area of Ucommune is under such a model. The company claims that this ancillary business is to become the primary driver of Ucommune’s growth in the future. Landlords under such a case will bear the most capital investment, according to the company’s prospectus.
Apart from the above, Ucommune has acquired several weaker players in the industry over the past few years – for instance, Hongtai Space in 2017, under an equity exchange arrangement. None of these core efforts have altered the company’s core competency, however.
Where is the defensibility?
Ucommune claimed to be the largest player in its domestic market regarding managed areas and the number of cities it operates in. However, being the first one can hardly add any advantages to building true defensibility – to protect its business from the competition.
In the commercial real estate industry, the upstream developers have more bargaining power. Middleman like Ucommune can hardly improve their pricing power by simply signing more long-term leases with real estate developers. In the end, facing small gross margins, squeezing net profits by cutting operating expenses like SG&A helps little in releasing pressure on the balance sheet.
Nearly all massive returns in business come from long-term defensibilities – some major forms include branding, network effect and scale. But in Ucommune’s case, there is no network effect. Because the platform that Ucommune relies upon has two sides – the supply side and the demand side. Adding more spaces would not either lead to more value delivered to users (or members, as the company calls them), not to mention more value to providers. Even another form of the sharing economy – the ride-hailing business – has its network effects. Loss-making as they sometimes are, Uber, Lyft and DiDi’s cross-side network effects are supposed to work. More driver supply decreases the rider’s wait time and fares, which in return brings more riders on the platform and increases driver’s revenues. Slowing scaling, thus, is just a tool to slow down losses, not a way to generate network effects.
Economics of scale appears not to work so well here. In addition, as Ucommune gets larger, a host of disadvantages approach. While revenue grows, losses keep pace with it. Will buying ancillary businesses contribute to value creation? WeWork’s story might teach us a lesson here. In the past, it purchased workplace management software companies. Now it has to turn its attention back to co-working management and sell these side businesses.
Besides, we have yet to see any policies in China that will help the company to build regulatory moats.
Brand and scale are the two competitive advantages and defensibilities Ucommune possesses right now. Keeping the mindshare of the best co-working brand in the market, however, requires a lot more investment, especially for a company that only has around USD 23 million in cash and cash equivalent as of September 30, 2019, and which is burning around average USD 47 million in operating costs per quarter in 2019.