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SEC Flags Cash-Flow Measure That Made WeWork Look Profitable (1)

Dec. 3, 2019, 9:45 AMUpdated: Dec. 3, 2019, 11:16 PM

The parent of WeWork, Lyft Inc., and Peloton Interactive Inc. have all been touting a cash-flow metric that shows that their core services are profitable—after subtracting key costs like rent, marketing, and stock compensation.

For We Co., the subleasing company that operates WeWork, that meant subtracting roughly $900 million worth of cash and noncash leasing costs plus other building expenses from its member and service-generated revenue. Using a version of the metric known as contribution margin, the company reported a $142 million profit for the first half of 2019—compared to a $904 million net loss under U.S. generally accepted accounting principles. In 2018, the company had reported a full-year $1.9 billion net loss .

The metric’s use—and the operating costs it excludes—has raised questions from analysts and grabbed the attention of regulators at the Securities and Exchange Commission, which is now reviewing WeWork’s financial reporting and disclosures to investors.

WeWork championed the metric throughout its registration statement and revised its presentation—along with a name change—in an investor document released publicly Nov. 8. Recent IPOs Uber Technologies Inc., Lyft, and Peloton all have included it earnings statements and presentations to investors, though Uber has pulled back on its most aggressive use. Shake Shack Inc. in a similar vein refers to a metric it calls shack-level operating profit margin, a figure used to set the company’s budget and determine performance bonuses.

Lyft’s use of a contribution margin turned what would have been a $463 million loss into a $479 million profit, according to its third quarter results. Peloton reversed a $50 million loss into a $42 million profit and boosted its margin to 63 percent.

Young companies that struggle to show profitability—startup tech companies in particular—are looking for ways to showcase what the profits would be if they could strip away all the costs related to growing their business, said Bloomberg Intelligence analyst Jeffrey Langbaum.

“They are hoping to point investors to metrics that show the underlying health of the business while setting aside expenses that they think will scale over time or moderate over time,” added Tom White, a tech analyst with D.A. Davidson Companies.

Public companies are allowed to provide investors with metrics that don’t follow generally accepted accounting principles, and many customize industry standards like funds from operations or store-level operating margin. But the alternative figures cannot pre-empt GAAP accounting or mislead investors.

Revenue Sliced and Diced

The metric is generally defined as the selling price per unit, minus any variable costs per unit. But it ignores fixed costs that a business has to pay no matter how much revenue it generates, said Bob Pozen, former vice chairman of Fidelity Investments who now lectures at the MIT Sloan School of Management.

As a supplemental measure, contribution margin can be helpful to executives looking to cut costs or to show revenue growth. But WeWork used it as its primary measure of profitability, Pozen said.

“You’ve got to decide not to subtract a lot of expenses to move you from a big loss to a profit,” he said.

WeWork declined to comment on its use of the metric, but pointed to a revised measurement it calls location contribution margin. That figure accounts for the impact of spreading out rental costs over the life of the lease. In its S-1registration filing with the SEC, the company highlighted a margin that didn’t account for the impact of those higher initial non-cash lease costs, resulting in a healthier margin.

The issue for WeWork is the difference between how much rent it pays versus how much the company is required to report as its rent expense. Under U.S. accounting standards, companies must spread out the cost of their rent evenly over the life of the lease —what is referred to as straight-line lease expense.

WeWork currently benefits from free rent through incentives but will see its rental payments grow incrementally over the life of a lease. Higher rent in the later years of a lease term hurts the company’s GAAP financial picture—indicating a larger expense than it is actually paying for its very young leasing portfolio. Compounding the pain on paper for fast-growing WeWork, those new properties aren’t yet generating much revenue.

The company, in its registration filing, said it would show contribution margin both ways “ in order to facilitate a reader’s ability to assess the impact of this adjustment.”

Getting Real, in Real Estate

Langbaum, the Bloomberg Intelligence analyst, said he has never seen a company use contribution margin in 20 years of covering real estate investment trusts. Instead, real estate companies typically rely on metrics that show how they are reinvesting in their properties, he said.

Funds from operations, or FFO, is the industry standard. The cash flow metric shows the cash spent to maintain a property. Net operating income, another commonly used metric, shows the revenue generated at a property after factoring in expenses spent to run that site.

REITS don’t have to pull out corporate overhead to highlight their profitability. Instead the industry standards allow companies to show that “we’re making money even if you count the amount that we’re spending to reinvest in our properties,” Langbaum said.

It’s a business model aimed at slow, stable growth, not the grow-at-all-costs strategy of young tech companies, he said.

But WeWork runs a fundamentally different business than office-building REITs. To start, rent is an ever-growing expense for We Work, not a stable source of income as it would be for building owners. WeWork also provides more services and support to its tenants and requires higher marketing costs to fill desks every six months compared to a typical real estate investment trust.

“It is a tough business to describe particularly in the frame of traditional real estate,” said Danny Ismail, an office REIT analyst with Green Street Advisors LLC.

Ismail argued that it makes sense for the subleasing company to present a different kind of metric than a traditional office REIT because as a lessee, not a lessor, the company faces a different pattern of expenses and income.

A Metric on Demand

Contribution margin is an uncommon metric among technology companies as well.

But the magnitude of losses reported by both Uber and Lyft meant that both needed a metric that excluded a lot of operating expenses to focus investor attention on the underlying health of the core business, said White, the D.A. Davidson tech analyst.

The two ride-sharing companies differ in how they define the metric.

Lyft sticks closer to the GAAP figure known as gross margin, which represents the cost to generate revenue. Uber’s figure included adjustments for depreciation and stock compensation. Those are adjustments typical of another common cash flow metric—EBITDA, or earnings before interest, taxes, depreciation and amortization, White said.

During a Nov. 4 earnings call, Uber said that it had swapped its contribution margin for a segment-adjusted EBITDA.

Uber, Lyft and Shake Shack didn’t respond to requests for comment.

Peloton pointed to its S-1 filing, which states that its subscription contribution margin excludes stock compensation, a significant recurring expense for the business, plus the cost of amortization and depreciation. The company uses the metric for budgeting, as a measure of operating results and to gauge the effectiveness of its business strategy.

“Once you start getting a lot more creative in terms of the expenses that you are adding back, that’s when you get on a more slippery slope. And I think in both the case of Uber and Lyft, the way they define contribution margin, there are elements of the adjustments that they make that definitely raise investor eyebrows,” White said.

A Rosy View

The SEC has raised concerns about the use of the metric to controllers and chief financial officers.

“We’ve seen it a number of times lately, and every one is calculated differently,” said Patrick Gilmore, deputy chief accountant with the Division of Corporate Finance, at a recent Financial Executives International conference in New York.

Without naming WeWork, Gilmore questioned the decision of a subleasing/space-as-a-service company that applied contribution margin at the individual property level and excluded the impact of straight-line rent expense, as is required under GAAP. The company also didn’t make a similar adjustments to revenue.

He said it painted an overly optimistic picture compared to the company’s negative gross margin.

Despite efforts to draw attention away from early losses, analysts say they haven’t relied exclusively on the figure to evaluate companies’ likely future performance.

Although the margin sheds light on how management views the business, analysts at S&P Global Ratings rely on other metrics, said Shripad Joshi, senior director and accounting specialist for the ratings agency.

“Have you ever seen management paint a picture that is worse off than their GAAP numbers?,” Joshi said. “It’s always trying to paint a rosier picture. I think you have to take it with a grain of salt.”

To contact the reporter on this story: Amanda Iacone in Washington at aiacone@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Bernie Kohn at bkohn@bloomberglaw.com