- Fast-growing, early-stage companies Netflix Inc., Tesla Inc., Uber Technologies Inc., and WeWork Cos. LLC have caught the eyes of debt investors with how they've disrupted their markets.
- We expect similar disruptors to find receptive investment if the early arrivers prove creditworthy.
- We compare the four in market position, competitive landscape, profitability, and liquidity, as well as environmental, social, and governance factors.
- Netflix has the most juice among the four despite a persistent cash flow deficit, while Tesla gains cash flow speed, Uber strengthens liquidity in a competitive landscape, and WeWork's strategic turnaround is still early, though supported by SoftBank.
Fast-growing, early-stage companies were once the purview of venture capitalists and IPO investors, but this is changing. Debt investors have become more receptive to these firms over the past several years, and the companies are taking advantage of less expensive capital. We expect to see more of them access the debt markets if early adopters' creditworthiness bears out.
In "Credit FAQ: What Factors Drive Ratings For High-Growth, Early-Stage Companies Like Tesla And WeWork?", published Dec. 3, 2018, we explored the nuances of rating these companies. Here, we directly compare and contrast the key credit attributes of the four most visible high-growth, early-stage companies in the debt markets. All are assigned low speculative-grade ratings, as the lack of a long track record of cash flow generation precludes the consistency and predictability we require for an investment-grade rating.
We view Netflix Inc. as the most creditworthy, followed by Tesla Inc., Uber Technologies Inc., and WeWork Cos. LLC. Netflix scores well on most business factors because of its large subscriber base and significant content library. A persistent cash flow deficit, which topped $3 billion in 2019, limits our rating on the company, a result of its aggressive original content investments. Tesla also scores well on most business factors with its leading technology, product, and brand. Additionally, its free operating cash flow has been positive five of the past six quarters--the best of the four--although it has less flexibility to curtail its investments because of its capital intensity.
Uber faces an intense competitive landscape with players battling for market share. This has led to significant negative cash flow, and it faces regulatory challenges as a result of social concerns. But its ability to curtail investments in noncore businesses and significant liquidity position providing multiple years of runway convince us its capital structure is sustainable. WeWork faced significant challenges following the governance issues revealed through its defunct IPO process. Large capital spending commitments and weakening liquidity cause us to question the sustainability of its capital structure, although we expect to review WeWork's rating after we understand more details about its $5 billion capital commitment from SoftBank Group Corp., including the use cases and timeline for receipt of note proceeds, its new strategic plan, and fiscal 2019 year-end results, which are not yet publicly available.
|Early-Stage Peer Risk Comparisons|
Uber Technologies Inc.
WeWork Cos. LLC
|Issuer Credit Rating||BB-/Stable||B-/Positive||B-/Stable||B-/Negative|
|Business Risk Profile||Satisfactory||Vulnerable||Weak||Weak|
|Industry Risk||Intermediate||Moderately high||Intermediate||Intermediate|
|Financial Risk Profile||Highly leveraged||Highly leveraged||Highly leveraged||Highly leveraged|
|Liquidity||Adequate||Adequate||Strong||Less than adequate|
Market Position: Challenging The Status Quo
When we assess market position, we look at characteristics such as brand recognition, market share, proprietary advantages (technology, patents, content, etc.), regulations, and barriers to entry. These key credit factors inform our opinion on the defensibility of the business model over the long term. Disruptive business models that change the customer experience result in high growth and greater market share relative to peers.
However, growth potential has not always translated into success since industries evolve rapidly and incumbents may have large resources to effectively compete and recapture market share. We view Netflix as having the strongest market position among high-growth peers. Our view is based on its position as the global leader in streaming video, with the largest global subscriber base and an expanding library of differentiated original content. While other peers have strengths within their markets, Netflix has greater product maturity, with its market position more entrenched. As we continue to assess these companies, their ability to defend and strengthen their market position will be a key determinant of our credit assessment.
The firm is at the forefront of the evolution in video entertainment consumption. First-mover advantage propelled it as an attractive alternative for linear TV customers because of viewing flexibility, no advertising, and lower prices in most markets. Strong brand awareness and a huge library of compelling content allow it to attract users and charge premium pricing. It continues to spend more on content ($14.6 billion in 2019), with an increasing allocation to original content and significant investment in local language original content globally. Content is a key differentiator, and aggressive investments are a core part of its international growth strategy.
A market disruptor and leading innovator in the electric vehicle (EV) segment with a strong brand, it has superior battery and powertrain technology, longer range per kilowatt hour than upcoming launches from its competitors, and ability to improve performance through over-the-air software updates. However, Tesla has a limited experience in managing high-volume parallel production, delivery, and services in international markets. Tesla generates 60% of revenue in the U.S., though it is expanding faster internationally. Its growth could slow relative to Netflix and Uber for several reasons: high upfront cost and abating tax incentives in the U.S., lack of infrastructure and services network, and potential trade disputes.
The global ride-sharing technology player has a leading position in virtually all its markets. It participates in food delivery, a still-evolving market landscape. Because of its large scale, Uber benefits from the network effect, with increased driver utilization it can reduce wait times and lower fares, resulting in better economics for drivers, customers, and the company. However, assessing market position by geographic location is also crucial, as economies of scale for certain industries are very localized--including competition, regulations, and consumer preferences. For example, Uber's competitive strength in many global markets did not insulate it from intense pricing competition with competitors in Russia and China, eventually exiting. It also faces legal and regulatory challenges in several markets, including the status of drivers as contractors, allegations of unfair competition practices from taxi associations, taxation disputes, and outright bans on ride-sharing services. Increasing regulation remains a key operational challenge and could affect Uber's value proposition to consumers.
One of the largest players in the niche coworking office market, it maintains the largest footprint in several key city markets, partly because of its aggressive expansion strategy. Broadly speaking, its pricing power is relatively limited because of high competition and relatively low switching costs, and it varies by based on market maturity (with pricing power being lowest in newer markets). We also view landlord relationships as important to sustaining its market position. Access to prime commercial office space and securing favorable lease terms is critical to the company's longevity.
Competitive Landscape: Innovation Invites Competitive Response
The competitive landscape is evolving rapidly for these market disruptors as growth potential attracted many new competitors. They are aggressively investing to catch up and can further alter the competitive landscape. As competition intensifies, it could slow their growth trajectories. In our view, companies with a stronger market position are better positioned to defend themselves against increased competition.
We view the competitive landscape for WeWork and Uber as the most intense. Both participate in an early stage industry and highly fragmented landscape, with competitors fighting for share. We view Tesla's competitive landscape similarly: While it has a more differentiated product, incumbents with access to large profit pools will release their own products over the next few years.
The company operates in an increasingly competitive market as legacy media companies invest heavily to launch competing over-the-top (OTT) services. Large companies such as Apple Inc., The Walt Disney Co., Warner Media LLC, and NBCUniversal Media LLC are entering the market in 2019 and 2020. Though Netflix faces strong competition from domestic players and some local players globally, it still has first-mover advantage, the largest global subscriber base, and an increasing library of owned content. However, as these large competitors enter the market, they drive up the cost of acquiring content and could slow Netflix's growth by giving consumers more viewing options. These factors could pressure margin improvement and slow Netflix's ability to improve its cash flow profile, which would weaken our credit assessment.
Tesla has over 70% share of the U.S. EV market, but it faces significant competition globally as legacy original equipment manufacturers invest heavily in their own EVs. For instance, we expect the number of battery electric vehicle (BEV) entries in the U.S. to more than double in 2020 to 34 models from 2018, and to further increase to 125 by 2025. We expect over 225 global BEV models in 2020 with nearly 445 mainstream models by 2025, most of them dedicated to the Chinese market.
In addition to increased competition, tax incentives in the U.S. ended for Tesla starting in 2020, which will raise the consumer cost and give some pricing power to other luxury carmakers, whose customers can still take advantage of the tax credit until 200,000 qualifying vehicles are sold. The increased competition and higher cost could slow the rate of unit volume growth. However, Tesla is continuing to launch new models (Model Y and Cybertruck), which could allow it to gain greater share of the BEV market. In addition, Tesla's proprietary battery and powertrain systems could help it maintain a competitive advantage as range-extending battery life and miles per charge are key differentiators.
The ride-sharing market is very competitive, with local dynamics driving the landscape. Price competition is very fierce in emerging markets. Uber exited several markets (China, Russia, and Southeast Asia) because of the difficulty maintaining a large enough market share. In mature markets, Uber is trying to improve its competitive position by offering more services through its platforms (Eats, New Mobility, etc.) and customer loyalty rewards programs. Additionally, business maturity and availability of capital drive competition.
In food delivery, the players are still in the early stages of expansion, which has attracted new capital that they have used to increase customers and drivers through aggressive subsidies, causing losses as they build market position. Ride-sharing continues to emerge from this dynamic; as the players solidify market position, capital for challengers has fallen off and the incumbents have pulled back on subsidies, driving profitability improvement.
Competition in the coworking space is increasing as it gains popularity and attracts new players--including very small and specialized hyperlocal companies and large global players such as International Workplace Group PLC (IWG, formerly Regus), as well as an assortment of new entrants. While competition is heating up, WeWork's challenge is to prove it can attain profitability and positive cash flow generation. This has become more imperative compared to high-growth peers because of challenges stemming from the failed IPO and management turnover.
ESG: Early Stage Companies Can Outgrow Their Capabilities
Environmental, social, and governance (ESG) credit factors influence the capacity and willingness of an obligor to meet its financial commitments. Among our group of early-stage and high-growth companies, governance and social factors present more meaningful risks to credit quality than environmental issues. Parallels between the group's ESG-related issues suggest the prevalence of governance and social issues stem from the hallmarks of a fast-paced growth culture and disruptive product introduction. As it relates to governance, founder-linked disruption has emerged as a theme, affecting Uber, WeWork, and Tesla to varying degrees. The source of social issues has been more dispersed, varying from technological issues, employee welfare, customer safety, and cultural differences. Environmental parameters have demonstrably less impact for the group, apart from Tesla given its manufacturing operations and focus on sustainable energy. We believe that over the near term, governance and social risks will continue to burden the group's credit quality more than environmental risks.
The personality of a CEO, especially when that person is also the founder, can be quite influential on the collective behavior of an organization and its stakeholders. Evidenced by WeWork, Uber, and Tesla, the magnetism of a visionary mind tends to attract a great deal of interest from investors and can support a lax demeanor from the board of directors. During this early period of growth, when a company is flush with external sources of liquidity and the founder revered for his vision, it is critical to properly allocate controlling authority so the board maintains oversight. As with WeWork and Uber, for example, a board's ability to act can be compromised if the ownership structure grants the leader with disproportionate control.
WeWork, Uber, and Tesla have experienced executive turnover, damage to brand integrity, legal action, and volatility in operating performance linked to actions by their outspoken founders. Scandals including controversial tweets (Elon Musk of Tesla), allegations of inappropriate workplace culture (Travis Kalanick of Uber), and questionable corporate spending, controlling power, and financial reporting (Adam Neumann of WeWork) led to changes in leadership, board composition, and strategy. These observable infractions in governance had negative implications on credit quality.
Problems arise when start-ups, which begin with closely composed boards and founders that have controlling authority, do not correct the governance structure as the company matures. Such is the case for WeWork, Uber, and Tesla. WeWork shelved IPO plans, initiated a corporate restructuring, made management changes, and suffered a liquidity crunch after its attempt to go public drew questions about the degree of control held by its founder and former CEO, Mr. Neumann, and concerns about corporate spending decisions and profitability. Uber faced reputational damage stemming from workplace misconduct, and regulatory actions due to drivers' working conditions and passenger safety.
At Tesla, Mr. Musk has been openly combative on social media, staunchly defending himself and his company through bold statements against various constituents. His controversial tweets and provocations of the U.S. Securities and Exchange Commission in 2018 demonstrated a lack of oversight controls with respect to his external communications, carrying a risk that his conduct may violate securities laws on fair disclosure. This resulted in settlement fines and the separation of Musk's dual CEO/chairman role. Tesla's board (which includes several directors tied to Musk, including his brother) did not take action against Musk or control his communication channels, a recurring theme among start-up culture. With the addition of two board members and the reduction in tenure to two years from three, the higher proportion of directors with fewer ties to Mr. Musk will improve board diversity and independence through a better balance with existing directors that have longstanding acquaintance. Changes, including shortening size and tenure, include a departure of some nonindependent members. We view these changes favorably. While governance remains the most impactful of the ESG factors for Tesla, we believe these changes have mitigated most of the risk. We score Tesla's management and governance as fair.
Despite positive changes in management, strategy, and board composition at WeWork, it remains unclear how the board dynamic will change under the company's new leadership. Absent a proven change in board effectiveness and demonstrated track record of improved decision-making, our view of the company's credit profile will likely remain limited by its management and governance deficiencies.
Uber is further along in its improvement of governance controls, following the transition to Dara Khosrowshahi as CEO and the changes adopted as part of SoftBank's investment in 2017 and the IPO. The company has made constructive strategic moves under Mr. Khosrowshahi's watch, including the sale of loss-making Uber Eats India operations to Zomato and the settlement of legal matters regarding autonomous vehicle trade secrets with Waymo, and he has built a professional executive team. As a result, we revised the management and governance score to fair from weak in September 2019.
An outlier to this group, Netflix has demonstrated sound governance and avoided controversy with a co-founder that retained the CEO role since the company's inception in 1997.
While similarities across governance issues for our subset of companies can be linked to a founder-led start-up culture, the emergence of social factors is more dispersed in origin, impact, and cause. Though we do not expect social factors to affect credit ratings, we recognize that Uber and Netflix have demonstrated higher risk exposure to social influences than Tesla and WeWork.
We believe Uber is the most exposed to negative implications from varying perceptions of social responsibility. The social impacts of Uber's disruptive business model, particularly its effect on the taxi industry and the status of its drivers as contractors, provoked legal and regulatory challenges. Some of these could lead to meaningful cash outflows or adjustments to its business model. Public criticism includes allegations of aggressive pricing practices, passenger safety controls, driver classification status, and damaging repercussions on the taxi industry from the surge in ride-sharing. These concerns provoked legal action, regulatory changes, revisions in pricing policy, and improved safety metrics through increased technology investments.
Uber faces regulatory challenges in two key markets, London and California. Assembly Bill 5, newly enacted into law in California, affects the classification status of drivers and could impair the economics of the ride-sharing industry if Uber is forced to reclassify its employees. Though California was the first to act, drivers' status as contractors is being contested in other jurisdictions. In London, the company is dealing with a revocation of its operating license over driver screening flaws that jeopardized riders' safety by allowing unauthorized drivers to pick up fares. Uber is appealing the decision and can still operate. While regulatory actions could result in future cash outflows or adjustments to its business model, we think they do not represent an existential threat to the company because it could adapt its business model.
For Netflix, social factors come into play as the company juggles the balance between free speech and artistic representation against socially acceptable norms across varying geographies. As Netflix introduces content at a quicker pace in countries throughout the world, it must manage potential cultural and regulatory backlash from how different countries perceive content. The company's policy is to comply with regulatory authorities in each country where it operates while adhering to its desire to maintain its free speech standards. Netflix also faces elevated brand risk from social issues, such as the gender wage gap, sexual harassment, and others. The company reacted to high-profile sexual harassment cases by swiftly removing offenders from shows. Netflix's ability to continue enhancing and systematizing its policies and proactively communicating them with external stakeholders is a key factor in preventing brand degradation that could negatively affect subscriber growth.
Tesla's autopilot technology exposes it to potential accidents, fires, and cybersecurity breaches. As a disruptor, this naturally exposes it to more headline risk and could increase the risk of product liability, government scrutiny, and regulation. Until those risks abate, in our view of Tesla's progress toward improving safety in its autopilot technology will at best remain credit neutral. After a number of fatal crashes linked to its self-driving vehicles, the company continues to invest in improvements with no major setbacks. In mid-2019, Tesla unveiled plans to introduce autonomous ride-sharing vehicles by 2020. This new technology may heighten regulatory focus on these vehicles as elevated on-road density increases the potential for accidents, affects driver employment rates, and spurs customer safety concerns, among other issues. As technology evolves and regulation becomes more robust, if fatality rates reduce, we could even view this as a positive factor for Tesla's credit story over the next decade or so.
Though no major social issues have arisen for WeWork, as the company embarks on its restructuring plan and faces stakeholder backlash from its recent lapse in governance, socially-linked risk factors could emerge. Several lawsuits have already been filed against the company and its former founder with accusations varying across gender discrimination and shareholder misrepresentation.
Environmental factors are immaterial for Uber, Netflix, and WeWork. As a car manufacturer, Tesla is the most exposed of the group though its environmental risks are minimal relative to other automakers, given its focus on full EVs and its ambitions to expand aggressively into heavy-duty trucks and energy storage markets. We think Tesla has an advantage given its battery and powertrain technology, superior range per kilowatt hour (as rated by the U.S. Environmental Protection Agency) of its vehicles compared with upcoming launches, and ability to improve performance through over-the-air software updates. However, Tesla's sales growth could be hurt by reduced U.S. tax incentives, which began to phase out after production of 200,000 vehicles in July 2018.
Profitability And Cash Flow: Investing for Growth
We use EBITDA and cash flow to judge the health of the four subject businesses and their ability to service debt, and we gain different insights from each. For Tesla and Netflix, we use cash flow as the primary measure of financial risk, since our financial risk assessment for both companies is highly leveraged. Their cash flow is weak despite debt to EBITDA that would support a higher assessment. This is because EBITDA does not capture a meaningful portion of these companies' investments, original content for Netflix and capital spending for Tesla, and limit their ability to repay debt.
However, EBITDA allows for interesting peer analysis. Tesla has higher margins than peers because of manufacturing efficiencies resulting from higher automation, fewer stock-keeping units, and fewer parts relative to a combustion engine, as well as the premium price its brand commands. This suggests that many years in the future when the company matures, growth slows, and investments decline as a percentage of revenue, it could have better cash flow dynamics than automotive peers. Netflix has lower margins than large media peers because of significant start-up and marketing costs to support international growth, less legacy content available to monetize, and more cost to license content from other creators. Nevertheless, EBITDA is positive and margins are growing. Uber's EBITDA and cash flow metrics align closely because the majority of its investments are included in the income statement in driver and rider incentives and research and development. As a software and services company, it is not capital intensive.
With the exception of Tesla, each company has negative cash flow since they are investing for growth, and this was true of Tesla until 2018. Tesla's free cash flow was around $1 billion in 2019 as it reduced capital expenditure (capex) by more than one-third, implemented cost controls, and achieved a good mix of premium optional features. We think cash flow will be slightly negative in 2020 from launch expenses related to the Model Y and reaccelerated capex for its Gigafactories, Model Y, Tesla Semi, Supercharger, and service networks.
Netflix's cash flow deficit was $3.1 billion in 2019 on more than $14 billion in spending on original content. This is more important than ever since companies that were previously licensing content to Netflix are not renewing, instead retaining it for their own streaming services (e.g., Disney). We don't see cash flow turning positive before 2023.
We see WeWork's cash burn increasing to the $3 billion area from the low-$2 billion area in 2018 on capex in excess of $4 billion to support desk growth above 100%. We think the earliest the company could pare back investments is the third quarter of 2020 because of its lease commitments. Uber's cash flow deficit exceeded $4 billion in 2019, up from the low-$2 billion area in 2018, as competition intensified in the first half ahead of Uber's and Lyft's IPOs. The company also invested to defend ride-sharing market share in Latin America and gain market share in its Eats business. Cash burn should improve in 2020 as U.S. ride-sharing competition eases, the trend in the second half of 2019, as the company gains operating leverage in Eats and sustains operating cost controls.
Ironically, these companies' prospects for reaching break-even cash flow may be inversely related to the strength of their market positions. WeWork may be the next to reach the milestone. Forced to consolidate spending quickly following the withdrawal of its IPO, the company already initiated substantial headcount reductions, noncore asset sales, and announced a strategic plan with a path to profitability by 2021. On the other hand, debt investors may be willing to fund Netflix's negative cash flow the longest since we believe it is perceived to have the strongest and most creditworthy market position.
Discretionary Investments: Flexibility A Plus
We expect early-stage companies to invest to achieve high growth. For our credit analysis, we consider how much flexibility a company has to consolidate investments, should growth or access to capital falter. Could the company curtail investment in an adjacent business without hurting its core? Could it cut investment in new customer acquisition and accept slower growth without harming its competitive position? Or are investments necessary and curtailing them would harm the core business?
Within our peer set, Tesla has the least flexibility to curtail investments, in our view. Its service network, China Gigafactory expansion, and Model Y are critical investments to support core operations, and curtailing them could preclude the company from achieving the scale it needs to generate positive cash flow. Tesla has more fixed costs and higher operating leverage than the other high-growth peers. As a manufacturing company rather than a services company, it must achieve a certain scale to deliver the utilization necessary to cover its fixed costs. However, it is the first to generate positive cash flow, which mitigates its relative lack of flexibility. It has generated positive cash flow in five of the last six quarters, with reported free cash flow of around $1 billion in 2019.
Uber and Netflix have the most flexibility. Uber has a portfolio of adjacent business including Eats, electric bikes and scooters, and Freight that are loosely connected to core ride-sharing. We think it could cut investments in these areas if necessary without harming the ride-sharing business. The company also has a track record of consolidating investments including its recent divestiture of its India food delivery business, capital intensive car leasing operation, and ride-sharing operations in China, Russia, and Southeast Asia, spinning off those business to local players in exchange for minority stakes.
Netflix had a cash flow deficit of around $3.1 billion in 2019, which supports spending of $14 billion-$15 billion on original content, so we think the company could trim spending to narrow its cash burn while maintaining a sizable content budget. It could also temporarily decrease its content budget allocation to original content, which carries significantly higher upfront costs. Finally, Netflix could save start-up and marketing expenses by accepting slower growth internationally.
WeWork has more flexibility, in our view, than Tesla but less than Uber and Netflix. Large cash flow deficits have been funding desk growth of over 100%. We think the company could slow its growth and reduce capital spending on new properties without harming the economics of mature locations that make up 30% of the total as of June 2019 and have 89% occupancy compared to break-even occupancy of 60%. Though the company is locked into spending through most of 2020 (on properties for which it has already executed leases), in response to the shelved IPO and the need to conserve capital, WeWork initiated (and is executing against) a strategic pivot that includes slower growth.
Liquidity: Bridge To Sustainability
For early-stage companies, liquidity can provide a bridge across a period of investment marked by large cash flow deficits to internally funding its investment. This is the case for Uber, which has a cash balance of over $11 billion against less than $6 billion debt outstanding and over $4 billion negative cash flow, which we expect to moderate over the next two years. In addition, the company has equity investments in foreign ride-sharing players with a book value of $11.5 billion that it gained when it exited the Chinese, Russian, and Southeast Asian markets. The value of the company's stake in Zomato is unclear, but is likely marginal relative to the other three stakes. These investments coupled with cash provide coverage of several years of negative cash flow. We expect the company to improve profitability in its ride-sharing and food delivery businesses during this time, and achieve more sustainable cash flow.
While Netflix and Tesla do not have liquidity positions that match Uber's, they are further along the maturity curve and don't require as much buffer. While Netflix invests heavily, we are confident in its access to capital markets and satisfied that $5 billion cash provides enough cushion for it to manage cash flow, either through price increases or reduced spending on original content, should market access change. Tesla made significant progress toward self-funding from 2017, when it used more than $4 billion, even paying off $566 million of convertible debt with internal cash flow in late 2019. So while less than Uber's, over $6 billion in balance sheet cash combined with proceeds from its $2 billion equity offering provide Tesla enough financial flexibility should the need arise.
Our liquidity assessment of WeWork was revised to less than adequate in September 2019, in parallel with its challenged IPO and inability to secure external funding to address committed capital spending needs. The company recently closed a new three-year $1.75 billion letter of credit (LOC) facility with SoftBank, part of a $5 billion commitment that also includes $1.1 billion of new senior secured notes and $2.2 billion of new unsecured notes. Though this transaction does not affect our ratings at this time, we view this as a positive for WeWork's liquidity position. The facility increases LOC capacity and frees cash by eliminating the former facility's $500 million minimum cash covenant requirement and replacing cash used for cash collateralized LOCs with LOCs issued under the new facility. Liquidity is a key component in our ratings on WeWork, as traditional debt and equity market access is limited and the company's path to sustainable cash flow is unclear.
Macroeconomic Sensitivity: Can High Fliers Beat The Cycle?
Our portfolio of early-stage and high-growth companies was cultivated during one of the most prolonged periods of economic expansion in U.S. history. Even Netflix, whose establishment in 1997 precedes its peers by at least six years, will enter the next recession with a different product than the one that survived the previous recession--streaming content distribution versus DVD. While we have no precise historical data to determine Netflix's, Uber's, Tesla's, or WeWork's sensitivity to macroeconomic disruptions, where possible we can tie assumptions to their industries' perceived cyclicality.
This industry tends to be counter-cyclical, as movies and home media are a small portion of household budgets, providing an affordable source of entertainment during an economic downturn. Netflix fared well during the last recession, but it and the competitive landscape have transformed over the past several years, presenting new risks that could hamper profitability in the next downturn. An increase in streaming providers (Hulu, Apple, Amazon.com Inc., and even Facebook Inc.) has intensified the market share grab, spurring a need for ongoing investment in content and productivity to offer the best media at the most attractive prices. Though many consumers maintain several steaming subscriptions, an economic downturn could encourage a consolidation of entertainment sources. Comparatively speaking, their low price profile should allow streaming providers to fare better than other entertainment sources in the next downturn, especially for in-home entertainment. Streaming providers have been displacing expensive cable subscriptions for a number of years, as expensive cable subscriptions become less attractive than cheaper OTT alternatives.
Automotive manufacturers: Tesla
Automakers are sensitive to economic downturns because recessionary pressures weigh on customers' financial flexibility, credit, and affordable access to auto loans. We believe Tesla may be less affected than its automotive peers in the next recession. Compared to the traditional auto consumer, the affluence of Tesla's demographic makes its customers less price sensitive and better insulated from macroeconomic shocks. While the car's eco-friendly features create added appeal and fuel cost savings, we believe a Tesla consumer is less likely to switch to a cheaper electric alternative in a downturn because of the additional values placed on aesthetic and luxury. The company's more affordable Model 3 and Model Y line, which are likely to account for an overwhelming majority of sales in 2020, would likely be more exposed to cyclical pressures than the Models S and X, which we believe are approaching sales maturity. We believe ongoing demand for EVs, the company's superior technology, its lower prices (because of lower battery costs), and government and economic incentives in Europe and China will support Tesla's sales to a greater degree than macroeconomic shocks.
Ride sharing: Uber
In an economic downturn, we believe ridership would be affected by changes in consumer habits stemming from a decline in discretionary spending for pleasure or convenience (i.e., rides to restaurants, bars, airports), a slowdown in rider growth (from rising unemployment and a lower corporate spending), and a change in commuting habits (toward cost-effective options). However, we think the still nascent and rapidly expanding penetration of ride-sharing and food delivery would likely overwhelm the macroeconomic impact. Bookings would still increase, albeit at a slower pace, although profitability could be more negatively impacted if costs are scaled for higher expected revenue. Facing financial pressure, remaining ridership would likely shift to cheaper transportation alternatives or less profitable ride-sharing pool options.
Uber would likely also face slower growth in travel-related sales (about 15% of ride-sharing gross bookings were derived from airport travel in 2018) amid declining corporate spending and high unemployment. Similarly, the Eats business (24% of gross bookings during the last quarter) would likely face pressure from a reduction in consumers' ancillary spending. Though labor would likely be a bright spot in a recessionary environment as elevated unemployment levels support an expansion of Uber's labor pool, we believe profitability would be burdened by an increase in promotional customer incentives.
WeWork's business model is highly susceptible to macroeconomic volatility. Individual members, small to midsize businesses and early-stage start-ups whose viability can be sensitive to economic swings, occupy the majority of total desk space. This nonenterprise customer base requires loose, short-term contracts that allow for market agility in contrast to landlord stipulations for 10- to 15-year lease terms. The timing mismatch and natural instability of the independent workforce presents a substantial risk to profitability, especially during market downturns. Revenue-sharing agreements introduce some downside protection though these agreements are still immaterial small as a percentage of overall contracts.
In the 2008 U.S. recession, the failure rate of small businesses exceeded that of larger businesses. Notably, large markets like New York City showed better resilience than less populous cities. WeWork's established market position in large metropolitan markets may help soften some of the blow in the next economic downturn and its scale in major cities could support negotiating leverage if the market turns and landlords are cautious about the impact on commercial real estate prices.
Over the past few years, WeWork successfully pursued the more stable enterprise customer base. These customers often sign longer-term member agreements because of the custom nature of their product. It typically calls for a longer commitment because of customization. (As of the year ended Dec. 31, 2018, enterprise contract lengths were around 17 months.) Despite the benefits of more enterprise customers, the spaces occupied by these corporate clients are largely ancillary relative to fixed obligations (i.e., corporate headquarters). As such, there is uncertainty surrounding enterprise retention in a downturn because customers would have to consider cost objectives and fixed lease renewal cycles.
Citing historical reference, WeWork competitor and coworking incumbent IWG (then Regus) filed for Chapter 11 bankruptcy in 2003 after too quickly accelerating growth during the years preceding the internet boom. The company was challenged by customer losses and rising costs as the U.S. real estate market plummeted, creating an abundance of cheap real estate against which Regus could not compete, having entered many leases during the top of the market.
Pricing Power: Differentiation Supports Pricing Power
Differentiation is the key to pricing power. We believe Netflix and Tesla have the best positions, while Uber and WeWork have the weakest. But changing industry landscapes could disrupt the status quo for each company. Netflix has a large and expanding library of original content, which we think gives it leverage to raise prices as in the past, although new streaming services from competitors such as Disney may dampen this ability. Tesla's technology leadership on battery efficiency, advanced driver assistance, robust charging network, and leading brand allow gross margins above traditional automakers. However, Tesla's pricing power could be limited by the exhaustion of its U.S. federal subsidies along with new electric models coming from automakers who still have access to those subsidies.
We view Uber as having low differentiation in ride-sharing, evidenced by the number of riders and drivers who use multiple platforms. Fierce competition and food delivery resulted in lower-than-expected profitability. It remains to be seen whether the company can improve differentiation by scaling adjacent services across its platform, such as Eats, bikes, and scooters, and through its recently introduced loyalty program.
While we view WeWork's pricing power as limited overall, this varies somewhat by geography and market tenure. We view the company as having a bit more leverage in denser and more mature markets, where demand for its differentiated product is greater, though high fragmentation and competition present alternatives and enforce pressure on pricing power. In newer markets, pricing power is rather limited, and the company offers upfront incentives to attract tenants. In addition, the impact of its recent governance issues on customer demand is still unknown.
This report does not constitute a rating action.
|Primary Credit Analysts:||Christian Frank, San Francisco + 1 (415) 371 5069;|
|Tatiana Kleiman, New York (1) 212-438-4872;|
|Jawad Hussain, Chicago + 1 (312) 233 7045;|
|Nishit K Madlani, New York (1) 212-438-4070;|
|Research Assistant:||Manjinder Singh, Pune|
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