Servcorp: Result 2018

There's only one way to beat Usain Bolt, the world's fastest man. You compete with him in anything except for a running race (and, perhaps, a game of football, too). Sometimes, the only way to win is by playing a different game.

That seems to be the approach that WeWork's taking in its bid to own the co-working market. Instead of following the well-worn path of maximising profits, self-funding growth and paying dividends to shareholders – the road taken by incumbents IWG plc (formerly Regus) and Australia's Servcorp – WeWork is blazing its own trail.

Armed with funding from Softbank, the firm known for losing 99% of its value in the tech bubble, WeWork's frantically adding new floors, and burning billions of cash in the process. That's making life hard for Servcorp, as it's not easy sourcing new office space and winning customers when the competition's not interested in making money.

WeWork's strategy has more than a scent of unsustainability about it. Investors seem to be valuing it as if it's a network effect laden software monopoly, rather than the sub-leasing arbitrager that it is.

But that offers little comfort to Servcorp. It may be the industry's most efficient operator – management claims Servcorp generates the highest yield per square metre – but WeWork's march will continue as long as investors stump up the money, and that could be years.

How Servcorp responds is the most important issue facing the company today.

The eye of the storm

In WeWork's home market of the US, Servcorp generated a pre-tax loss of $9.4m as expected. But it's not just WeWork causing grief; Servcorp has had a misaligned US offering for years ... and the operating losses to prove it.

Despite the significant drag the US has caused, management is intent on pressing on for now. The strategic review, led by father and son duo Alf and Marcus Moufarrige, didn't deliver any big revelations, although there is the possibility that they'll enter partnerships with a ‘global commercial property group' at some point down the track. We're expecting continued losses, and higher expenditure on refurbishments, for the time being.

Conditions were also difficult in Singapore and Saudi Arabia, with each region experiencing a meaningful decline in profitability. Together, the three were the main culprits behind Servcorp's 5% decline in total revenue to $314.4m, and its 34% fall in pre-tax profit to $32.1m.

Battle-hardened

Despite the challenges, management still thinks Servcorp can carve out its own niche in the co-working space, targeting the older demographic with a premium offering of better technology, and even soundproof spaces. 

Encouragingly, Servcorp has the resources to defend its turf, with $93m of net cash and a business still spinning off $18m of free cash flow each year, at least for now. Management has been tested by difficult operating conditions before, such as the post-tech-bubble fallout in the early noughties. On the conference call, Marcus Moufarrige noted that the US experience had 'battle-hardened' the company, providing a number of transferable insights that would help it in other regions.

But they're going to have to spend up to defend themselves. Capital expenditure is expected to pick up to $50m–60m in the coming year – a big increase from the $33m spent this year – as more floor space is dedicated to co-working and the general look and feel is refreshed. Floor capacity is expected to increase 7.5% to 6,040 offices in the 2019 financial year, which points to a light year of free cash flow.

Management is currently expecting pre-tax profit of between $34m and $40m for 2019, which includes new floor operating losses of between $4m and $5m. This places Servcorp on a price-earnings ratio (PER) of 16, although we need to tread carefully with PERs for cyclical businesses like Servcorp. Dividends will be held flat at $0.26 per share for the full year.

Betting against the Moufarriges hasn't been a winning strategy in the past. But given the low barriers to entry in the co-working space, and the cyclicality of the business, we're still concerned that the price isn't low enough to compensate for the risks. As a result we're keeping our price guide as is, and we continue to suggest you HOLD.