2 small caps in the shared office space

Financial Journalist
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I joined a co-working space this month – a decision that made me think about co-working’s disruptive effects and potential stock winners from this trend.

Having dabbled in co-working and office space over the years, I was wary of joining a co-working space with hundreds of other businesses. It’s easier working from home.

A noisy bathroom renovation (next to my home office) forced me out and my latest co-working stint looks more permanent this time. I’m impressed by how much co-working facilities have changed in just a few years and how they could hurt and help different property owners.

My co-working space (I’m sitting in it as I write this column) surprised in a few ways. First, it is a large, swanky space at a suburban shopping centre. Most co-working spaces are inner-city and are often converted offices. This one’s well out of town and the size of a football field.

Second, many co-working spaces effectively “rent” a desk and provide paid office services to start-ups and other micro ventures. This space has plenty of those, but also larger businesses and even some well-known corporates with space inside the co-working facility.

The third surprise was price. On my math, a business could have nine staff work at the co-working facility (the maximum number on the entry-level rate), hire a room for the morning meeting and have a postal/office address for under $50 a day.

This example shows how disruptive co-working facilities could become to commercial property and how they could benefit other industries such as retail. Big companies will increasingly ask why they pay so much rent for city office space and are locked into long-term contracts and expensive fitouts, when they could house staff in co-working spaces for far less.

Co-working, of course, does not suit every business and every employee. Many businesses need staff working side by side in a city location. However, in the digital economy, where more staff work between locations, cheap, flexible office space is the future.

The co-working boom coincides with the boom in freelancers and Gig Economy workers. The recent Freelancing in the US: 2019 survey estimated that 57 million Americans, or a third of that country’s workforce, are either full-time or part-time. The survey’s definition of freelance includes independent contractors and other self-employed people.

Large retail property owners are surely watching the co-working trend closely. As anchor tenants such as department stores exit shopping centres or cut back on space, shopping centres could convert some of that space to co-working facilities, attracting hundreds of small businesses and their employees and customers to the centre precinct.

Property is the obvious way to play the co-working trend. Care is needed: the recent float fiasco of WeWork, a United States-based provider of co-working space, shows the dangers of crazy valuations for companies leveraged to the co-working trend.

Here are two ways to play the co-working trend via the ASX. Each suits experience investors who are understand the features, benefits and risks of investing in micro- or small-cap stocks.

1. Victory Offices (VOL)

The service-offices and co-working space provider listed on the ASX in June through a $30-million Initial Public Offering (IPO).  Victory has attracted good support since listing, its $2 issued shares rising to $2.54 as investors see it as a faster-growth play on co-working.

Victory had 19 locations around Australian at the time of its float and targets businesses needing serviced office space, virtual offices and co-working space. Like other providers, Victory provides a range of higher-margin office services to clients in the highly competitive and rapidly maturing flexible-workspace industry in Australia.

The main risk with flexible workspace is contract length: the average client licence term for Victory is about 15 months, according to its prospectus. Businesses want cheap space without long contracts: that’s a risk for earnings visibility and margins.

A stronger competitive response from commercial property owners is another threat to Victory. Office owners are aware of the co-working boom and more will integrate this form of accommodation into their portfolio or convert some offices into shared-space facilities.

The other risk for Victory and flexible-space providers is the cyclicality of their industry. Economic downturns dent demand for office space, particularly from small enterprises that are more vulnerable to industry shocks and have less cash to ride them out.

The potential upside is Victory building a larger network of customers and leveraging to  provide more products and services. Victory has a first-mover advantage as a specialist listed provider in this market, but is due for consolidation after recent price gains.

Long-term investors who are comfortable with small-cap stocks could consider Victory, preferably watching and waiting for better value during a market pullback.

Victory Offices (VOL)

Source: ASX

2. Servcorp (SRV)

The serviced-office provider has had a difficult few years after a string of profit downgrades and lower-than-expected growth in its United States operations. The three-year annualised total return (including dividends) is negative 13.5%, Morningstar data shows. But Servcorp has rallied this year from a low of $2.55 to $4.42.

Servcorp operates in more than 155 office floors in 52 cities across 24 countries. Its services range from executive suites to virtual offices, co-working facilities and secretarial services. The $4.30 million company has been around a long time and was once a small-cap market darling

Lately, the bears thought global co-working juggernaut WeWork would crush Servcorp and those fears partly contributed to the stock’s fall in 2017 and 2018, although there was much more to Servcorp’s problems than hype about WeWork.

But in a fickle market, WeWork’s woes – its high-profile float was cancelled due to investor scepticism about its business model, governance and cash-burn rate – have boosted sentiment towards Servcorp and other established flexible workspace providers.

WeWork’s main contribution was to raise awareness of the global boom in co-working space and focus investor attention on alternative providers.

After a few underwhelming years, Servcorp beat its guidance for the second half of FY19 ($18.4 million net profit versus guidance of $14-18 million) and management said the business had stabilised. The result provided much-needed good news for Servcorp’s true believers.

Servcorp is adding more co-working space to its offering and says the flexible-space industry is growing at 20 per cent annually and remains highly competitive. The company’s balance sheet, ability to upgrade offices and provide more co-working space per tenant than rivals are an advantage. Servcorp is well down the path of offering higher-margin digital products to clients – such as virtual offices – and has good long-term growth prospects in this area.

The Moufarrige family owns just over half of Servcorp and reportedly has no intentions to sell. My sense is Servcorp would be worth more in the hands of a global player that wants greater exposure to growth in co-working/serviced offices.

Also, executive and board turnover has been an issue in Servcorp in the past few years and succession will be a bigger issue given legendary founder Alf Moufarrige is in his late 70s.

Servcorp has no debt, solid cash flow and has always focused on sustainable rather than runaway growth, even though the market would like to see it grow faster by adding more floors in more locations. The company needs to get its Return on Equity (ROE), 10.6% at the end of FY19, back to 15% (achieved in the peak years in FY16 and FY17).

Some small-cap fund managers I know prefer Victory over Servcorp because the former has faster growth prospects, albeit with higher risk.

I prefer Servcorp. I like the look of its emerging turnaround: after a few disappointing years, Servcorp is getting its mojo back. If economic conditions hold, Servcorp will have a strong tailwind thanks to the co-working boom and its share-price rally will have further to run.

A faster-than-expected deterioration in Australia’s economy in the next 12 months – a possibility if global growth keeps slowing – would be a red flag. Some relief might come from companies downgrading from costlier office rent to co-working spaces, to preserve cash. But this is an inherently cyclical sector on short-term lease arrangements.

Servcorp (SRV)

Source: ASX

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 15 October 2019.

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