This post is a few months late compared to my usual semi-annual book review schedule. Just as a reminder, my scale is from one to five, with five being the best, and the last review being my top pick as the best book I’ve read in the past half-a-year.
The Meaning of Human Existence by E.O. Wilson: When you name your book “The Meaning of Human Existence”, you’re setting a high bar from the get-go. The primary problem is that the majority of the book does not address the question in the title. Instead, Wilson discusses two topics: a brief history of evolutionary biology research, and the relationship between science and the humanities. Worthwhile topics, sure, but not what readers would expect from the title. He doesn’t answer the question posed from the start except with this off-hand line near in the conclusion: “What is the meaning of human existence? I’ve suggested that it is the epic of the species…it is also what we will choose to become.” If you finish this book, you won’t have learned much about why we are here.
What If? Serious Scientific Answers to Absurd Hypothetical Questions by Randall Munroe: This first book from the creator of nerd-to-mainstream webcomic XKCD is a collection of responses to his webcomic reader emails. Chapters are structured as Q&As, with the answers comprising both essay explanations of the science of how the hypothetical situations would work and cartoons visualizing said unrealistic scenarios. If you’re a fan of XKCD or hypothetical thought experiments, this is worth the couple hours it takes to read.
The Circle by Dave Eggers: The obvious comparison, made by other reviewers, is to Huxley’s “Brave New World”. This is the first book by Eggers I’ve read, although multiple friends swear by his other works. Eggers does not seem to be nearly as strong a writer as Huxley (as measured by creative use of the English language and Huxley’s ability to say more with fewer words). However, what “The Circle” lacks in grandiosity and profundity, it makes up for being relatability. He’s written a compelling story about a web company that takes over the world economically and politically, as told from the perspective of one of its employees. Nearly all of the technology mentioned in the book exists today, which is the most chilling part. “The Circle” does a solid job of demonstrating the potential horrors of modern technology to a millennial reader.
The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means by George Soros: This is billionaire investor George Soros’s thoughts on the causes of and solutions to the 2008 financial crisis. Like many of his books, a third of the book is devoted to reiterating the philosophical theory of “reflexivity” and its application to economics. The second third reviews the recent financial crisis, which doesn’t contain much material different from other sources except for Soros’s investing strategies amidst the events of 2008. The book then ends with his prescriptions for fixing the global economy: central bankers should be worried about asset bubbles along with the money supply, complex financial securities should be standardized and forced to go through clearing houses with margin requirements, and the housing bubble should be addressed by keeping people in their homes and adjusting bankruptcy proceedings. While this book walks a lot of previously covered ground, the content is still thoughtful enough that any reader, whether familiar or unfamiliar with Soros, will take something away from it.
Bad Paper: Inside the Secret World of Debt Collectors by Jake Halpern: I have a soft spot for stories from the financial underworld, and Jake Halpern’s investigative work into the underbelly of debt collection. He managed to submerge himself into the side of everyday finance most individuals don’t think about but are linked to: if you don’t pay off a credit card bill, where does that debt go? Who takes the loss? Halpern has found the answer (and reveals it in balanced thrilling yet sobering fashion) in the debt secondary markets. This business, largely trafficked through Buffalo, New York, is managed by a combination of high class bankers and lower-class ex-convicts trying to make a living by tracking down individuals who miss their phone bills. Like Martin Scorsese, Halpern makes mobsters sympathetic and complex-to-the-layman financial deals understandable.
Good Guys and Bad Guys by Joe Nocera: New York Times business columnist Joe Nocera published a compilation of his articles over the past three decades that were specifically memoirs or interviews with high-profile business leaders, especially those with distinct public images. Warren Buffett, Michael Milken, and the Enron crew all make appearances. Nocera’s writing is most intriguing when trying to highlight the shades of grey between what we think of as good and evil (was Milken a scapegoat for an entire industry that was misbehaving? Can good businesses be bankrupted by predatory lawyers?) The collection is bookended by interviews, done two decades apart, with oil tycoon T. Boone Pickens, whose personal life and career have had as many ups and downs as the economy.
The Money Culture by Michael Lewis: This is another collection of articles from a business journalist. Famed financial journalist Michael Lewis focuses on the mid-80s to mid-90s era of financial globalization. Broken up into three sections (United States, Europe, and Asia) with pieces Lewis wrote for The New York Times, New Republic, Washington Post, and others, Lewis guides us through the laughable idiocy of the financial elite (or what would be comically stupid if it didn’t pay so well) as they almost destroyed venerable companies such as Macy’s, American Express, Nabisco, and the mortgage lenders in the post-leveraged buyout era. When they had taken over and destroyed what they reasonably could in America, the bankers moved to Japan to run the same playbook, and there too was Michael Lewis to share with the masses with his sense of sarcasm and understandable explanations of financial chicanery. This is definitely a quick, worthwhile read for those who want to understand a not-so-distant but not-so-recent time in the history of big, bad business.
Dead Companies Walking by Scott Fearon and Jesse Powell: “Short selling” (making money on the decline of stock) is a unique, difficult, and controversial art. Hedge fund manager Scott Fearon has been making these contrarian bets for decades and has assembled a guidebook for identifying these opportunities. As Fearon points out, most business failures aren’t from Enron-like fraud, but from changing technologies, competitive landscape, or simple mismanagement. He takes examples from company collapses he’s seen during his finance career and explains how to identify broken businesses before bankruptcy sets in. Even for non-financially literate readers, the lessons on how to think about what works and what doesn’t in business teaches a perspective of skepticism that is lacking in a lot of people.
Fooled By Randomness by Nassim Taleb: I read most of his other books before coming back to Fooled By Randomness. This makes it tricky to review because each of his successive books builds intellectually from the predecessors. As the title suggests, the book is about how people are prone to mistaking random events for those that they think have a known cause, and applying this idea across different fields (mostly financial markets in this book). For me personally, I had already covered most of this ground. However, this is still a great starting point for anyone who is unfamiliar with Taleb, as it’s significantly shorter than The Black Swan and the concepts are quite as a deep as those in the later books.
Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager by Keith Gessen and n+1: I’m certainly not part of the literary community nor a regular reader of the n+1 magazine, but everything I’ve read from them has been great. Here, Keith Gessen, one of the publications cofounders, sits down for a series of interviews with an unnamed hedge fund manager from September 2007 through August 2009. What starts as an inquiry into high finance becomes a roller coaster ride through the 2008 financial crisis with each cliff documented by two people unaware of what’s around the corner.
The star of the novel is the anonymous investor. Gessen does an incredible job of maintaining an enigmatic vibe for what this person is really like personally, but giving enough background to convey that this man is not your stereotypical rich asshole. He’s an insightful, down-to-earth non-economist who happened to find himself in his position through a series of fortunate events. Anonymous man has learned much about the roots of economics and human psychology along the way and is happy to share his wisdom. I highly recommend this as an introduction into the workings of markets, economics, and the financial crisis.
This Idea Must Die: Scientific Theories That Are Blocking Progress by Edge Magazine, Edited by John Brockman: Edge magazine sends out its annual “Edge” question to various members of the intelligentsia who are asked to write essay responses, the results of which are compiled into a book. 2014’s question was “What established scientific idea is ready to be moved aside so that science can advance?”, and the answers come from a range of experts and fields of thought (apparently many physicists are tired of the search for a “Theory of Everything” and “string theory”, while economists are trying to select the successor theories to the historically strict definitions of “economic growth” and “rationality”). Whether or not you are familiar with a scientific niche (say, evolutionary biology), the vast majority of the answers provide an interesting perspectives and food for thought in a couple pages. The best part is that this “book” is available entirely free online, so there’s no excuse for not skimming to see if there are any essays that pique your interest.
“Command and Control” tells two stories, alternating chapter by chapter: First, the story of a 1980 accident at a nuclear missile silo in Damascus, Arkansas, and second, the rise of the military-industrial complex throughout the 20th century in response to the Cold War.
The writing itself is paced like a Tom Clancy story, except real, and the science of nuclear weapons is explained in enough detail to appreciate their power without confusing readers or slowing the story.
The takeaway of the Damascus incident and Cold War is that mankind’s current existence is owed to the sheer luck that the world’s mismanaged nuclear warheads were never detonated anywhere, even accidentally, despite ample opportunities.
Schlosser summarizes the story’s moral:
“An entire generation has been raised without experiencing the dread and anxiety of the Cold War, a conflict that lasted almost half a century and threatened to annihilate mankind. This book assumes that most of its readers know little about nuclear weapons, their inner workings, or the strategic thinking that justifies their use. I hope readers who are familiar with these subjects will nevertheless learn a new thing or two here. My own ignorance, I now realize, was profound. No great monument has been built to honor those who served during the Cold War, who risked their lives and sometimes lost them in the name of freedom. It was ordinary men and women, not just diplomats and statesmen, who helped avert a nuclear holocaust. Their courage and their sacrifices should be remembered.”
Disclaimer: I am short Bank of Internet. Supporting documents referenced in this article can be downloaded in zip format. Also, the title is just a joke related to short selling, this article is more than 140 characters.
Since I started writing reports on my favorite stock trades, the only one which has, so far, not worked in my favor is my bet against Bank of Internet.
Excess profits were driven by a one-time opportunity in buying cheap mortgage-backed securities in the aftermath of the 2008 financial crisis that would not continue.
BOFI’s assets are structured to have a “negative interest rate gap” where a rise in interest rates could cause its depositor liabilities to become more expensive more quickly than its real estate investments could increase in value, thereby shrinking profits.
There was a real risk in its proposed acquisition of H&R Block Bank that the government would force BOFI to increase its spending on legal services and regulatory compliance software. The government cares about this deal is because the H&R Block Bank is involved in the “pre-paid card” business, a financial product used by terrorists for moving money/money-laundering.
The company is overvalued from a financial standpoint using either a discounted cash flow analysis or comparable price-to-earnings/price-to-book ratios versus competitors.
The top two executives (CEO and CFO) were involved in two previous financial companies which both collapsed and had to be saved by the government.
Shortly after I first wrote on the company in August, 2014, the stock dropped from $80 to $65 in two months. Since then it’s gone on an unhalting tear upward to $106.
Why Did The Stock Dip Lower in October? The Regulators Delayed BOFI’s Acquisition of H&R Block Bank
On October 5, H&R Block announced that the Office of the Comptroller of the Currency was delaying the deal past the 2015 tax season, with an expiration date for the deal’s approval on April 30th, 2015. The deal was originally announced on April 10th, 2014.
The next day, H&R Block CEO William Cobb said on a conference call, “I am obviously extremely disappointed, and frankly I am surprised in this development.”
June 30th passed without an SEC filing updating progress on the deal from either company involved. However, Bank of Internet did announce that its next annual earnings call would be on July 30th.
The BOFI CEO Responds to Investor Questions About the Deal with Wife-Beating Reference
During the second quarter conference call for the 2015 fiscal year, Julianna Balicka, an equity researcher for Keefe, Bruyette, and Woods, asked CEO Gregory Garrabrants about the government’s investigation into the H&R Block deal:
“On the H&R Block Bank transaction, to the extent that in reviewing the transaction and kind of based on — my comments are based on kind of how regulators have approached other bank acquisitions. To the extent that the regulators have asked you or H&R Block Bank to go back and fix ABC or change ABC with how you run your own bank and then they have to go back approve the ABC changes, and then they go to approve the deal, right? To the extent that, that happened with H&R Block Bank deal, have A, B and C that they’ve asked for already been completed?”
To which the CEO responded with an in-poor-taste joke (emphasis mine):
“That’s — I have to say, actually, I’m going to give you, like, the award for that. I think my dad had a good sense of humor, and he used to say, ‘If that’s a question’– When you get a question, like, ‘Have you stopped beating your wife?’ You always have to stop back and say, ‘Wait a minute. What was that — just question?’”
It’s Not Surprising To Hear These Comments from the CEO of a Company Without a Human Resources Department
My own research on the job review site Glassdoor revealed an interesting company secret: Bank of Internet does not have an HR department.
A search through its 330 employees on Linkedin found that the company has (at least of publicly available employees) an in-house recruiter, a payroll and benefits administrator, and a workforce operations administrator. Other than the workforce operations administrator, there doesn’t appear to be any human resources employees at Bank of Internet.
The nine Glassdoor reviews below all mention this issue:
It’s not only the bad reviews or disgruntled employees. Even this positive, four-out-of-five-stars review of the company admits to no HR department:
H&R Block’s CEO is Not Happy About The Deal’s Progress
“I’d like to comment on H&R Block Bank. Let me be clear. While we respect the work of the regulators, we are frustrated by this process and the length of time it is taking for the transaction to come to conclusion. We continue to work with BMI and our regulators, and believe that on its merits this transaction should be approved.”
Before going into further details from the call, I should explain upfront again why H&R Block is selling their banking division. Aside from the regulatory risks related to its prepaid card business I’ve explained before, H&R Block is primarily a tax preparation services business which also happens to run this bank business on the side. It wants to get out of the banking business for two primary, related reasons: First, it’s banking division is regulated by the OCC, and second, it’s required to maintain extra cash reserves to support its bank in case the bank runs into trouble and doesn’t want to risk depositors losing money. If H&R Block can sell its bank to another bank, then it can use its extra cash for other business expansion or share it with investors, and it won’t have to answer to as many government officials.
Mr. Cobb elaborated these points during the call: “We continue to expect to have approximately $1 billion of excess capital on the balance sheet when the bank deal closes. It is the desire of the board and management to use this capital and also incur some incremental net debt while maintaining an investment grade rating to return capital to shareholders. More details regarding the capital plan will be shared after the bank deal closes.”
When the question-and-answer session of the call started, the analysts continued to ask for further BOFI deal details.
Gil Luria of Wedbush Securities asked, “In your prepared remarks, you talked about the fact that the regulator hasn’t approved, or doesn’t seem to have any merits for not approving the bank sale. It sounds like you’re maybe implying that there’s other factors at hand here. And if that’s the case, and even if it’s not the case, and the regulator’s going to take an unknown period of time to approved this, doesn’t that make this the new normal? And if it is the new normal and even in consideration of everything that you talked in terms of volumes and unit accounting, how do you generate earnings growth on a sustainable basis going forward without a bank sale?”
“I don’t think we wanted to indicate anything other than there is no information at this time. And while we’re frustrated by the pace of the project, we don’t see any reason why this wouldn’t – transaction would not be approved on its merits.
Now, so there’s no signaling, there’s no, nothing of – and this seems to be taking a long. That is from our perspective, and probably many people would be with the same way. I’m not sure the regulator does. And for those of you who would deal with other banks and this whole industry, things are taking a long time in terms of any kind of deals that are being approved. I don’t want to speak for the regulators, but I don’t think they think this is – I think they feel they’re being thorough and complete as they approach this transaction.
So while it’s frustrating, while I would have thought we would have had an answer by now, there is nothing – and hopefully, we’ve gotten this through -there’s nothing to indicate that anything other than that this will move forward. However, the timing is something that is still in the hands of the regulators, and I think from their perspective, and again I can’t speak for them and I don’t think they’re going to speak about this, I think the timing is consistent with some of the ways they look at other deals.
Now, as for what the implications of that are – and again, I think every one of us also want to be very clear, we are not going to change our mind, if you will. We do not want to be regulated as a savings and loan holding company any further, and our intention is to exit holding – owning our own bank.”
Luria continued by asking, “Is there not a possibility for you to unwind the bank without having to sell it, and therefore not have to go through the same regulatory approval cycle? Is that not a possibility that you would have if this process was to keep going on or was to end with an unfavorable ruling?”
Chief Financial Officer Greg Macfarlane handled this question: “The important point number one is what Bill said, is we’re going to get out of this business…. We will get it figured out. It’s been frustrating, but we believe that the transaction we’ve entered into with BofI and talked about with all you many times is the way to go. As a hypothetical, in the event that doesn’t work out, what is the next backup? There is a way to separate the going-forward bank support that this company needs to continue to sell Tax Plus products, which we’re very committed to, and the actual formality involved with having a bank balance sheet. So effectively, we want to still be in the business of offering bank products, and we’ll need a partner bank to do that. So think of that as one transaction…. But really, just to finish up my response to your question, the plan that we have with BofI is the right plan we believe, on its merits, will be approved.”
Thomas Allen from Morgan Stanley tried to get a timeline for the deal closing out of Bill Cobb, who neutrally responded, “I’m out of the forecasting business. I think what we share and we continue to work very closely with BofI. We’re committed to them. I think they’re a terrific partner. We think the deal is going to be approved. But as for timing, we’ve been wrong a couple times on this. That’s why I’m out of the timing business.”
Why Is BOFI Even The Bank Getting H&R Block Bank? Because No One Else Really Wanted It
H&R Block has tried to sell its banking division before. In July 2013, it had an agreement to sell H&R Block Bank to Republic Bancorp. When the Republic Bancorp withdrew its offer that October, H&R Block stated:
“So we, last fall, when we made the decision to move forward in this direction, engaged Goldman Sachs and First Annapolis and they’ve been working with us every step of the way. We ran a full process. So we talk to lots of interested parties. They called us; we called them….You then narrow it down to a smaller group of qualified people, have more detailed conversations. We then narrow that list down further to about six counterparties and had in-depth detailed diligence two-way type discussion before we narrow it down further and that sort of the end of that process, we ended up with Republic.”
“BOFI had no real edge in bidding for this asset: unlike RBCAA, it doesn’t have a history of offering tax-related financial products, and unlike a firm like The Bancorp (TBBK), it has little experience serving as the back office for a prepaid debit-card program. Yet BOFI still managed to win the transaction, suggesting that it was willing to be more aggressive than its competitors and accept worse economics.”
What are those worse economics? The H&R Block Emerald Prepaid Card business and the bank’s deposits are not even growing.
In April 2014, Huntington Bank took over $450 million deposit accounts in Michigan from Bank of America and paid BofA $16 million, or 3.5% of the value of the accounts. In layman’s terms, a bank’s deposits are our money as individuals or business, and are actually liabilities for the bank who owe consumers that money if we ever want to withdraw it. One bank would acquire another bank’s deposits, despite deposits actually being liabilities, because it gives them a relationship with a customer to make money over the long term.
But in H&R Block Bank’s case, Bank of Internet is not paying H&R Block any significant amount beyond taking over the liabilities of the deposits.
In other words, BOFI somehow outbid other “interested parties” for H&R Block Bank with a bid of…nothing.
As summarized by Kerrisdale, “While the transaction isn’t costless – among other things, BOFI must put up capital to support the assets backing the acquired deposits – it surely says something about the quality and value of HRB’s deposit business that at least six parties closely examined it and none was willing to pay HRB anything for it. Potential buyers may have been unimpressed by the growth trajectory: in a rapidly expanding sector, HRB’s prepaid debit-card transaction volume grew only 3% in 2013, far slower than the 20%+ that BOFI shareholders expect from the company’s core business. Buyers may also have worried about the regulatory and operational risks of dealing with tax refunds and prepaid cards, both areas rife with fraud and money laundering. Whatever the reasons for buyers’ unwillingness to pay up, we doubt that there is much real value to be found in a transaction that was widely and repeatedly shopped yet failed to attract a meaningful bid.”
A month after Kerrisdale’s updated report, H&R Block’s own Annual Report (included in the downloadable folder) stated on page 35 (27 of the 10K SEC Filing): “Emerald Card fees decreased $5.2 million, or 5.0%, primarily due to lower transaction volumes resulting from a decrease of approximately 14% in prepaid debit cards issued.“
Even with an average yield of 34% (according to the the same filing’s line on “Emerald Advance on page 37), the HRB prepaid card business volume is decreasing, and BOFI is buying into it.
Aside from the HRB Deal, The “Negative Interest Rate Gap” and Rising Interest Rates Could Kill Profits
In my last report, I outlined the issues with the company’s focus on mortgage-backed securities, negative interest rate gap, and overvaluation compared to its peers.
The most worrisome of these issues to me is the negative interest rate gap, because it’s another area of its business where BOFI is both placing risky bets with its depositor’s money and regulators are not happy about it.
As a refresher, a bank’s “interest rate sensitivity” is a measurement of the effect interest rate changes (influenced the the Federal Reserve and/or the financial markets) have on the bank’s assets and liabilities. High interest on its assets means it makes more money, but high interest on liabilities means the bank has to pay its depositors higher rates on products like savings accounts. It’s the bank’s management’s job to delicately balance multiple factors: The interest rates it’s earning on its assets, how much it is paying out in liabilities, and the timespan over which it’s collecting money and paying back depositors.
On page 56 of Bank of Internet’s April 30, 2015 quarterly 10Q filing (also in the downloadable folder), the company reveals it has a -45.99% interest rate sensitivity gap, or approximately $2.5 billion in liabilities that will be repriced at potentially higher interest rates than its assets in the next six to 12 months (considering this was end of April, it’s now more like three to nine months).
BOFI explains on the same page: “In a rising interest rate environment, an institution with a positive gap would be in a better position than an institution with a negative gap to invest in higher yielding assets or to have its asset yields adjusted upward, which would cause the yield on its assets to increase at a faster pace than the cost of its interest-bearing liabilities.”
Rephrased, an institution like BOFI with a negative interest rate gap is in a worse position because the cost of interest on its liabilities will increase faster than the interest it earns on its profits.
Summarized, over the next three to nine months, if the Federal Reserve raises interest rates like it says it might, BOFI’s costs will substantially increase, shrinking its profits. Costs will rise because depositors, particularly those using online banks, can switch banks to whoever is offering the highest interest rate on savings accounts and CDs, so BOFI will be forced to increase its payments to depositors if it wants to keep them. But its assets, which are mostly mortgage loans, don’t increase their profitability as quickly.
This negative interest rate gap is also an area of interest to regulators. If interest rates rise, so does BOFI’s costs. And if costs rise enough, the bank may no longer be profitable and could eventually run the risk of bankruptcy. The government does not want to have to publicly deal with more bank failures.
The FDIC in October 2013 issued a four page guide/warning on managing interest rate sensitivity risk: “The FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment.”
Recently on June 30th this year, the OCC stated in a report: “The prolonged low interest rate environment continues to lay the foundation for future vulnerability. Banks that extend asset maturities to pick up yield could face significant earnings pressure and capital erosion depending on the severity and timing of interest rate moves.“
Related to the prepaid card business, the same report states: “Compliance risks remain high, as banks work to comply with new mortgage lending requirements and manage Bank Secrecy Act/Anti-Money Laundering risks.”
Could I Be Wrong? And if I Were, How Would I Know?
I ended my first report on Bank of Internet by listing the three ways I could be wrong about this pick. What I had failed to take into account the first time was that the regulators would postpone making a decision on the deal for over a year.
So I will state the criteria I personally use to judge whether this is a good pick.
I will continue to short Bank of Internet until the the H&R Block Bank acquisition deal has one of three outcomes: The deal is approved by regulators with no issues, the deal is approved by regulators on the condition that Bank of Internet spends a lot of money on regulatory compliance software and legal staff, or the deal is canceled because Bank of Internet is unwilling to spend the money on compliance or the government has issues with how Bank of Internet’s depositor money is being managed.
Any result beyond the first will be a very public signal that Bank of Internet will not live up to its own hype going forward, and I expect the stock price to drop to reflect that reality.
That’s the primary short term thesis upon which I am trading.
If the government does not act, then it could take a while before Bofi’s stock drops, and I would lose money while waiting. I’d be wrong regarding the government’s view of the H&RB Block deal.
Over the long term, Bank of Internet is still one of the most overvalued banks by fundamental financial valuation metrics with its profitability hinged on the Federal Reserve keeping interest rates low. If the regulators don’t take action against BOFI, its own risk-taking bankers will.
Disclosure: I am short Textura as of January 20th, 2014.
A lot of companies are overvalued in the stock market these days. Not many of these companies have distant ties to Stratton Oakmont, the very real and very shady brokerage firm featured in last year’s Oscar nominated hit The Wolf of Wall Street. The title of this research may be click-bait, but it’s not wholly untrue. I’ll explain the movie tie-in shortly after introducing the company under inspection: Textura.
Textura provides software applications for various parts of construction industry paperwork management, including (from their November 2014 10Q):
1. “Construction Payment Management (“CPM”) enables the generation, collection, review and routing of invoices and the necessary supporting documentation and legal documents, and initiation of payment of the invoices.”
2. “GradeBeam supports the process of obtaining construction bids, including identifying potential bidders, issuing invitations-to- bid and tracking bidding intent.”
3. “Greengrade facilitates the management of environmental certification.”
4. “BidOrganizer helps contractors save time and money by providing a central, online location to prioritize, track, and schedule all bid invitations.“
5. “PlanSwift, a take-off and estimating solution used in preparing construction bids, and Contractor Default Claims Management, which supports the process of documenting a subcontractor default insurance claim.”
Textura classifies these products and others under two types of revenue:
Activity-Driven: “Owners/developers, general contractors and subcontractors using our CPM, Submittal Exchange, Greengrade and LATISTA solutions pay us fees that are dependent on the value of the construction project or contract.”
Organization-Driven: “Participants using our GradeBeam, PQM and BidOrganizer solutions pay us subscription fees. These fees are dependent on a number of characteristics of the organization, which may include size, complexity, type or number of users.”
I first found this company through Citron Research, a notorious short-seller and investigator into fraudulent publicly-traded companies. Since Textura’s stock went public in June 2013, it has been Citron’s most heavily researched stock, with over five different research reports published on the company. If a quote is not attributed in this essay, then its source is included in this downloadable zip folder containing Citron’s research reports, Textura’s own investor presentations and SEC filings, and some additional documents from my own research.
Textura’s Business: Construction Payment Management (CPM)
Textura’s products are relatively straightforward: They are software applications for managing contractors and payments for construction companies. As of 2013, 62.8% of came from Textura’s primary CPM app which allows for the signing and submission of “Lien Waiver Forms”.
I am admittedly not an expert on the construction industry in any capacity. According to its research reports, Citron reached out to its own advisors and construction industry experts to help explain what Textura’s products are used for:
“Lien Waivers are one-page signature forms that all subcontractors on all typical construction projects need to sign in order to get paid…. There’s an opportunity for a niche workflow software solution here. In 2013, this need should be filled with a modest app. CPM’s lack or relevance can be seen right in their numbers… just $22.3 million in revenue generated by this app in 2013.”
“Subcontractors sign on to the Lien Waiver system when the general (or the master subcontractor) who engages them for the project commits to the software – in essence, forcing the subs to subscribe as conscripts, for the master contractor’s own convenience. But these signups are most often limited only to the lifespan of a particular project…. As soon as the project is over, perhaps 6 or 9 months later, are most of them churning right out? Why would they stay subscribed? If their next project has some other method of managing Lien Waivers, or no method, why would they continue to pay fees to Textura?”
This paragraph leads into discussion about Textura removing hyperbolic statements following SEC questioning. Textura tried to claim “high retention” of customers to the Securities and Exchange Commission and quite likely backed away because it’s customer relationships, by the nature of the business, are temporary and project-based.
Lying to the SEC in its Initial Filings?
In its December 29, 2013 report, Citron unveiled unusual banter between Textura and the SEC prior to Textura going public.
When it filed to go public in January, 2013, Textura claimed: “Recurring revenue model with high visibility. Our solutions historically have exhibited a predictable pattern of fee generation from projects managed on our system; our large portfolio of clients has resulted in a predictable number of projects; and we have experienced high client retention.” (emphasis mine)
The SEC contested this claim, saying: “You state that you have experienced
high client retention. Please provide specific quantitative disclosures in this regard, here and elsewhere in the registration statement where you discuss client retention.”
Instead of providing data to support its assertion to the SEC of “high client retention”, Textura instead chose to remove the disclosure.
And this happened a second time. Textura claimed to have “growing demand from our increasingly multinational clients” but removed the claim after the SEC questioned it.
Citron summarizes this back-and-forth: “In over 13 years of publishing and reading SEC comments we have NEVER seen a company make two bold claims as above, but simply turn and run from them without even an attempted defense when challenged by SEC staff.”
What executive would try to slide hyperbolic statements past a government regulator?
The Wolf of Wall Street History of CEO Patrick Allin:
From Textura’s website: “Prior to co-founding Textura, Mr. Allin served as a senior client delivery partner, Chief Operating Officer and Chief Financial Officer of the Global Consulting Practice at PricewaterhouseCoopers LLP. Earlier in his career, Mr. Allin served in a number of executive positions, including President, at Moore Business Forms North America and as an audit partner at PriceWaterhouse.”
Citron notes in its December 2013 report that, “Mr. Allin recently sold 230,000 shares in the follow-on offering at $38.00, cashing in an $8.74 million payday without disclosing the skeleton in his closet.”
On page six of the same report, Citron discusses Patrick’s job prior to Textura:
“As early as January 15, 2003, Mr. Allin was appearing in press releases as the CEO of Patron Holdings (later Patron Systems), promising a bright future of ‘driving growth and
profitability’. In fact, during 2002, Patron was purportedly engaged in a strategy to buy various security technology companies such as TrustWave Systems, and roll them into an OTCBB shell company called Combined Professional Services…. The share exchange transaction (disclosed to SEC on October 22, 2002) was signed by Patrick J. Allin as CEO of CPFS.”
Presumably an auditor would know the consequences of misrepresenting a company’s financial state. Patron’s accounting firm resigned, citing “it could no longer rely on Patron’s representations and, as a result, Grant Thornton is unwilling to be associated with the financial statements prepared by Patron,” and that it, “was withdrawing its audit reports and those audit reports could no longer be relied upon.”
That same year the Department of Market Regulation started to recognize that Patrick and CPFS were running something closer to a stock pump-and-dump: “In late July 2002, the staff of the Department of Market Regulation (the “staff”) saw an article on the Internet about CPFS. The article asked how a shell company with no cash, no revenues, no business, and no immediate prospects could be selling at prices above six dollars a share. Searching the public filings on the SEC website, the staff learned that CPFS was indeed a shell with no operating history, no revenues, minimal assets, and no financial resources.”
Naturally, this shady business led to jail-time for many involved who weren’t Patrick Allin: “Mr. Allin’s counterpart in these transactions with Patron Holdings and CPFS was Jeffrey Spanier of Florida Discount Brokerage, and an associate of Paul Harary, both penny stock promoters. By the time Allin resigned from Patron Systems in 2004, his CFO had already jumped ship. Meanwhile, FINRA exposed the blatant pump-and-dump operation operated by Spanier, Harary and others with CPFS stock. Harary and Spanier are both currently in Federal Prison for stock fraud-related charges.“
Another associate of Mr. Allin’s during his time running Patron was a Mr. Thomas Prousalis.
In December 2013, Prousalis’s daughter wrote a dark open letter in LA Weekly to her father, a former lawyer for Stratton Oakmont, the all-too-real firm which is now famous for inspiring the book and movie “The Wolf of Wall Street”. A 2004 Washington Post article elaborates on Prousalis’s role in the now defunct-yet-infamous brokerage firm.
As listed in twoSEC Filings, Patron Systems and Patrick Allin issued Prousalis 1.5 million shares of stock for “Legal Services”. Not much later, Prousalis was in jail and Patron Systems was bankrupt.
Patrick Allin proceeded to co-found Textura.
Did Patrick Allin Run Patron Systems From a House?
Did Textura’s Financiers Also Participate in a Pump-and-Dump?
William Blair and Barrington were the two leading investment banks which offered Textura’s stock to the public. This wouldn’t be a problem if their employees weren’t using their companies to line their own pockets.
As Citron found in an amended SEC filing, a group of William Blair and Barrington employees, specifically Mr. Richard Kiphart and Mr. Arthur Simon, were members of an investment group called ACPP Capital LLC which owned shares (specifically “159,062 shares of common stock and warrants to purchase 16,556 shares of common stock”) of Textura before their employers sold it to the public.
Citron comments on the incredulity:
“Ok so check this out: There was an undisclosed LLC shareholder, owned by individuals from two different underwriters? This is a direct conflict of interest, and the failure to even include this information in the IPO prospectus is like a Wall Street version of a brown paper bag….
Let’s factor in the head of Corportate Development at Textura, who used to be an analyst at William Blair. As a matter of fact he was the boss of the current analyst at Blair who covers the stock – with an ‘Outperform’!”
From Textura’s own SEC S-1 Filing: “Franco Turrinelli has been our Executive Vice President of Corporate Development since January 2010. Prior to joining Textura, from July 1996 to December 2009, Mr. Turrinelli was at William Blair & Company LLC, an investment banking firm.”
So for my less-financially inclined readers, what does this mean?
The bankers themselves owned shares in money-losing company, recommended the company to the general public, sold the stock to them, and got hired by the company in executive-level positions. When/if the company runs out of money to lose, the bankers will have made their millions for bending the truth to the public, who will have lost all its investment.
Michael Nemeoff of the investment bank Credit Suisse First Boston refuted Citron’s analysis of Textura, stating: “We base our opinion on our own research, performed over the last few days, as much of the innuendo that suggests impropriety is based on publicly available information that anyone can find using Google.”
To which Citron and I reply, if you are suggesting we don’t use publicly available information, I guess all that’s left is insider information and listening to whatever the CEO says. Of course, you would expect this kind of response from one of the investment banks which sold Textura’s stock to the public.
“One of its most hilarious ‘disclosure moments’ is how Textura reports the total amount of construction reported in the Lien Waiver system as though it is a meaningful number. They disclose “Client-reported construction value added (billions)” as though it meant anything, boasting of 55.7 billion in “construction value” reported as released from claims using their software. The reality is that the company’s CPM “solution” generated a whopping 22.3 million in topline revenue for 2013.
To offer an example of just how stupid this is: Suppose you ran a pen company. And at the end of the year, you reported, “A Trillion dollars in contracts were signed with our pens!!!” That number is irrelevant at best, or intentional promotional misdirection at its worst.” – Andrew Left, Citron Research
While talking about how a company like Textura even gets funded in the first place, it’s worth noting that during this company’s history, it has received no significant venture capital investment. This is during a time when enterprise software and software-as-a-service companies are raising hundreds of millions of dollars. Hell, even my previously researched company Castlight Health got top-name technology investors. Textura only has a handful of old Wall Street types involved. It’s not like Silicon Valley has anything against the construction industry. In 2012, not too long before Textura’s IPO, a startup named Plangrid raised $1 million in funding from a few of the Valley’s elite.
And while we’re comparing construction-industry technology companies, Plangrid’s website looks a heck of a lot more modern compared to the larger Textura. Not every company needs a modern website, but it looks better to have one if you’re in the software business. Even more disconcerting is that Textura’s “Investor Relations” page looks better than it’s company homepage (this is me speaking subjectively on February 22, 2015), which suggests they are more interested in pitching investors than customers.
Disregarding Executive Sketchy Dealings and Taking Textura at Face Value, How Do the Company’s Finances Look?
Quoting Citron, “You’re telling us that all that money went to build a lien waiver processing system? That’s all they have to show for it? A small software company with 385 employees and revenues well lower than $100K per employee?”
From page 11 of the September 10, 2013 S-1 Filing:
“We have incurred significant losses in each period since our inception in 2004. We incurred net losses of $15.9 million in the fiscal year ended September 30, 2010, $18.9 million in the fiscal year ended September 30, 2011 and $18.8 million in the fiscal year ended September 30, 2012. We incurred a net loss of $31.3 million in the nine months ended June 30, 2013, and as of June 30, 2013, we had an accumulated deficit of $169.9 million. These losses and accumulated deficit reflect the substantial investments we made to acquire new enterprise client relationships and develop our solutions. We expect our operating expenses to increase in the future due to anticipated increases in research and development expenses, sales and marketing expenses, operations costs and general and administrative costs, and, therefore, we expect our losses to continue for the foreseeable future.“
That looks kind of bad but it’s from an older filing. What’s the most recent November 2014 10Q quarterly report have to say?
Revenues For the First Nine Months of 2014: $45.106 million Total Operating Expenses During That Time: $65.759 million Net Loss to Stockholders In Nine Months of 2014: -$20.978 million.
Compared to the first nine months of 2013 where Textura lost $42.896 million, last year’s $21 million loss is a slight improvement. But it’s still not a great sign for a company with dwindling cash reserves.
Cash and Cash Equivalents Available as of September 2014: $66.035 million Accumulated Deficit in Company’s History: -$205.512 million.
I am listing only the first nine months of 2014 because Textura does not announce results from the end of 2014 until this upcoming Tuesday, February 24, 2015.
Examples of Management Mistakes
“Investors could overlook all that if the real Textura was in fact a rapidly growing SaaS outfit, gobbling up substantial market share in a huge addressable market, by offering an integrated suite of software poised to rapidly [sic] that market at very low cost of sales. But the current company is the opposite of a real SAAS company: It offers only one narrow solution (CPS, the lien waiver/payment solution), plus a hodgepodge of small software acquisitions that don’t integrate well, if at all,” Citron explained.
An example of an arguably bad acquisition is Latista. As disclosed in the November 2014 10Q filing, Textura paid $34 million for Latista Technologies in December 2013. In the nine months since the acquisition, Latista earned only $2.172 million in revenue and lost $4.571 million.
It was also revealed the company has some decent severance packages for an unprofitable software outfit:
“In September 2014, two co-founders retired from full-time employment with the Company, and two other non-executive members of management were terminated from the Company. Pursuant to the severance arrangements provided in their respective employment and separation agreements, we recognized severance-related expenses of approximately $1,488 during the three months ended September 30, 2014. This severance expense includes salary, payroll taxes and bonus payments to which the former employees were entitled under their respective arrangements. We expect to pay the severance expense, of which $1,460 was accrued as of September 30, 2014, over the next twelve months.”
Those dollar amounts are in the millions (as in $1,000 is a thousand-thousands). They expect to pay $1.460 million in severance over the next year.
Additionally, page 16 of that SEC filing states that stock-based compensation for employees was $6.405 million in the first nine months of 2014.
How can I get a job, then fired, from there?
Looking Through the Glassdoor
Speaking working at Textura, I hopped over to Glassdoor to see what former employees had to say. For those who don’t know what Glassdoor is, it’s a website where workers can review the companies they currently or previously worked for.
To its credit, as of February 22, 2015, Textura sports an average score of 3.8 out of 5 from 38 employee reviews.
Even the positive reviews reveal insights into problems with the company:
Most of the time when I’m trying to value a company to buy or short, I’ll attempt a full discounted cash flow model so I know approximately what the business is worth. Considering Textura’s vast history of losing money and it’s only very recent attempt to lose slightly less money, projecting any future free cash flow would be unrealistic.
Much like I did with Castlight, I would use some metric, like the market-valuation-to-revenue multiple, from companies similar to Textura and apply those in this situation. One publicly traded leader in the construction industry accounting software market is Sage Software, a $5 billion dollar company traded on the London Stock exchange. Sage is profitable with $1.3 billion in annual revenue and $187 million in profit. This implies a valuation of about 3.8 times annual revenue.
If we applied this to Textura, who had revenue of $45.106 million in the first nine months of 2014 and is expected to announce Tuesday fourth quarter revenue of $17.06 million for a total of $62.166 million in revenue for the year, then we get a value for Textura of $236.231 million ($9.28 per share). The company currently trades at a valuation of about $691.72 million ($27.16 per share).
If one wanted to claim the company is growing at a faster rate than Sage (which is true regarding revenue), and despite it’s lack of profitability, large continuing losses, and questionable management practices, it justifies using a higher multiple, we could double the multiple to 7.6 times annual revenue for a value of $472.462 million ($18.56 per share).
Either valuation, $9.28 or $18.56 per share, represents at least 33% drop from its current price.
Foundation by Isaac Asimov: Despite being one of the canonical science-fiction works, I found Foundation to be disappointing. Upon opening the Amazon package, I was surprised by how thin the book is. Once I began reading, I realized the characters and plot were equally non-existent. The book does not get a lower rating for one reason: Considering it was written in the 40s and 50s (originally published in serialized form in a magazine, as so many novels were at the time), the two central themes of psychohistory (predicting social phenomena via mathematics) and interstellar travel were ahead of their time. Asimov was a great thinker, not a great writer.
Big Data: A Revolution That Will Transform How We Live, Work, and Think by Viktor Mayer-Schonberger and Kenneth Cukier: A solid non-technical discussion of the currently popular “Big Data” buzzword. There is actually less discussion of the cultural impact of “big data” than I expected. Instead, the authors mostly highlight a dozen or so companies and government agencies that have used the improved digital storage hardware and software of the past decade to build original business and learn new things about humanity. It was worth reading just for one insight I had not mulled over enough: What “Big Data” means is that one can achieve his or her goals better with naive algorithms and lots of data versus complex algorithms on smaller data sets.
Not That Kind of Girl by Lena Dunham: I didn’t know that the young creator of the hit HBO show “Girls” had a book out until I saw it prominently pimped at an airport bookstore. Her first published book, Dunham’s collection of essays cover what I think of as standard fare for girls who were unpopular kids in school. None of the essays really spoke to me personally, yet I finished the book due to its short essay/memoir format and Dunham’s clever but conversational writing style.
The New New Rules by Bill Maher: Whether you love or hate him, Bill Maher is (and has been for decades) one of the country’s standout political commentators. The “New Rules” segment of his HBO talk show Real Time (where he explains his satirical rules for improving society) is the show’s highlight and this book is a compendium of those segments. Despite this being a collection of previously-aired television segments, there are enough witty observations here worth reading.
Console Wars by Blake Harris: Alternatively titled “A SEGA CEO’s Memoirs”, Console Wars follows Tom Kalinske in his battle against the Nintendo monopoly of the early 90s, creating the first videogame “console war” since the 70s. The author is clearly biased in his dedication to the narrative that Sega of America was the tenacious upstart against a conservative, complacent Nintendo. In Mr. Harris’s defense, he admits his longtime acquaintanceship with Tom Kalinske. While the bias hurts the story’s depth (it focuses primarily on marketing moves and high level business politics, as opposed to deeper discussion on the state of entertainment in the 90s or the games themselves), it’s still a hell of a fun story.
The Alliance by Reid Hoffman: The founder and alumni of LinkedIn propose their alternative theory for ongoing employee-employer relationships. The Alliance establishes an honest dialogue for employees to align their career goals with companies, even if they are short-term by historical standards, and for companies to improve employee retention and productivity in our increasingly volatile work environments. It’s a thin book, as the primary points are pretty simple to explain. These points are valuable enough, along with anecdotes of these ideas in practice at LinkedIn, to spend an afternoon reading.
If This Isn’t Nice, What Is? by Kurt Vonnegut: I hadn’t read any of Vonnegut’s works, and he’s famous in American literary history, so I figured I should. I started with this collection of his graduation commencement speeches. These short insights into his mind were alone to convince me that, yeah, Vonnegut was a unique kind of genius. Although the content of some of the talks overlap, there is a lot of wit and wisdom in these 100-or-so large fonted pages.
Hatching Twitter by Nick Bolton: This short biography of Twitter focuses on it four cofounders: Ev Williams (the creator of Blogger and original supporter of Twitter), Jack Dorsey (the first developer of Twitter), Noah Glass (the co-originator of the idea with Dorsey and developer friend of Ev’s) and Biz Stone (the operational cofounder and sanity-checker of the chaotic startup). The Twitter story is really made by the sensational growth of the company and the characters that tried to corral it. Worth noting is how poorly Jack Dorsey comes across; A narcissistic, ineffective Steve Jobs wannabe who hijacked the company and media attention from the other founders.
No Matter the Wreckage by Sarah Kay: From the leading spoken word poet of our times comes a collection of poems about young love and growing up in New York City. I don’t personally relate to most of the poems due to my personal half-cynical personality. However, the half-optimist side can’t discount her ability to make intimate, clever, and effortless wordplay. I’m also slightly biased after having seen her perform in person. Anyone who has will read this book with her energy and voice.
Lolita by Vladimir Nabokov: Nabokov is brutal and beautiful in his writing. The first quarter of this fictional autobiography of a pedophile swiftly pierces the soul with imagery of underage prostitution and immoral nubile lust. The ending is a somber conclusion to a wholly believable illicit love. Unlike, say, F. Scott Fitzgerald, who can say more than most authors while using fewer words, Nabokov’s strength is effortlessly writing flowery prose. The only weakness of this classic is the slowly paced midsection.
Slaughterhouse Five by Kurt Vonnegut: If anyone ever asks me to define “dark humor”, I’ll hand them Slaughterhouse Five. I now get why Vonnegut is famous. The closest comparison that came to mind is observational stand up comedians. Reading Vonnegut feels like listening to Jerry Seinfeld or Louis CK commentary on humanity’s worst depravities.
Dataclysm: Who We Are When We Think No One’s Looking by Christian Rudder: One of the founders of OkCupid uses the statistics and the large data generated by the burgeoning online dating scene to understand people. From his unique vantage point, Rudder mostly reveals things you’d already assume. There’s a lot of reaffirming stereotypes here, but perhaps it’s because stereotypes are true and most of us don’t admit it publicly? Or will having data to confirm our preconceptions change how individuals think of themselves and others in the future? These are some of the questions I walked away from Dataclysm wondering.
How Adam Smith Can Change Your Life by Russ Roberts: I wrote previously about Russ Roberts being one of my biggest influences, but this is the first book of his I’ve read. Roberts updates Smith’s less famous book, “The Theory of Moral Sentiments”, for the modern age. The Theory of Moral Sentiments is Adam Smith’s philosophy book. It’s his pursuit to the answers of what morals are, what morals people should have, and how morals are an innate part of humanity. Smith’s original book, published in 1759, is hard to read. Roberts makes it accessible to everyone with modern language, examples, and length. The only reason this doesn’t get a five is that it’s tough to give the top score to a summary of someone else’s ideas. But don’t let that from deter you; this is highly recommended reading to anyone interested in bettering themselves and society.
So We Read On: How the Great Gatsby Came to Be and Why It Endures by Maureen Corrigan: “Forget great. It is the greatest.” So begins Corrigan’s defense of The Great Gatsby as the Greatest American Novel (whose sentiments I agree with). Corrigan, a lecturer in the English department at Georgetown and NPR show host, discusses the life of F. Scott Fitzgerald, the making of The Great Gatsby, it’s lack of popularity upon its release, its mid-century revival, and its canonization in American Culture. Like the Russ Roberts book reviewed earlier, it’d be hard to give a five out of five to a book about another, greater book. However, I’ve been asked many times what my favorite fiction book is. Corrigan explains the greatness of Gatsby more eloquently than I could. She’s written the definitive defense of Gatsby as the greatest English novel.
I Wear the Black Hat: Grappling with Villains (Real and Imagined) by Chuck Klosterman: I’m not sure how one becomes a paid cultural essayist, but Chuck makes me want that job. “I Wear the Black Hat” is Chuck’s collection of thoughts on the concept of “villainy” in Western/American culture. He loosely presents a cohesive thesis while trying to answer the question: How do we classify someone or something as “villainous”? Chuck presents an answer, kinda sorta, and the ending is pretty anti-climatic (not that essay collections need to have a conclusion). Yet, due to Klosterman’s ability to make the mundane riveting, I read through this in a handful of days. When I can’t put a book down, even when I’m not sure why I like it so much other than the author’s style, I have to give it a great rating.
The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Weatherall: There’s been a great debate the past century about whether using highly complex mathematics can improve the stock market and investing versus older business fundamentals. I generally fall toward the latter based on what I perceive as very little value provided to financial markets by “economists” misguided by “physics envy”. But if there was ever a great counterargument to my side of the debate, Weatherall has written it. The Physics of Wall Street chronicles the history of physics’s influence on finance and concludes with his manifesto on improving and increasing the use of math in finance. His stance, which is that much of the math has been naive and that continued mathematical creativity will only improve our understanding, is compelling and even-keeled. While I haven’t been drawn to the quant dark side, and a lot of the historical figures and events have been told in other books, Weatherall (himself a physicist) has done a thorough research job. I learned new things, and the things I already knew are accessible to newcomers to the field.
The Tragedy of the European Union: Disintegration or Revival? by George Soros and Gregor Schmitz: In this series of interviews in 2013 between the German report Schmitz and famous investor Soros, Soros prescribes his solutions to the European Union’s political and economic woes. His primary ideas: Germany needs to worry less about following existing treaties, lighten it’s forced austerity upon debtor nations, and move all European Union country’s debts from national issues to one “eurobond”. The book is short but filled with insight as Soros elaborates on these points and includes a paper of his published in an economics journal on his “Reflexivity” philosophy of financial markets. Regardless of how closely you follow Euro-zone politics, any insight into Soros’s thinking is worthwhile.
Zero to One by Peter Thiel and Blake Masters: Based on his lectures at a startup class at Stanford, entrepreneur and investor Peter Thiel has published (with the help of student/employee Blake Masters) his critical insights he’s learned from a lifetime in the technology industry. It’s short and every line is filled with business wisdom. Anyone going into business or economics needs to read Zero to One.
The Best Book I’ve Read in the Last Six Months
Zen and the Art of Motorcycle Maintenance: An Inquiry Into Values by Robert Pirsig:
I could write my own review of this masterpiece. However, in the afterword for the ten-year anniversary of its publishing, Pirsig commented on why he believed the book became, according to The London Telegraph, “the most widely read philosophy book ever”. I feel his description of his work is more insightful than anything I would add:
“There is a Swedish word, kulturbärer, which can be translated as “culture-bearer” but still doesn’t mean much. It’s not a concept that has much American use, although it should have.
A culture-bearing book, like a mule, bears the culture on its back. No one should sit down to write one deliberately. Culture-bearing books occur almost accidentally, like a sudden change in the stock market. There are books of high quality that are a part of the culture, but that is not the same. They are a part of it. They aren’t carrying it anywhere. They may talk about insanity sympathetically, for example, because that’s the standard cultural attitude. But they don’t carry any suggestion that insanity might be something other than sickness or degeneracy.
Culture-bearing books challenge cultural value assumptions and often do so at a time when the culture is changing in favor of their challenge. The books are not necessarily of high quality. Uncle Tom’s Cabin was no literary masterpiece but it was a culture-bearing book. It came at a time when the entire culture was about to reject slavery. People seized upon it as a portrayal of their own new values and it became an overwhelming success.
The success of Zen and the Art of Motorcycle Maintenance seems the result of this culture-bearing phenomenon. The involuntary shock treatment described here is against the law today. It is a violation of human liberty. The culture has changed.
The book also appeared at a time of cultural upheaval on the matter of material success. Hippies were having none of it. Conservatives were baffled. Material success was the American dream. Millions of European peasants had longed for it all their lives and come to America to find it…a world in which they and their descendants would at last have enough. Now their spoiled descendants were throwing that whole dream in their faces, saying it wasn’t any good. What did they want?
The hippies had in mind something that they wanted, and were calling it “freedom,” but in the final analysis “freedom” is a purely negative goal. It just says something is bad. Hippies weren’t really offering any alternatives other than colorful short-term ones, and some of these were looking more and more like pure degeneracy. Degeneracy can be fun but it’s hard to keep up as a serious lifetime occupation.
This book offers another, more serious alternative to material success. It’s not so much an alternative as an expansion of the meaning of “success” to something larger than just getting a good job and staying out of trouble. And also something larger than mere freedom. It gives a positive goal to work toward that does not confine. That is the main reason for the book’s success, I think. The whole culture happened to be looking for exactly what this book has to offer. That is the sense in which it is a culture-bearer.”
These are notes I took during the two days of Windy City Rails 2014 Conference. Since I attended on behalf of my employer, Springleaf Financial, my notes are skewed towards ideas that may be applicable in a enterprise setting. For anyone who might randomly find this post, keep this in mind, as the speakers had plenty to say on topics outside of the enterprise application development domain.
Bank of Internet is exactly as its name suggests: It’s an online-only bank. Individuals can make deposits online and the company uses those deposits to make investments. Started in 1999, BOFI has grown to over 300 employees and a market value of over $1 billion. It’s stock has rocketed upwards over 900% in the past five years. This tremendous run is about to end.
The BOFI Short Reports
Two short sellers have come out with public research reports against BOFI: Kerrisdale Capital (with a 36 page PDF and 37 slide Powerpoint presentation) and Citron Research (10 pages, shorter but more scathing).
Particularly scary for BOFI is that Kerrisdale Capital was once one of its biggest fans, bought the stock in 2009, held it as their largest investment for the firm, and published a positive report back when the stock was around $8 per share in 2009. Now that it’s at $79, Kerrisdale is calling it quits. They have a target price of $50 for BOFI stock and have flipped their position, betting it drops down to reasonable levels after having made huge sums of money buying the stock the past five years.
Citron is even more negative, with a $40 price target for reasons you’ll soon learn.
As a fan of Citron and Kerrisdale, I encourage you to read their reports. I’ll explain their key points against BOFI here, which should reveal the understandable problems with BOFI’s stock price. If you are worried about being bored by numbers, jump to section “Reason Five” which might intrigue you to read the rest (although I listed it last as its probably the least directly relevant to the company’s value).
Reason One: Earnings Driven by Mortgage-Backed Securities Are Ending
Page 16 of Kerrisdale’s report highlights the primary reason for BOFI’s huge growth and eventual decline: It’s assets are residential mortgage-backed securities (RMBS). For my less financially-inclined readers, RMBS are financial assets that represent pieces of residential mortgages.
Kerrisdale writes, “During the financial crisis, BOFI recognized that RMBS were undervalued and aggressively used depositors’ money to build up what was, by the end of FY2009, a $458 million portfolio, amounting to a whopping 35% of total assets.”
This investment by BOFI in cheap, post-financial-crisis mortgage assets was smart and has driven much of their profits in the past five years. However, these were opportunistic, non-recurring purchases. Once these assets, which are structured to last for a fixed amount of time, end or are rolled over into new assets with new terms, BOFI’s advantage versus its competition will be gone, as Kerrisdale demonstrates in this slide:
Kerrisdale continues, “Roughly 45% of the company’s securities book, equivalent to 15% of earning assets, is in non- agency RMBS with a high yield of ~5%. These securities are expected to decline by 15%-20% annually and could lead to a ~175 basis point decline in the overall securities yield. This would translate to a 25bps decline in the net interest margin over the next few years.”
And here is a demonstration of how the company’s overall earnings will be hurt by vanishing derivatives profits:
Kerrisdale elaborates: “BOFI management, to its credit, recognized during the financial crisis that non-agency mortgage-backed securities were attractive investments. By putting almost a third of its balance sheet into these securities at low prices, it built up a store of future earnings that it has been gradually recognizing over time. As these assets continue to pay down, BOFI will have to reinvest at much lower yields, further depressing its NIM and reducing profitability. Moreover, in a post-Dodd-Frank regulatory environment, we question whether a bank of BOFI’s current size would ever again be allowed to make such an extreme gamble with its depositors’ money.“
Bank of Internet did make money from buying these mortgage-backed securities. Yet, as those investments expire, their money will have to be invested in new assets with different rates of return. Except….
Reason Two: Interest Rate Sensitivity Could Cause Cash Crunch
“BOFI has one of the largest negative interest-rate gaps among publicly traded banks. In other words, its assets reprice much more slowly than its liabilities. As rates increase, its funding will become dramatically more expensive, but its asset yields will stagnate. At a time when almost every high-profile bank has sacrificed short-term earnings to make its balance sheet “asset sensitive,” with assets repricing faster than liabilities and thus positively levered to higher rates, BOFI has made the opposite bet, pumping up its earnings today at the cost of returns tomorrow,” writes Kerrisdale on page four of their report.
An interest-rate gap is the difference in interest-rate sensitivity between assets and liabilities. In the case of a negative number, that means if interest rates go up, liabilities would increase faster than assets, so profits are likely to decline.
Bank of Internet’s interest-rate gap, by its own admission on page 57 of its March 2014 third quarter 10Q filing with the SEC, is -157%.
The not-so-subtle Citron explains, “Banks are not supposed to take on interest rate risk any more than a Vegas Sports Book is supposed to bet on one horse in a race. They are supposed to be structured so that most of their rate risk is hedged…. Most banks are
within 10% or 20% of zero. Any steep interest rate rise would obliterate earnings.“
BOFI’s liabilities are the deposits individuals and businesses keep at the bank (remember from personal finance 101 that you are a liability to the bank), and its assets are the loans it makes and the mortgage-backed securities it buys. The reason BOFI has such a dramatic negative interest-rate gap is that mortgage securities are long dated while deposits like savings and checking accounts can be moved around by the account holders (you and me) any time. I am admittedly not an expert on interest-rate risk management and how banks manage assets to maintain a zero interest-rate gap, but this table comparing BOFI’s rate gap to other online banks makes BOFI’s problem pretty clear.
“Even a modest increase in interest rates, which is largely expected at this point, will result in a relatively significant reduction in BOFI’s earnings power due to the rapid increase in funding costs for its deposit base. Larger rate increases would put BOFI in a position where it could have capital shortfalls,” adds Kerrisdale.
In plain English, Kerrisdale is saying when interest rates rise, the short-term depositors will cost the company more money because the rates for their savings accounts will be higher. But because so much of BOFI’s money is tied up in mortgage loans and securities that it can’t get cash out of quickly, the company could be in a position where it’s tight on money.
One would think that if a company is systemically at risk of running out of short-term cash, even with a low probability, and is selling its own stock ownership stake for more money, it’d start getting conservative with the cash it does have. But if you’re Bank of Internet, conservatism is for pansies who don’t pay themselves enough. Why ensure the future stability of your business when you can double down on a new risky business venture….
Reason Three: Regulatory Risk in New Stored Value Card Business and H&R Block Bank Acquisition
In April, BOFI and H&R Block announced a deal for BOFI to buy H&R Block Bank (a subdivision of H&R Block) for $200-$250 million. In exchange, BOFI receives $450 to $550 million in customer deposits and prepaid card balances. Prepaid cards are generally things like gift cards or metropolitan subway cards where there is no account connected to the card. The money is tied directly to the card. However, there are businesses that issue these kinds of cards for other general purposes.
There is notable increased regulatory risk with the new prepaid card business BOFI is in the process of acquiring.
In June, The Bancorp’s stock was cut by 20% in a single day by a “Consent Order” issued to them by the Federal Deposit Insurance Corporation (FDIC) to improve their regulatory compliance (read the list of required company changes in Bancorp’s SEC filing here). The Bancorp is the USA’s largest issuer of prepaid or “stored value” cards.
An article by Computer Services Incorporated explains why the government cares so much about the prepaid card business. It’s ripe for terrorist activity. Since there is no account linked to a prepaid card, these cards can be used as an alternative to cash, and used for illegal purposes with no name or bank attached.
The government has a slew of new rules (such as the Prepaid Access Rule, the Bank Secrecy Act, and Anti-Money Laundering Rules) banks must comply with to avoid fines and penalties.
This regulatory risk is Citron’s primary short thesis:
“Citron notes that we are not saying that BOFI either supports illicit activities or even that stored value cards do not offer useful service. What we are observing is this area of the business will soon get disrupted and stay disrupted for a long time.
BOFI added to their risk of regulation with their recent acquisition of H&R Block bank. Citron notes that The Street’s initial euphoria over the H&R Block deal has completely worn off – the stock rallied from 75 to 100, but has now retraced all the way back to where it was before the deal was announced. The reason? The Street wised up to the reality that nobody else wanted H&R Block’s bank because of the regulatory risk – principally, becoming a major player in the stored value card space.
Here’s the issue, according to the CFO of a huge credit union who didn’t want to be named in the article: “It’s very difficult for a bank in the Stored Value Card business to comply with the Bank Secrecy Act (BSA – the banking regulation on money laundering) because the bank needs to verify every person who buys a Stored Value card. For example, if they give that card to someone else there are possible compliance problems. Without an over-the-counter deposit and withdrawal system, tracking the stored value cards is difficult. The government is highly concerned with terrorism activity right now and Stored Value represents a high-growth potential problem that needs tight regulation.“
I’m just speculating, but it seems to me that Bank of Internet is most likely buying into the prepaid card business in an effort to boost top line revenues and its total depositor and asset numbers. It’s an attempt at keeping up its high growth while exposing its internal operations to painful compliance cost increases and/or regulatory fines.
Reason Four: Fundamentally Overvalued
Disregarding the potential increased regulatory costs, Bank of Internet is overvalued right now at its market price.
Kerrisdale has done a better valuation job than I can. They’ve taken two approaches to deciding what BOFI is really worth: First, they calculate what they think the company is reasonably worth. Second, they take the company’s $73 per share, over $1 billion valuation and figure out what the company would have to do to earn this valuation.
Kerrisdale finds, using its model, that BOFI is worth $48.34 per share.
So what would BOFI’s business have to look like for it to earn enough money to be worth $73 per share?
Here are the remarkable conclusions Kerrisdale draws from this model:
BOFI will have to triple its deposits by 2021 from $2.4 billion to $7.5 billion. Kerrisdale notes that US GDP growth is only a couple percent annually, so most of these deposits would have to be taken from competition, not economic growth. This would have to be accomplished while competition is increasing.
BOFI must maintain Net Interest Margins at 3.5%. Due to BOFI’s negative interest rate gap, a rise in interest rates will destroy its margins.
For an easier side-by-side comparison based on simpler metrics like price-to-book (for the non-finance readers, book value basically being the value of a company’s assets minus its liabilities), Citron put together these handy tables:
Reason Five: The CEO and CFO Previously Ran Two Financial Firms….Which Went Bankrupt
My personal favorite reason to be skeptical of Bank of Internet is that it’s top management has a pretty poor record of running financial institutions.
Chief Executive Officer Gregory Garrabants was previous job was Senior Vice President in charge of business development at IndyMac until October 2007. IndyMac was the seventh largest mortgage originator in the United States. That is, until the housing crisis began in 2007 when the stock collapsed, the company’s mortgages and mortgage-backed securities lost money, and IndyMac was put into government “conservatorship” in 2008, becoming the fifth largest bank failure in US history.
Chief Financial Officer Andrew Micheleti was Controller and Vice President of Finance of Imperial Savings. Imperial used depositor money in the 1980s to buy junk bonds from the now-defunct investment bank Drexel Burnham Lambert. Both Drexel and Imperial would not survive the 90s (Drexel shut down after its leader Michael Milken went to jail and Imperial was taken over by the Federal government before it lost all its depositors’ money).
Given management’s background and the mortgage-related investments previously explained, what Greg and Andrew have done with their careers is this: Learn as much as possible about the mortgage and mortgage securitization industry as possible, find conservative financial companies that are moseying along, come in as upper management aiming to juice profits with risky mortgage loans and derivatives bets, cash out (as evidenced by Garrabant’s $2 million in compensation just last year), and move on when the company crashes when the penalty for short term risks over long term sustainability comes calling.
It’s ingenious really: pump up a shaky market, pay yourself good money while it goes up, quit as it’s about to collapse, and come back after everything has crashed and buy back all the old crappy assets you sold to people at higher prices just a couple years prior on the cheap. Wash, rinse, repeat.
It’s possible for Greg and Andrew to have learned from their previous debacles how to run and grow a sustainable bank. However, given the derivatives on their balance sheet I’ve shown earlier, the damning narrative seems to fit.
How I Could Be Wrong
With any idea, it’s important to try and figure out how it could be wrong, and an easy way to do that is support the inverse of your arguments. Any of the following items could help Bank of Internet grow profitably and prove me wrong. For their sake, I hope so.
The OCC or FDIC Do Not Force New Compliance Costs: If for some reason the government does not take action against BOFI for its prepaid card business, then this new division could add to the profitability of the company.
Interest Rates Remain Low For Years: If interest rates remain low, then BOFI’s net interest margins will take longer to decline.
BOFI Improves Its Organic Growth: Of course, if BOFI improves its competitive position either through improved loan selection and underwriting, improved marketing/branding to consumers, or some new investments I’m unaware of that could replicate the success of its mortgage-backed securities portfolio, then it could outgrow its competitors. There is little sign of any of these things happening, but they’re not impossible either.
The Bottom Line
Given all the reasons why BOFI’s stock may take a hit, it seems unlikely they can avoid them all. Even if earnings and their deposit base grow, interest rates stay low, and their H&R Block Bank acquisition is purely beneficial, the company is still valued at twice the earnings multiple of its competitors, leaving buyers less room for potential upside. If any of these positive pillars holding the stock up collapse, investors will be inclined to reevaluate their position. If we learned anything from the financial crisis, it’s that our banks should not be treated as high-flying growth businesses. This is particularly true when the growth is from investing in the types of derivatives that caused the last financial crisis from executives who crashed companies in that crisis.
My previous book review posts have been some of my most popular, so I’ll continue to post reviews every six months. This time around I’ll add some context for how I designate my ratings:
One Star: I would not recommend to anyone for any number of reasons (poorly written, lack of content, or plain unreadable).
Two Stars: Generally would not recommend, but tends to have a few worthwhile moments that would merit skimming.
Three Stars: Recommended, but either covers too niche a topic to get a stronger recommendation for a broad audience or doesn’t offer enough depth to be really interesting.
Four Stars: Recommended, well-written, and covers material I think most people would find useful or interesting.
Five Stars: Strongly recommended due to superb writing or research material. These books could expertly appeal to a wide audience or cover their source subject so thoroughly to be authoritative accounts of their topic.
As I’ve done previously, I’ll continue to pick one book as my “Best Book Read in the Past Six Months”, which is generally the Five Star book which I loved and feel others could connect with as well.
Last note: I typically exclude textbooks. The line between non-fiction and textbook is grey. When it comes to defining something as a non-fiction, non-textbook, I respond as Supreme Court Justice Potter Stewart once did: “I know it when I see it.”
Here the books I’ve read thus far in 2014.
Trading with the Enemy: Seduction and Betrayal on Jim Cramer’s Wall Street by Nicholas Maier -
I’m generally a fan of Jim Cramer’s (having met him briefly and taking his show with a shaker of salt). Hearing a book by an ex-employee was published claiming Cramer’s hedge fund committed nefarious market manipulation and front-running in the 90s, it was only fair of me to read it and weigh it against my bias. Sadly, the story is thin (read the whole thing in a couple hours!) and the writing is high school amateurism. I was entertained, but if the Maier’s intent was to whisteblow on Cramer’s potentially unethical activities, one would think he’d approach it with more professionalism.
The New New Thing by Michael Lewis -
The weakest of the Michael Lewis books I’ve read. The New New Thing chronicles the experiences of technology entrepreneur Jim Clark as he comes from nowhere to become one of the central figures of the dot-com boom. Published in 2000 just before the crash, the book seeps optimism for the new economy and its new new things. What keeps this book from being as interesting as Lewis’s others is that Jim Clark himself is mostly not as interesting as Michael Oher in The Blind Side, Billy Beane in Moneyball, or the short-sellers in The Big Short. Lewis loses focus midway through the book with chapters on Clark’s high-tech yacht. Despite understanding that it’s really a metaphor for Clark’s vision and ambitions, it’s doesn’t hold your attention. The bulk of the character development is saved for the final chapter, which gives The New New Thing a strong finish, but in a character-driven story, it means most of the book lacks all the intrigue which gets shoehorned in at the end.
No Regrets by n+1 -
This second roundtable discussion from the growing literary magazine’s staff focuses on two questions: What do we regret in our youth, and what should the relationship between women and literature be? As in the previously reviewed “What We Should Have Known”, the editors are simultaneously insightful and relatable. Compared to the aforementioned book, No Regrets wasn’t as relatable to me personally due to the feminine focus. A worthwhile read for men regardless.
How to Fail at Everything and Still Win Big: Kind of the Story of My Life by Scott Adams -
“Nothing in this book should be seen as advice. It’s never a good idea to take advice from cartoonists,” writes the Dilbert creator. He probably wrote that knowing that he had essentially written a self-help book. I typically avoid the genre, but who wouldn’t want to hear how to become rich and happy from one of the most famous and hilarious comic creators in history? It doesn’t hurt that he’s an entertaining writer outside of comic strip boxes too. Most of what he writes is truly valuable, giving his anecdotal experiences with low carb diets, weightlifting, and generally being lucky (and unlucky) in life.
Flash Boys by Michael Lewis -
Lewis still knows how to make complex, high stakes, and high finance stories entertaining. This book still follows the structure of most of his books: A disenchanted industry insider makes radical moves to reshape his part of an industry. Flash Boys’s failing is that, while Lewis explains the problems with high-frequency trading well, he doesn’t really present in the book enough content from what goes on inside those firms. Other than listing Citadel, Virtu Financial, and some talk of big bank dark pools, he doesn’t turn any of them into a real villain. Whether that’s due to a lack of access to insiders or more interest in telling a different story, I’m not sure.
Young Money: Inside the World of Wall Street’s Post-Crash Recruits by Kevin Roose -
In an impressive piece of journalism, Roose follows almost a dozen recent college grads over multiple years in New York City as they live the investment banker lifestyle post-financial crisis. Roose does a solid job of painting a picture of an industry still living more lavishly than it deserves, yet slowly rotting from the inside as new recruits start to jade and question their lives sooner.
The Everything Store by Brad Stone -
This biography of Amazon and its founder, Jeff Bezos, is a solid piece of modern internet business journalism. Despite spending limited time on Amazon’s initial growth (the company goes from $0 to $1 billion in sales in what seems like twenty pages), Stone’s writing vividly expresses Bezos’s early understanding of the Internet’s potential and ruthless drive toward a digital future.
MFA vs NYC by n+1 -
The latest essay collection from n+1 polls its various contributors for their thoughts on one of modern literature’s major questions: Is it better to go to grad school or work your way up through industry. In this case “grad school” means an MFA program and “industry” is the New York City publishing houses. This basic premise can really be expanded to other industries and the perspectives provided here could be helpful to anyone, not just aspiring writers.
Coders at Work by Peter Seibel -
I believe a good way to learn about a field of study is to read candid discussions between experts in said field. Coders at Work is a collection of Seibel’s interviews with some of the premier coders and computer scientists of our time. Despite being occasionally too technical for a casual reader, it contains so much wisdom for programming and project management that I’d still probably recommend it to non-programmers. Google whatever terms in the book you don’t understand.
The Secret Club that Runs the World: Inside the Fraternity of Commodity Traders by Kate Kelly -
After three years of interviews, tracking down quiet, powerful people worldwide, and learning an opaque industry, Kelly entertains and educates on a sector of the financial markets that, until recently, has largely escaped public scrutiny.
Aristotle and an Aardvark go to Washington by Thomas Cathcart and Daniel Klein -
If you’ve ever heard a politician speak and considered if assassinating a political figure would qualify as a public good, then this is the book for you. From the authors of the equally brilliant “Plato and a Platypus Walk Into a Bar”, “Aristotle and an Aardvark” teaches the philosophical concepts of logical fallacies with examples from United States politicians. I wish Cathcart and Klein could teach every academic subject. We’d all learn a lot more if our teachers were better jokesters.
Born Standing Up by Steve Martin -
Few books I’ve ever read are as immediately impactful as Born Standing Up is within the first thirty pages. Martin, once atop the comedy business, opens his old wounds to readers, vividly teaching us the struggles required to earn greatness. Martin spends the majority of the story on the destitution of his twenties, only to quickly and quietly cover the lightning bolt that was his rise to fame. Few stories are as succinctly honest as Born Standing Up.
The Hard Thing About Hard Things by Ben Horowitz -
Former entrepreneur and current venture capitalist Ben Horowitz compiles the lessons he’s learned in his business career. I particularly enjoyed this book more than most business books I read because of his very honest approach. I agree with his fundamental message: Every company is unique, which is what makes business difficult, so to claim there is one roadmap to business success for everyone is naive. All an advice-giver can give is personal anecdotes and lessons learned. That’s exactly what Horowitz does here, and it’s appreciated.
What Do You Care What Other People Think? by Richard Feynman -
I’ve yet to read something by Feynman which wasn’t brilliant. This particular collection of Feynman tales packs more emotional punch than most of his previous collections. The essay about his wife’s early death (from which the title is pulled) is the most heartbreaking story I’ve ever read. For the intellectuals, half the book is dedicated to Feynman’s fascinating work uncovering the cause of the Challenger Space Shuttle disaster. It concludes with his essay, “The Value of Science”, which should be made mandatory reading for all middle school science students. If I had read it at age 14, I’d have probably become a physicist. I’d have certainly become a better person.
When Pride Still Mattered: A Life of Vince Lombardi by David Maraniss -
Biographers have perhaps the hardest jobs of all those who consider themselves writers. It must be tough to balance years of journalism (hunting down sources, engaging people in interviews over topics that have long since occurred, foraging for faded photographs from lost eras) and bring the research into a compelling story equal in size and scope to fictional novels. The biographer is aided by one reality: Often, truth is stranger than fiction.
Every winter, tens, if not hundreds, of millions of people witness the Super Bowl. Every year, the winner of that championship game hoists what’s called “the Lombardi Trophy”. Maraniss, a Pulitzer Prize winner, opens up the Vince Lombardi legend with a level of journalistic research I have not read since All the President’s Men. Lombardi is both humanized and mythologized simultaneously. The highest praise I can give Maraniss and “When Pride Still Mattered” is that it takes a seemingly simple idea, the biography of a football coach, and use it as a piece of glass: a lens through which we can see the past and a mirror in which we see our present. Regardless of how you look at it, the image is never as clear as we want it to look.
Antifragile by Nassim Taleb -
A significant achievement in modern thought. In his magnum opus, Taleb culminates a lifetime of research and his unique insight into his concept of “antifragility”. Without explaining it in depth here, the book demonstrates experimentally, mathematically, and philosophically how systems and societies should be designed to improve from stress. Bending and growing from adversity, rather than breaking like so many things seem to do in our current era. Taleb commits a sort of philosophical biomimicry, taking most of his ideas either from his observations of nature (of the human variety and otherwise) or expanding upon past thinkers who did the same. If I could install a mandatory philosophy course into the school system, this would be required reading.
Best Book Read in the First Half of 2014:
Enough: True Measures of Money, Business, and Life by John Bogle -
Bogle, the founder asset management firm The Vanguard Group, has written a manifesto for reforming the moral fiber of the United States. It’s important for those who have greatly benefited from the financial system to come out and say that it’s broken and should be smaller. He does that and more by extrapolating the problems of the financial sector as caused by a systemic breakdown in how our society conducts business at large. The chapters are short, to the point, and data supported. The chapter titles (such as “Too Much Cost, Not Enough Value” and “Too Much Business Conduct, Not Enough Professional Conduct”) should be printed out on a poster. Short of hanging that on your bedroom wall, you should at least read this book.
“The Bubble Question” is the title of a recent Fred Wilson blog and the frequently asked question: “Are we in an stock market and/or technology company valuation bubble?”
Fred Wilson is a managing partner at Union Square Ventures, prolific venture capital blogger, and (from what I’ve gathered reading his blog for years) a pretty smart guy. Given his position, he gets asked the aforementioned question quite often and laid out his current conclusive response via blog. The gist of his explanation for the bubble is:
“valuations are at extreme levels because you cannot get a decent return on your money doing anything else…. really just one factor (cheap money/low rates)… is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime. I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies…. It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.”
After having read Fred’s blog and my recent analysis of Castlight Health, my good friend and old Heyzap coworker Micah Facebook asked me for my thoughts on the tech bubble discussion. With his permission, I’ve posted the transcript from our April 24th conversation which contains my simplified explanation of the outrageous tech company valuations we are currently seeing and other thoughts on the internet industry.
Note: After the transcript I’ve included some further references related to points in the discussion. I also realize some comments in the conversations are over-simplified, but my friends/readership fall all along the spectrum of economics knowledge, so I usually opt for over-simplifying and clarifying details for those who ask. Any comments, critiques, or elaborations are welcome at email@example.com.
Part One: Shortly Before Leaving Work, Micah Asks Me a Question
4/24, 5:10pm – Micah Fivecoate: So, does Fred’s post explain Castlight?
4/24, 5:10pm – Logan Frederick: I haven’t read through his post yet
But Just from the comments
It is a big part of it
I will respond tonight
After I read his article
4/24, 5:10pm – Micah Fivecoate: I don’t understand yet how it’s tech-specific
4/24, 5:10pm – Logan Frederick: Basically the simplified chain is
Fed lowers interest rates -> Means it’s really cheap to borrow money -> So everyone starts borrowing money -> That money is expected to be put to work to earn a return -> But given the economy now, a lot of industries and assets do not look that appealing -> Tech/internet sector looked pretty strong coming out of financial crisis with increased usage and actual revenues/profits from the giants -> Investors with cheap cash view that as the best place to get a return -> All the money goes into tech
4/24, 5:13pm – Micah Fivecoate: Ah, okay
4/24, 5:13pm – Logan Frederick: Even more basic, it’s just two factors: Tech companies look like the biggest growth opportunity compared to all other asset class, and the Federal Reserve policy makes it very easy for investors to get money to invest in tech
4/24, 5:13pm – Micah Fivecoate: So, it’s a combo of free money + tech looking good
4/24, 5:13pm – Logan Frederick: Yeah
That’s really it
If/when Fed rates rise
It will surely hurt tech company valuations
Even as some commenters said it would be a signal the economy is stronger or inflation is higher
But regardless, less money would be available for investment
So some companies might do better with higher interest rates, but overall valuations will be lower in real terms
4/24, 5:15pm – Micah Fivecoate: Wonder what would do better with higher interest rates
I guess any co with lots of cash
or that facilitates loans
4/24, 5:16pm – Logan Frederick: Well assuming rates go higher because of a strong economy, you could reasonably expect that the large tech companies would be doing well
4/24, 5:16pm – Micah Fivecoate: Oh
4/24, 5:16pm – Logan Frederick: The fed interest rate moves
Are more a trailing indicator
“Oh, economy is strong? Then we raise rates”
But your point was right as well to a degree, a company with a lot of cash can weather a rate increase better because it does not need to borrow
4/24, 5:18pm – Micah Fivecoate: So, is the effect to slow change when things are strong, and accelerate change when the economy is weak?
4/24, 5:18pm – Logan Frederick: Yep
That’s the basis of Monetary Policy
4/24, 5:18pm – Micah Fivecoate: cool
4/24, 5:19pm – Logan Frederick: You can continue down the rabbit hole of Monetary Policy theory, but all the research and debates are about what is the best mechanism for maintaining/finding the right equilibrium of economic strength or growth in relation to interest rates
The libertarian/anti-Fed Reserve crowd’s argument boils down to: The Fed does more to deviate us from the right equilibrium than help
In the pre-modern Federal Reserve era (pre-1917 if I have the year right)
Individual banks set their interest rates
I could go on and on, but I am packing up at work
Will respond more after reading Fred’s blog
4/24, 5:22pm – Micah Fivecoate: Cool, I’ll read up a bit on monetary policy in the meantime
4/24, 5:22pm – Logan Frederick: lol Good deal, see ya in an hour
4/24, 5:22pm – Micah Fivecoate: later
Part Two: An hour later with a glass of wine and dinner at Logan Bar and Grill
4/24, 6:16pm – Logan Frederick: I did not realize that this blog post
Was the same one posted a month ago
4/24, 6:17pm – Micah Fivecoate: Oh
4/24, 6:17pm – Logan Frederick: I didn’t fully read it then either
Halfway through, don’t see anything I disagree with and is pretty simple finance
I like Fred
It’s pretty simple finance but his readership is tech folk
So it’s good to post this kind of analysis
So Finished his post
Agree with it all, but it’s only half the story
Which is disappointing
4/24, 6:20pm – Micah Fivecoate: Yeah, it wasn’t clear from his post why the money would be going in to tech
4/24, 6:21pm – Logan Frederick: Well that’s not what I meant by half the story
4/24, 6:21pm – Micah Fivecoate: oh
4/24, 6:21pm – Logan Frederick
But that’s also true
But I filled in that part for you
That you can draw, from his post
4/24, 6:21pm – Micah Fivecoate: yeah
4/24, 6:21pm – Logan Frederick:
If you judge things by growth rate
Tech offers the best right now
And always, really
I don’t like “tech” as a sector term
I prefer “software” or “internet”
4/24, 6:22pm – Micah Fivecoate: oh, makes sense
“tech” isn’t necessarily the same sort of low-marginal cost business
4/24, 6:23pm – Logan Frederick: Well I just mean it as tech is too vague a term
In a recent copy of Intelligent Investor, editor Jason Zweig overlays one of the tech stocks of the 80s (IBM I think) on top of General Motors in the 1920s and it’s the exact same. Because General Motors was the “tech” of that era
4/24, 6:23pm – Micah Fivecoate: hah, yeah
4/24, 6:23pm – Logan Frederick: But that’s semantics
4/24, 6:24pm – Micah Fivecoate: barnes and noble isn’t doing too well with their printing press tech
4/24, 6:24pm – Logan Frederick: Your point is valid too, in that different “tech” companies have different business models
Barnes and Noble has a lot of issues and I should look again at shorting them maybe
It’s scary now that they keep decreasing in market cap, someone will take them over before they go bankrupt (possibly)
Hard to short in that situation
4/24, 6:25pm – Micah Fivecoate: Oh, yeah
4/24, 6:25pm – Logan Frederick: I can guarantee some PE firm has run numbers on them
If it’s a takeover candidate or not
4/24, 6:26pm – Logan Frederick: High profile, really the only monopoly in the space left, even if it is a shitty industry of bookstores
But that’s the job of a PE guy, run the numbers of what their debts are, do they own their real estate locations? What’s the value there?
How many costs can be cut?
If we can get them for $100 or $200 million, can we reconfigure them to spit out enough free cash flow to cover whatever debt they have/we add AND give us a private equity level return?
4/24, 6:35pm – Logan Frederick: I should turn this into a blog post
And write a blog post in response to Fred’s
I did not elaborate on what I meant as “the other half of the story”, which is what happens when interest rates rise again to the levels he suggests in the post
4/24, 6:36pm – Micah Fivecoate: Oh, yeah
4/24, 6:36pm – Logan Frederick: And that’s the sound of the bubble popping
The high valuations will end either when the Fed decides to raise interest rates (by their indications 2016 I think?) or when companies with high valuations fully realize that they can not earn returns on their investments
Whichever comes first
4/24, 6:37pm -Micah Fivecoate: the giant sucking sound of all the money leaving SV
4/24, 6:37pm – Logan Frederick: At least some of it, yes
I’m still a big believer in tech and think software still has a lot of room to run
4/24, 6:38pm – Micah Fivecoate: Oh, are they planning to raise rates in 2016?
maybe going to 2%ish in 2016?
4/24, 6:42pm – Logan Frederick: But I think people forget that software is meant to improve things and that largely means taking process which cost $100 using humans to cost $10 using machines, but that generally speaking means a lot of software companies don’t need to be as big as companies of old
Paul Graham says as much in one of his essays
The goal should be maximizing profit per employee. Can you have a billion dollar company with only 10 people?
Software shouldn’t require a business to need to be valued at $100 billion
You can replace General Motors with new high tech cars…at a lower valuation
I’m kind of shooting ideas from the hip, but you could vet them out and qualify them where need be, but the general point stands I think
4/24, 6:43pm – Micah Fivecoate: What principle does the rev/employee metric maximize?
4/24, 6:44pm – Logan Frederick: Well from the PG essay he was just talking about software leveraging human talent, that was his point there
I’m sort of adding on that you could make the link that PG’s point implies valuations don’t need to be as big to have as significant an impact/be as disruptive
A five person, $10 million company could hypothetically replace a 10,000, $10 billion company
Craigslist versus the newspapers as an example
4/24, 6:45pm – Micah Fivecoate: Yeah, i guess it’s how you define disruptive
4/24, 6:45pm – Logan Frederick: So then why, taking it a step further, are investors and tech entrepreneurs *seeking* valuations larger than the company is intrinsically worth
4/24, 6:45pm – Micah Fivecoate: Oh, and the profits of the $10B company just dissipate into the market at large
4/24, 6:45pm – Logan Frederick: Intrinsically judged by how much money they actually make over a future time span
4/24, 6:46pm – Micah Fivecoate
Shouldn’t the smaller company be able to keep profits as high?
like, costs could go down
maybe the profits would fall because the competition could implement the same software, and there wouldn’t be as much room for differentiation
or just it’s harder to justify to customers such a large profit margin
or is valuation tied in some way to gross revenue rather than net
4/24, 6:49pm – Logan Frederick: If a new software startup has costs of revenue (cost of providing the service) much lower than an old non-software company in the industry, the company won’t keep their price point at the same as old company because their customer’s substitution costs wouldn’t be affected. Their disruption will lower the costs to customers, and then depending on the industry, competition could drive those lower over time
Yeah, I typed that as you typed, but basically you as a new disruptive company would have higher profit margins, but lower prices than your old incumbent
4/24, 6:50pm – Micah Fivecoate: yeah
So you can initially keep the same profit, but lower price due to lower costs
but then other people start competing with you with software
and that’s what takes the valuation down
4/24, 6:52pm – Logan Frederick: Well valuation goes down even before your second step of competition
4/24, 6:52pm – Micah Fivecoate: because they know it’s coming?
4/24, 6:52pm – Logan Frederick: Well no, I take my last statement back
This would be an empirical question, but I would guess most software that very directly replaces an old manual task
Does not have gross profits greater than the old manual business
That’s hard to test empirically I think because most software replaces a cost of an old manual task
So you’d have to say, what were people spending on process A that was replaced with software product B
And cost of B is probably less than A
So in terms of valuation
It’s odd to word it this way
But what was the “valuation” of the dollars spent on A versus the valuation of company B
But I would guess if you did that kind of test
B is significantly lower
And that’s my point of valuation being naturally lower
4/24, 6:55pm – Micah Fivecoate: Weird
It seems like if one company can provide the same service at a lower cost
they should have a higher valuation
Might be running in to some sort of efficient-market fallacy
4/24, 6:56pm – Logan Frederick: I always view valuation in terms of return on investment
If the cost and price are lower
You can have a high ROI and still come up with a valuation number lower than the old incumbent
And then like you said earlier
If the ROI is *that* good
Then competition comes in and keeps everything in check like prices, cost, valuation
4/24, 6:58pm – Micah Fivecoate: Yeah
I guess, I’m thinking if the incumbent charges $100 for a product that costs them $90 to produce
and the disruptor charges $90 for $10 cost
then disruptor should have a higher valuation
4/24, 6:59pm – Logan Frederick: That is true
4/24, 6:59pm – Micah Fivecoate: but it probably just rarely works out so well
and then competition
4/24, 7:00pm – Logan Frederick: And that’s where it’s a case by case basis and where I think the tech industry screws up
I agree with your statement
Maybe half of software companies are like that
And another half, the bad ones, think they are doing that but are really only charging $20 at a $10 cost or charging $90 at an $80 cost, and so shouldn’t have a higher valuation
But because they are “tech” they and others think they should have the same multiples
4/24, 7:01pm – Micah Fivecoate: Hah, yeah
4/24, 7:01pm – Logan Frederick: And that’s part of why you get bubbles
Businesses thinking they can achieve a level of profitability and margins that similar-ish companies have
But really the business is not the same
And they don’t achieve it
And I guess my larger point would be
There is nothing wrong with *not* having the best margins
You just have to accept your okay margins and profits and accept that your valuation will be okay
But in a bubbly environment, every company thinks they will have the best margins, profits, and a valuation that their real margins and profits do not justify
4/24, 7:04pm – Micah Fivecoate:
So, is that purely because there’s too much money that wants in on this market
4/24, 7:06pm – Logan Frederick:
Yeah, so companies raising money can get away with it
If there wasn’t as much money available, investors would be more picky
4/24, 7:07pm – Micah Fivecoate: Doesn’t seem like the risk tolerance would shift with the amount of $ available
maybe it does though
4/24, 7:08pm – Logan Frederick: I could be wrong, but I think it does, although long-term it has been trending toward high valuations and more entrepreneur control, specifically in the computer software and hardware industries. Over decades that may continue.
But I say the risk tolerance does shift
Because VCs, the main drivers of these valuations, have investors themselves
And in weaker economic climates
There is a real possibility of VC investors, the big funds, saying they won’t do as much VC investing
And if VCs are worried about bad returns
They will get more choosey when it comes to investing
4/24, 7:09pm – Micah Fivecoate: Oh, interesting
4/24, 7:09pm – Logan Frederick: I can think of some counterarguments on both the high and low end though
On the high end, you could argue that VCs will still pay whatever it takes to get into the clear winners, the “next Google”
And on the low end, the dollar amounts are so low it doesn’t hurt them to continue this
And that leads into what people have been saying about Series A and B crunches
Companies in the middle of these two places who haven’t proved their worth to VCs that they can earn big returns but need more money than seed rounds can provide
I dunno how valid the Series A or B crunch is based on a few articles I’ve read, but that logic I just laid out would explain why it exists
VCs are just increasingly worried about investments in those stages
4/24, 7:11pm – Micah Fivecoate: Yeah
4/24, 7:11pm – Logan Frederick: Series D is safe
Seed is safe
By VC math
4/24, 7:11pm – Micah Fivecoate: right
4/24, 7:12pm – Logan Frederick: Any other thoughts/questions for me?
That I can come up with half-assed, on the spot answers for
Regarding my comment about wanting to maximize revenue per employee from Paul Graham, I tried finding the exact PG comment I had in mind. My memory of it may have been off. His essay “How to Start a Startup” has the closest passage to what I was thinking that I could find quickly:
“If hiring unnecessary people is expensive and slows you down, why do nearly all companies do it? I think the main reason is that people like the idea of having a lot of people working for them. This weakness often extends right up to the CEO. If you ever end up running a company, you’ll find the most common question people ask is how many employees you have. This is their way of weighing you. It’s not just random people who ask this; even reporters do. And they’re going to be a lot more impressed if the answer is a thousand than if it’s ten.
This is ridiculous, really. If two companies have the same revenues, it’s the one with fewer employees that’s more impressive.”
My comments at the end about Seed funding and late stage funding being safe for venture capitalists is based on discussion in the past six months on what the media called the “Series A” and “B” crunches. There was debate on whether there was a trend in venture capital of increasing investments in really young or really old companies, but a lack of investment for companies in the middle. Google “Series A Crunch” or “Series B Crunch” for more details.
Disclaimer: I shorted (bet against) Castlight Health on April 1 at $23.21 and held this position until Friday, April 11 when I exited at $16.99. I exited to lock in my winnings, but as this essay explains, Castlight is still overvalued and I may short them again. Any reader unfamiliar with “short selling” stocks should reference Investopedia’s introduction to short selling.
Additionally, it’s hard to complete these writeups in my evenings in a timely manner while the market continues to move. I began writing a week and a half ago when I shorted Castlight and had a number of friends, such as Andrew Virata, Reece Arthur, Ben Gilbert and others, aware of Castlight. This note is here to add credibility so it doesn’t look like I’m writing the analysis after the stock has already moved in my favor. Additionally, I have uploaded a zip folder where you can download Castlight’s income statement, balance sheet, and cash flow statements in Excel format and the PDF of their public FORM 424B4 filing from which most the research was derived.
“We expect to continue to incur operating losses for the foreseeable future and may never become profitable on a quarterly or annual basis, or if we do, we may not be able to sustain profitability in subsequent periods. As a result of these factors, we may need to raise additional capital through debt or equity financings in order to fund our operations, and such capital may not be available on reasonable terms, if at all. “ – Castlight Health, Page 13 of Form 424B4.
Castlight Health is an internet business which went public on March 17, selling 11.1 million shares at $16 per share, raising approximately $161.2 million for the company ($177.6 million from the public stock sale, but a $12.4 million fee for the bankers). On the first day of trading, the stock rocketed 149% to $40 per share, valuing Castlight at over $4 billion.
What is Castlight Health? It is a web app for enabling employers and employees to easily view and manage their health care and insurance plans. It’s leading application is called Castlight Medical which they say, “simplifies health care decision making for employees and their families by providing highly relevant, personalized information for medical services that enable informed choices before, during and after receiving health care,” and “enables employees and their families to intuitively search for robust and comprehensive information about medical providers, including personalized out-of-pocket cost estimates, clinical quality, user experience and provider demographic information.”
How does one lose $62 million in one year building a website for health data? And how is it still in business?
Castlight’s Income Statement
“I would say there is no one here who can understand some new internet company. I said at the annual meeting this year that, if I were teaching a class in business school, on the final exam I would pass out the information on an internet company and ask each student to value it and anybody who gave me an answer I’d flunk.” – Warren Buffett’s Q&A at the University of Florida in 1998
When I first noticed Castlight and it passed my eyeball test as a terrible stock, I wanted to see if I could possibly value the company. I quickly relented.
Castlight filed its Form 424B4 paperwork to the SEC on March 14 which includes all the required information for a company selling public stock. This document contains the company’s historical performance going back to 2011. Typically a financial analyst will use these SEC filings to do a Discounted Cash Flow analysis (link to my introductory tutorial on the subject), but with a company burning through as much cash as Castlight (and many other internet businesses) the DCF analysis quickly breaks. The primary problem is that, unlike a more mature company, or even a barely profitable one, you can’t even begin to predict the company’s future with any degree of confidence or reliability. The two sub-problems when making those future predictions are projecting future revenue increases and cost decreases. In looking at Castlight, I realized I had few ideas on how either of those line items would look over the next five years.
Here is their slightly organized income statement (numbers are in millions):
The last row, Castlight’s earnings, paints a pretty grim picture of not just three consecutive years of losses, but increasingly large losses. While revenue (row three) has grown substantially, costs (rows five and nine) have grown faster.
Castlight is an enterprise software company, so initial development and sales expenses are likely to be higher than mainstream consumer software. Yet after three years, these numbers clearly show a company that’s been lighting dollar bills on fire with matches in front of large customers for a pittance.
Page 82 of Castlight’s filing lists its top customers: Wal-Mart, Microsoft, Eaton, Indiana University, Microsoft, Mondelez, Purdue, Safeway, Honeywell and others. While this is a seemingly impressive group, they only totaled $13 million in revenue. If you can’t become profitable with Wal-Mart and Microsoft as your customers (two firms with a large number of employees), how many customers and how large do your future orders need to be? By Castlight’s own admission, Wal-Mart accounted for about $2 million of the $13 million in revenue under a contract which expires in 2015. Are there potential customers bigger than Wal-Mart who are willing to pay more than $2 million? With $58 million in selling and administrative expenses, it’s unclear if Castlight has figured out how to sell services at a higher price than it costs to do the selling (I could have phrased this much less glowingly).
In Castlight’s defense, they dedicate page 83 to “Customer Case Studies”, examples of their application saving companies or their employees money on health insurance. For Honeywell, “employees who used Castlight to shop for laboratory services paid 14% less than those who did not search (February 2012 through September 2013).” This would be more impressive if it weren’t preceded by: “Castlight developed a health care management platform that connected Honeywell health care vendors in a single integrated solution and offered employees a consistent user experience and message.“
Although Castlight Medical is a web application, their business model is not entirely Software-as-a-Service. A large component of their revenues is from “professional services”.
Professional Services is their consulting business of customizing its software suite for each client, which they say typically takes three to twelve months. While there are highly successful consulting businesses, the profit margins on such an employee-heavy business model are typically worse than a pure software business.
In its own documentation, Castlight almost creates a paradox. On page 50 under the section “Key Factors Affecting Our Performance”, the company says about its Professional Services business:
“We believe our professional services capabilities support the adoption of our subscription offerings. As a result, our sales efforts have been focused primarily on our subscription offering, rather than the profitability of our professional services business. Our professional services are generally priced on a fixed-fee basis and the costs incurred to complete these services, which consist mainly of personnel-related costs, have been greater than the amount charged to the customer…. These factors contributed to our gross loss percentage from professional services of (249)%, (596)% and (739)% in 2011, 2012 and 2013, respectively. The increase in gross loss percentage in 2012 was due to non-recurring professional services fees. The increase in gross loss percentage in 2013 was a result of an increase in the number of customers and complexity of our customer implementations. We expect to continue to generate gross losses on professional services for the foreseeable future as we focus on adoption of our subscription offerings.”
That can be summarized as: Professional Services loses money. We have no intention of it directly making money, but using it to up-sell our customers into profitable subscriptions.
That’s not so bad a proposal, until page 51’s “Costs and Operating Expenses”:
“Cost of professional services consists primarily of employee-related expenses associated with these services, the cost of subcontractors and travel costs. The time and costs of our customer implementations vary based on the source and condition of the data we receive from third parties, the configurations that we agree to provide and the size of the customer. Our cost associated with providing implementation services has been significantly higher as a percentage of revenue than our cost of providing subscriptions due to the labor associated with providing implementation services…. We expect to continue to generate negative gross margin on our professional services for the foreseeable future. As our implementation processes and technologies mature and our use of automation increases, we expect our gross margin on our professional services to improve.”
And back on page 50 under the “Revenues” section: “We expect professional services revenue to constitute a significant portion of our total revenue in the future.“
This reads to me as, “Professional services is going to generate a lot of our revenue, but because it’s so personally customized at big upfront costs for each client, it’ll create even greater losses, even if our margins improve.”
Speaking of margins, they are usually easier to improve when you’re not in a competitive industry.
Page 22 highlights the industry’s competitive landscape:
“While the enterprise health care cloud market is in an early stage of development, the market is competitive and we expect it to attract increased competition, which could make it hard for us to succeed. We currently face competition for sub-components of our offering from a range of companies….These competitors include Truven Health Analytics Inc., ClearCost Health, Change Healthcare Corporation, Healthcare Blue Book and HealthSparq, Inc. In addition, large, well-financed health plans, with whom we cooperate and on whom we depend in order to obtain the pricing and claims data we need to deliver our offering to customers, have in some cases developed their own cost and quality estimation tools and provide these solutions to their customers at discounted prices or often for free. These health plans include Aetna Inc., Cigna Corporation, UnitedHealth Group, Inc. and WellPoint, Inc. Competition from specialized software and solution providers, health plans and other parties will result in continued pricing pressures, which is likely to lead to price decline in certain product segments, which could negatively impact our sales, profitability and market share.”
The fundamental premise behind Castlight is valid; web applications that allow companies and their employees to more easily manage their health insurance and doctor relationships will be the future. This is not an original concept to the industry’s existing players or other startups, which they clearly admit here.
Also dangerous is that there is little stopping health insurance providers from cutting off their data supply to Castlight if they deem it a competitor to their business or cutting into their revenues from companies/end users. Castlight already acknowledges this: “If health plans perceive continued cooperation with us as a threat to their business interests, they may take steps that impair our access to pricing and claims data, or that otherwise make it more difficult or costly for us to deliver our offering to customers. “ It’s possible for the insurance companies to offer this service themselves. An agnostic third-party application is a good idea, but the clear competition and clear stranglehold the data providers have on them makes it a tough business that could have its valuation multiples suppressed.
There is one potential positive to support Castlight’s valuation: Its “backlog” of customer contract agreements to be fulfilled in the future. My reading of their filings points to the backlog information as one of the few indicators of potential revenue.
Castlight explains what constitutes its backlog on page 60: “At any point in the contract term, there can be amounts that we have not yet been contractually able to invoice. Until such time as these amounts are invoiced, they are not recorded in revenue, deferred revenue or elsewhere in our consolidated financial statements and are considered by us to be backlog.”
Potential future deals that haven’t been recognized in their numbers seems promising. The actual backlog size is , as of December 30, 2013, $108.7 million for the “total backlog”, but only half of it, $50.9 million is non-cancellable. Perhaps they give the $108.7 million number to give people a reason to be optimistic, but it seems near-meaningless to me. The $50.9 number is interesting as its a lot larger than last year’s $13 million in revenue and could indicate huge growth for Castlight.
Except Castlight says they do not “expect to fulfill our non-cancellable backlog as of December 31, 2013 over a period of approximately four years, with the substantial majority expected to be fulfilled after 2014.” $50.9 million spread over four years, with most of it in the last three, does not indicate much, if any, growth. Castlight admits as much: “Accordingly, we believe that fluctuations in our backlog may not be a reliable indicator of our future revenue.”
I was hoping the backlog might help them out, but it seems pretty useless except for Castlight to say that some potential customers are kinda sorta considering paying them between $50 million and $100 million over the next four years. And who knows how much it’ll actually cost Castlight in Selling and General Administration expenses to service those contracts.
After having highlighted many of Castlight’s numerous negatives, one may be tempted to try and bet against them (as I am). Despite Buffett’s statement, it could still be worth a back-of-the-napkin valuation so as to have an idea of when the stock may stop its decline.
Since Castlight lacks any significant cash flows to discount, our best guess would be to compare it to similar companies and see if Castlight is overvalued relative to them. The two I will use are BenefitFocus and athenaHealth. Warning that for the purposes of this essay, these valuations are very rough and guaranteed to be inaccurate. I don’t worry too much about the inaccuracy of these valuations considering the company doesn’t make any money.
BenefitFocus is a web application “that enables its employer and insurance carrier customers to more efficiently shop, enroll, manage, and exchange benefits information.” The company went public last September. They are valued at about $1 billion with 2013 revenue of $104 million and $-30.36 million in net income. Still not profitable, but large revenues and valued at about ten-times those revenues. Castlight has $13 million in revenue with -$62 million in net income, so about a tenth of BenefitFocus’s revenue with twice as many losses at three times the market valuation for the company. By using the same 10x revenue multiple as BenefitFocus, Castlight would be valued at about $130 million. In fairness to Castlight, their revenues have been growing at a faster rate the past few years than BenefitFocus, so we’ll double that multiple to 20x revenue and the valuation to $260 million. The stock price would be about $1.60 at a market capitalization of $260 million. The price is currently $18.09.
Now we’ll use athenaHealth, a health care and health insurance software company which offers, “cloud-based services are packaged as four integrated offerings: athenaCollector for revenue cycle management, athenaClinicals for clinical cycle management, athenaCommunicator for patient cycle management, and athenaCoordinator for referral cycle management.” athenaHealth went public in 2007 and is profitable with a mere $2.59 million in net income last year but $18.73 million in 2012. athenaHealth deserves its own research, as it’s currently trading at a price-to-earnings multiple of 8,000-plus. Using the same revenue multiple approach used with BenefitFocus, athenaHealth trades at about 9.2-times its annual revenue ($595 million in revenue and current market value at $5.47 billion). This 9.2x is pretty close to BenefitFocus’s and should arguably be higher considering athenaHealth is profitable and has grown revenues by about $100 million every year for the past five years.
Castlight is currently valued at over 225 times its annual revenue. From a Yahoo! Finance interview: “Jay Ritter, a professor at the University of Florida and my go-to source on IPOs for the past few decades, tells me that Castlight’s insane level of valuation – 107 times revenue (not profits, as they had huge losses last year) – of the original IPO pricing hasn’t been seen for a tech deal since the year 2000, the twilight of the 20th century. Of the prior 13 deals priced at 100 times revenue or more and sales of at least $10 million, the average 3-year return was -92%.”
I’ll reiterate that you can refine these multiples all you’d like or use other metrics, but you can’t refine Castlight’s revenue. Professor Ritter’s stat is the most damning evidence against Castlight’s stock: The average three-year return of company’s as overvalued as Castlight going back a decade is -92%.
Venture Capitalists Cover Castlight’s Losses
If Castlight hasn’t made any profits and lost over $100 million over the past three years, how has it stayed in business? With the help of $177 million in investor funding from 2009 to 2012, of which there was only $67 million left going into last year. Crunchbase includes a quick list of its investors and the size of each investment round. Prior to IPO, but at the end of 2013, Castlight had $67.17 million in cash and short term investments that could be liquidated into cash. Their losses for 2013 were $62 million, so they had about one year’s worth of cash left. The IPO raised an additional $161.2 million for the company, so they have about $166 million in cash now, minus whatever they’ve spent in 2014. This is also probably off by plus or minus $20 million, but it should be in the ballpark.
The investors have primarily been Venrock (the largest shareholder and a large Silicon Valley venture capital group), Oak Investment Partners, Maverick Capital, Fidelity Investments, The Wellcome Trust (a British charity endowment specializing in healthcare funding), T Rowe Price, and Morgan Stanley (also one of the investment banks who helped take Castlight public).
Given their history of increasing expenses more than they increase revenue, we can reasonably expect Castlight to spend somewhere in the range of $60 to $100 million this year. Their current cash reserves should last them two years before they will have to raise even more money, either through a secondary stock offering, sell bonds, or a credit lines with a bank. I guess they could accomplish that through increased sales too, but I’ll reiterate that for Castlight increased sales means increased costs.
Castlight’s Two-Class Ownership Structure and Management Compensation
With all these big investors, who owns Castlight?
Pages 113 and 114 list the major owners of the company and their total voting power for company decisions following the IPO:
Venrock and affiliates own 20.6% of the class A shares and 18% of the voting power.
Oak Investment Partners owns 15.8% of the class A shares and 13.8% of the voting rights.
Maverick Capital owns 10.2% of the class A shares and 8.9% of the votes.
Fidelity Investments owns 9.8% of the A shares and 8.6% of the votes.
The Wellcome Trust owns 8.7% of the A shares and 7.6% of the voting rights.
CEO Giovanni Colella owns 8.2% of the A shares and 7.2% of the votes.
Chief Operating Officer Randall Womack owns 1.7% of the A shares and 1.4% of the votes.
Combined, these majors shareholders control 75% of the A shares and 65.5% of the management votes.
What do I mean by “Class A” shares? Well, the public offering is of “Class B” shares. Castlight has two types of shareholders: “Class A” a.k.a “Those with lots of power” and “Class B” a.k.a “Those with little power”. Public investors are Class B.
What’s the difference? Right on the very first page of Castlight’s SEC filing, they explain: “We have two classes of common stock, Class A common stock and Class B common stock. The rights of the holders of our Class A common stock and Class B common stock are identical, except with respect to voting and conversion rights…. Immediately following the completion of this offering, outstanding shares of our Class A common stock will represent approximately 98.6% of the voting power of our outstanding capital stock.”
I’m pretty sure voting rights are an important right and the legalese here, in context of everything I’ve already shown, comes across as flippant.
Pages 9 and 116 elaborates on the rights of these different classes. Class A shareholders have the majority vote on the sale or merger of the company, the sale or lease of property and assets, the dissolution of the company, changes to the certificate of incorporation, or “every matter” if an outside individual or investment group has or announces intent to buy 30% of the Class A and B stock combined. Even outside of these issues, one Class A share counts for 10 times as many votes as a Class B share. There are only 11.1 million B shares compared to 75,469,707 Class A shares.
I have to note that this setup is actually relatively common with public companies (where there are two or more types of stock with certain investors having more control than others). It just looks a lot worse for those Class A people when the company doesn’t look healthy.
The list of investors and executives above control the decision making of the company. But if they’re making good ones for the business, the class B public investors could be okay with the setup.
Or the Class A investors could just let management, some of them former employees at the investment firms, pay themselves large sums of money, as shown in this chart from page 100:
That’s right. In the last year, the top five executives were paid $965,156 in salary and total compensation of $6,183,012. This is during a year when the company lost $62 million and only had sales of $13 million.
The reasonable argument is that there is a job market for executives and, given their resumes, the Castlight team could get similar or better offers elsewhere. But these individuals are surely already rich given their previous jobs as venture capitalists for Greylock, having sold previous health care companies, and worked in executive capacity for other billion dollar public companies (page 92 lists the biographies of these five executives). I do make an exception for Head of Product Dena Bravata, who has been a practicing doctor and I assume has made good, but not outlandish sums of money prior to Castlight.
But view the situation from a different perspective: What kind of system pays people hundreds of thousands of dollars for losing tens of millions? Only a venture capital funded business could operate this way. They would presumably argue that sometimes you will need to take losses for a while in the early stages to grow the business. I retort that once you have a multi-billion dollar valuation, you are not in the early stages, even if the industry itself (healthcare IT) is not yet fully mature.
Amazon is the common exception people cite for the burn-money-for-years-to-dominate-an-industry, but Amazon’s stock was abysmal for years, going from above $100 in 1999 to $5 in 2001, and 2001 is when you should have bought their stock. Don’t buy Castlight while it’s expensive. If you believe in them, buy them after their stock collapses and they show some signs of success.
Having hopefully made the case that Castlight is a horrifically overvalued company that has offered no prospects for investors to earn a return on their investment (other than for the investment banks and their hand-picked clients who received the initial stock), who is responsible for the inevitable shareholder losses?
I don’t blame Castlight’s management. I am giving them the benefit of the doubt that they believe they have the solution to health care management for employers and employees, and the public investment markets are willing to invest in them, they are incentivized, if not obligated, to raise more money while they can.
The reality is much more grey with blame to be partially owned by everyone. I’m at best an armchair philosopher, but surely there is a moral/ethical argument to be made against Castlight’s management taking public money at multi-billion dollar valuations to pay executive salaries and stock options which put them in the top 1% of earners while losing tens of millions annually just because they can. Someday I will have better philosophical expertise to make a more foolproof assertion.
More blame falls next to the IPO underwriters and brokers: Goldman Sachs, Morgan Stanley, Allan and Company, Stifel, Canaccord Genuity, and Raymond James. In our post-SOX, IPO starved world, investment banks are starting to sell whatever they can now that investors have cash they’re willing to put to work, stock market returns looking more promising than any other asset class, and distance from the original dot-com bubble. Companies come to them with the willingness to be taken public. Bankers compete for the opportunity to support the company’s public offering and get their cut of the deal. Taking companies public is their job. Yet it seems short-sighted of them to sell obviously overpriced companies to public investors. The public has no chance of earning a return on its investment, but the banks and their closest clients get the public’s money. Over time, these kinds of offerings degrade the public’s trust in markets, as we saw in the dot-com boom and bust. The Goldmans of the world claim to have standards that separate them from the scams such as the one depicted in The Wolf of Wall Street. But when the public markets want to invest in stocks and new businesses, the big banks lower their standards to create supply to meet the demand. All this does is put public money into businesses that fail, losing even more money for everyone involved except bankers and executives.
Lastly, the public and the institutions which represent them. Why do we let companies, venture capitalists, and banks get away with making money from selling us stock in companies that lose money? I suspect it’s for two primary reasons: People do not take the time to learn how the financial industry and markets work and they put too much trust in the institutions managing their money without knowing what they are doing either. There is probably academic research measuring those two points. For the institutions like mutual funds, pension funds, and insurance companies, they are looking to make money from investing their cash from the public. New stocks may hold the potential to grow into the next Microsoft, Exxon, or Walmart. Both the institutions and the individuals they represent want to believe this is still possible, and invest accordingly in new stocks with their cash and hope.
That’s the real root of Castlight, the current market boom, and most investment bubbles. We all want to believe the future is brighter, regardless of the present conditions. And it’s usually true that technology will continue to, paraphrasing Gordon Gekko, “mark the upward surge of mankind.” What is lost is that the future is brighter because of today’s work. Though they may help, no amount of high finance or VC funding replaces the work that goes into sustainable solutions to hard problems. That’s what a healthy economy is: sustainable. Currently, Castlight and many internet companies of its kind are not.
If you have any questions, feel free to email me at firstname.lastname@example.org.
UPDATE: Monday, April 14, 2013:
Jim Cramer directly addresses technology IPO oversupply in 2014 and lists Castlight Health as an example of a disappointing IPO harmful to the market. Maybe he reads my blog.
Once again, the books are sorted from worst-to-best on a one-to-five scale, with my highest rated book given special recognition at the end.
Note: The books marked with an asterisk are ones I read in the previous time period but forgot to include in the last post because they were e-books.
Lean In by Sheryl Sandberg: Yes, we get that you were able to attend Harvard and were lucky enough to work for Larry Summers *and* your husband also runs a multi-hundred million dollar business. And I don’t hold any of that against Sandberg personally, but the book reads as, “Let me show you what my life, as a successful woman, is like,” instead of, “Here is how any woman can achieve her goals.” Any lessons for women are reworded cliches with “Lean In” being a 21st century brush up of “Speak Up More” which teachers have been telling the shy kid in class for decades. Men will get the most out of it. It’s a good reminder of our cognitive biases and weaknesses when dealing with women. You can get the same effect from older feminist writings.
The Games That Changed the Game by Ron Jaworski: I only give this a two star rating because its for a very specific niche and I don’t feel it even nails its topic. Jaworski’s book is, like his ESPN commentary, a breakdown of the game film from the seven most influential games in NFL history (in his opinion). Even if you’re a football junkie, you will question his choices for the first and last chapter (a Sid Gilman game all about the rushing attack and the 2001 Patriots-Rams Super Bowl focusing on defending Marshall Faulk). I did enjoy the exclusive interviews with players from these games across many generations and Jaworski’s individual play analysis, it’s only a portion of a book aimed for diehard football fans.
*The Return of the Great Depression by Theodore “Vox Day” Beale: Beale is an economic crank, but that doesn’t mean he’s without good points (as tends to be the case with cranks). His most convincing chapters debunk a Paul Krugman article nearly line-by-line and establish how the Federal Reserve has failed to reduce bank failures and financial crises. He hurts his Austrian arguments with his poorly thought out sexist policy recommendations and over-referencing of the inaccurate ShadowStats site.
Catching The Wolf of Wall Street by Jordan Belfort: Considering I had read the first book sophomore year of college (I suspect I was one of the few students in 2010 who did) and the Scorcese movie was being released, I felt it appropriate to read the sequel. Belfort maintained the outrageous writing, both in style and substance, that was present in the first book and displayed in the movie. It’s not a book about finance, it’s about one man’s descent into madness in some of the most destructive, off-the-charts ways possible, and the FBI’s attempts to pin him.
Confessions of an Economic Hitman by John Perkins: In this memoir, Perkins explains his life as an “Economic Hitman”, a consultant hired by governments and corporations to convince third-world nations to borrow money from the first-world at indenturing terms. Given the premise, I was hoping for a real expose. Sadly, Perkins is light both on technical economic details and gritty drama. This does leave the book as a quick, thin read. It pairs well with Naomi Klein’s “The Shock Doctrine” which I previously reviewed.
The Defining Decade by Meg Jay: I’d been hearing from friends and media outlets alike that this book was a must-read for young adults in my generation (whatever that means). Given the attention the book got upon release and Dr. Jay’s credentials, I was expecting something more substantive. Defining Decade still contains useful, relatable anecdotes for those in their 20s who are searching for happiness and meaning. I’m just disappointed most of the science was absent.
*The Launchpad: Inside Y Combinator by Randall Stross: New York Times journalist Stross was able to get exclusive access to the inner workings of Y Combinator, the revolutionary startup investment firm, as it led one of its famed startup “batches” through a summer. The book is a quick read as Stross jumps through the all the startup stages in his three months in Mountain View. It’s length is a great strength, as every page brings the wisdom of Paul Graham and company to readers considering starting a company of their own.
*Effective Programming: More Than Writing Code by Jeff Atwood: A collection of essays by the creator of the Coding Horror, Atwood covers a wide breadth of technology topics including software testing, programmer hiring, project management, and application security. Given his years of enterprise experience, co-founding Stack Overflow, and still maintaining his popular blog, every essay in this book is worth digesting and re-reading.
Without Their Permission by Alexis Ohanian: Written by the cofounder of Reddit, Without Their Permission is a half biography/half pep talk about the origins of Reddit and the modern internet ecosystem. Alexis writes with a sense of humor, a clear understanding of how lucky he is, and explains the work he put in to be in that position. While anyone who is familiar with Reddit’s history will find the first half a bit redundant (or anyone familiar with SOPA will feel the same way about the second half), Without Their Permission covers enough varied material that any reader will get something new out of it while enjoying Alexis’s storytelling.
The Undercover Economist by Tim Harford: This introduction to economic thinking meanders aimlessly from topic to topic, but doesn’t feel aimless. Despite not providing much depth for those with a pre-existing background in economics and seemingly disorganized chapter structure, I would recommend this book as a primer on practical applications of economics to those unfamiliar with the field.
The Smart Swarm by Peter Miller: This high level explanation of the research into animal group behaviors is readable, understandable, and educational. Miller accomplishes the tough task of simplifying complex flocking and biomimicry research, presenting its real-world applications, and keeping a steady pace for the casual reader.
The Bed of Procrustes by Nassim Taleb: It seems kind of narcissistic to write a collection of your own one-liners and publish it. Since most people aren’t as insightful as Taleb, he gets away with it. It’s cheap, takes an hour to read, and the most wisdom you can get in that time for that price.
The Blind Side by Michael Lewis: Lewis’s second sports work after Moneyball and a popular movie starring Sandra Bullock, he continues to tell the stories of unsung heroes with outsized impact on their fields (in this case, a literal one). What the movie left out of Lewis’s book is the entire half dedicated to explaining why Michael Oher’s position at left tackle became so valuable in the NFL. The Blind Side reminds one that everyone has potential, especially those with the most unappreciated skills in the most overlooked places.
Average Is Over by Tyler Cowen: Cowen, one of my favorite economists and author of “The Great Stagnation”, presents his latest thesis: The future of the American economy is a class divide driven by an individual’s aptitude for complementing computers. Programmers and those with fantastic soft skills which are difficult to quantify will be at the top of the income scale, leaving everyone else competing for minimum wage service work. The book meanders while making its point in the middle chapter and goes increasingly off-topic. It is saved by the final chapter “The New Social Contract” which takes his thesis to its practical societal conclusions. Cowen has said he hopes it reads like a history book of the future and I hope more social scientists attempt this presentation style.
The Score Takes Care of Itself by Bill Walsh: Recommended by Twitter creator Jack Dorsey as his manual for leadership, this posthumously published guidebook lays bare the thoughts of a football legend. Walsh led the San Francisco 49ers to three Super Bowls and two more under his self-appointed successor during the 80s and early 90s. His core philosophy of teaching his employees/players to rise to his “Standard of Performance” can transfer into any workplace. Although the book is just a tad repetitive, the central thesis mixed with Walsh’s personal stories from coaching one of the NFL’s greatest and longest dynasties makes it recommended reading.
Currency Wars: The Making of the Next Global Crisis by James Rickards: The book for understanding how currencies work and the dangers of mismanaging them on a global scale. The book is split into two parts: First, a history of the past 100 years of fiat currencies; Second, Rickards’s projections on the future of international monetary policy. These discussions are centered around the concern that countries are increasingly using currency manipulation as economic warfare. This should be read by everyone in a position of political and economic power who decides these very issues.
The Count of Monte Cristo by Alexandre Dumas, translated by Lowell Bair: The 2002 Kevin Reynolds film rendition of this classic is one of my favorite movies. I was concerned that seeing the movie first would spoil my view of the book. Luckily, major plot lines are significantly different enough to keep the two separate in my mind. Monte Cristo is the definitive revenge story. I am not surprised it has survived for centuries.
*Bubble Logic: Or How I Learned to Stop Worrying and Learned to Love the Bull by Cliff Asness: Billionaire founder of AQR Capital Management wrote this unpublished-book-turned-long-academic-paper in August 2000 as the dot-com bubble was crashing. Asness eviscerates the Internet bulls using simple financial mathematics. As someone who is a believer in the potential of internet companies, Asness provides the logical, sobering truth to the Silicon Valley-ites who misunderstand market realities. A must-read for value investors or anyone who wants a deeper understanding of the stock market.
Fate of the States by Meredith Whitney: I’ve already written another blog post based on the information in this book. Whitney and her research team have compiled damning evidence on the widespread mismanagement of state and municipal governments on both coasts of this country. While her calls against these municipalities might be criticized for early timing, her broader points can not and should not be ignored by politicians and the broader citizenry.
Best Book Read in the Second Half of 2013:
Fooling All of the People Some of the Time by David Einhorn: While Fate of the States, my runner-up for this position, is an easier and more relevant read for most, Fooling All of the People was too memorable to not have the top spot. Hedge fund manager Einhorn documents his multi-year fight against the fraudulent Allied Capital. Einhorn clearly walks through how white-collar criminals, Wall Street banks, Harvard professors, government agencies, and shady accountants conspired to steal hundreds of millions of dollars from taxpayers and individual investors. Compared to writings about the 2008 financial crisis, Fooling All of the People is a personal tale of a small group of individuals investigating the very corrupt corporate systems that preceded the crisis and have really existed throughout history. This is a book that will leave you a less naive person. That feeling alone is worth the price of the paperback.