Buying Biotech – 10x Genomics

I own $TXG as of June 15th, 2020. This is part of a new series I’m starting studying publicly traded biotech companies. The below is my take and analysis, but all investing decisions are your own. Their latest annual report and investor presentation are downloadable here.

10x Genomics is a provider of hardware and software tools for “academia, governments, other biopharma and biotech companies.” TXG’s products help these institutions research scientific solutions for a wide range of fields, including cancer, neuroscience, drug development, and beyond.

The 10x products have resulted in scientific acclaim (having helped their customers get 700-plus papers published in major science journals by using 10x tools) and patent defensibility (over 200 currently owned or exclusively licensed with another 480 pending).

Before explaining their solutions, the challenges these customers faced before 10x Genomics include (from page 5 of the TXG annual report):

  • Average, or bulk, measurements obscure underlying differences between different biological units, such as individual cells
  • Low throughput prevents requisite sampling of the underlying complexity–for example, when only a few hundred cells can be evaluated at a time.
  • Limited number of biological analytes are interrogated, giving a myopic view of only a few biological processes….
  • Inefficient use of sample to generate a signal of sufficient strength to analyze the biological molecules of interest
  • Inadequate bioinformatics and software tools

In plainer English, even with modern advances, scientists still run into limitations in their ability to analyze, faster and in larger volumes, the smallest “biological units” like cells and their molecules.

How does 10x solve this problem?

Continue reading “Buying Biotech – 10x Genomics”

Buying Benefytt Technologies (

Disclosure: I am an owner of BFYT as of March 23, 2020.

What is Benefytt Technologies?

Benefytt Technologies, Inc. (BFYT), formerly known as Health Insurance Innovations, is (in the company’s own words): “a technology driver distributor of Medicare, health and life insurance products.”

In other words, it is primarily a lead generation service for other health insurance companies. For those unfamiliar, “lead generation” is jargon for “gets a fee for finding customers for the companies actually providing the insurance, without taking the insurance policy risk itself.”

Continue reading “Buying Benefytt Technologies (”

Short-Selling During the Coronavirus

“In 2008, it was the entire financial system that was at risk. We were still short. But you don’t want the system to crash. It’s sort of like the flood’s about to happen and you’re Noah. You’re on the ark. Yeah, you’re okay. But you are not happy looking out at the flood. That’s not a happy moment for Noah.” – Steve Eisman in Michael Lewis’s The Big Short

There’s a third type of investor during these times: the short-sellers.

I didn’t intend to become someone who makes money from suffering from others. It’s a mindset some people have, gained often through negative life experiences, a desire for truth, or just genetic skepticism. For me, it’s the first two.

That said, I’ve been having my most profitable month in the stock market at a time when many people have been panicking.

This is because, in January, I took short positions on four companies:

Continue reading “Short-Selling During the Coronavirus”

A “Short” Update on Bank of Internet

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.

My original thesis claimed Bank of Internet was an overvalued company whose stock price would decline for five reasons:

  • 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.

BOFI Stock Chart Since First Blog Post

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.”

Then on February 17th, they announced another deal delay in an SEC filing, extending the deal talks again with a projected closing date of June 30th and a termination date of July 31st when the deal would be canceled.

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

On June 9th, H&R Block had its latest quarterly earnings conference call. Its CEO Bill Cobb did not sound nearly enthused about the progress of the deal as his counterpart at Bofi.

“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?”

Cobb responded,

“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.”

Kerrisdale Capital asked the important question: If there were actually multiple interested parties, how or why did Bank of Internet manage to outbid the others?

“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.

Unfortunately for Bofi, Federal Reserve Chairwoman Janet Yellen said in a Congressional hearing earlier this week that she expects the Federal Reserve to increase interest rates this year.

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.

Textura and Its Ties to the Real Wolf of Wall Street

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 two SEC 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?

I do not know for a fact whether the house in the picture is Mr. Allin’s house. This is the suburban neighborhood given to the SEC as Patron System’s address.

Google Maps URL to this location as of February 22, 2015:

Screen Shot 2015-02-22 at 5.08.01 PM

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?

Screen Shot 2015-02-20 at 1.37.46 AM

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.

Betting Against Bank of Internet

Disclosure: I am short against Bank of Internet as of July 28, 2014 and at the time this post is published. You can download a zip folder containing some of BOFI’s public filings, two Kerrisdale PDF reports, and Citron’s report. Compared to my two previous public reports (Gamestop and Castlight Health), Bank of Internet is a more complex business. I’ve tried to keep the content interesting and education for financially literate and non-financially literate readers alike. Also, given the essay format, I’m only able to tell part of the story. The zip folder contains the material to answer any further questions one might have.

What Is Bank of Internet (BOFI) Holdings?

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:

BOFI Advantage is Securities, Soon Ending

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:

BOFI Profit Falls

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.

BOFI Rate Gap

Given interest rates have been low for years, there’s not much room for rates to go lower and mostly talk of rates going higher. When the Federal Reserve chairwoman is debating whether rates will rise slowly or quickly and doesn’t even mention them declining further, that should scare the crap out of BOFI.

“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.

Company management probably sees this coming since they announced two weeks ago they will be raising $50 million by selling more stock. Even if this works in protecting them from a cash shortfall, selling additional stock diminishes the value of current shareholders stocks and will probably push the stock price lower as the new shares hit the market.

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.

Poor Bancorp

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.

This became apparent in 2010 when prepaid cards issued by Meta Financial (the second largest issuer of stored value cards in the country) were used by the suspects of the assassination of HAMAS commander Mahmoud al-Mabhouh. Meta Financial was quickly dealt regulatory fines which also cut their stock in half and required many years to recover.

Meta Financial 2010

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.

Kerrisdale BOFI Valuation

So what would BOFI’s business have to look like for it to earn enough money to be worth $73 per share?

Market BOFI Valuation

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:

BOFI Price to Book Overvalued

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.

Castlight Health Casts Bright Light on Market Bubble

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.

In 2013, this business lost $62 million on sales of $13 million. Since it went public a month ago, the stock has dropped over 50%. This is where I start my analysis of what Yahoo has deemed “the most overpriced IPO of the century.” I do not disagree.

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.”

Castlight App Screenshot

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):

Castlight Income Statement

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.

Castlight’s Customers

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

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.

The Backlog

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.

Possible Valuations?

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 companies 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:

Castlight Exec Comp

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

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.

Is Gamestop Overvalued? – Conclusion

We’ve come to the end of this tutorial on Discounted Cash Flow analysis. Using Gamestop’s publicly available data, we have determined that Gamestop’s stock is worth $23.78 (I have used “we” throughout this tutorial, but of course you are welcome to get different results by modifying the model). Considering the stock at the time of the research as evidenced by the Introduction page was $50.29, it seems like a good investment to bet against Gamestop’s stock, or at least avoid buying it.

I’ll also reiterate that all the data and spreadsheets used for this tutorial are available for download so that you can tinker with it and read more information about Gamestop’s operations.

If you have any questions or comments, your emails to loganfrederick [at] are welcome.

Is Gamestop Overvalued? – Extending the Research

The following aspects of Gamestop’s business were not thoroughly researched for this paper and should be to complete the analysis:

Leasing versus Ownership:

Gamestop uses a combination of leasing and owning for its retail locations and distribution centers. It is possible that the renewing leases could help or hurt Gamestop in some significant way or that the financing environment might affect how these leases are paid. Lease accounting is discussed in the 10K on page 35 and page 49.

Tax Rates:

The model uses a standard 35% corporate tax rate. Gamestop has some tax credits that can be used in the future to potentially help its earnings, but has also had some historical years with effective tax rates above 35%. These were not used in the model and should be to get a more accurate price.

Choosing a Different WACC:

After attempting to use comparable companies to Gamestop to select the model’s Weighted Average Cost of Capital, I set this value to 8% as it seemed the most reasonable. A more rigorous model for selecting the WACC involving different comparison companies or industry information could be used.

Better Methods for Modeling Future Sales

Despite all the discussion about what might affect Gamestop’s sales in the future, the model uses a simple method for growing and declining sales. The first couple projected years grow based on previous sales growth rates due to the launch of new game hardware. Then the last few years show steady sales decline based on the reasons given in the thesis.

A better, potentially more accurate method for estimating future revenue would include factors such as projected consumer spending patterns, more precise adjustments for the potential hardware and software sales with a new gaming generation (which could be determined using patterns from past generation launches), and other sector and economic factors.

Investigate the Increase in Selling, General, and Administrative Expenses:

Why has SG&A increased by $400 million in five years? This is the primary question which came to mind when building the model.

On page 38, Gamestop notes: “Selling, general and administrative expenses decreased by $6.2 million, or 0.3%, from $1,842.1 million in fiscal 2011 to $1,835.9 million in fiscal 2012. This decrease was primarily due to changes in foreign exchange rates which had the effect of decreasing expenses by $26.7 million when compared to fiscal 2011 offset partially by expenses for the 53rd week in fiscal 2012. Selling, general and administrative expenses as a percentage of sales increased from 19.3% in the fiscal 2011 to 20.7% in fiscal 2012. The increase in selling, general and administrative expenses as a percentage of net sales was primarily due to deleveraging of fixed costs as a result of the decrease in comparable store sales. Included in selling, general and administrative expenses are $19.6 million and $18.8 million in stock-­based compensation expense for fiscal 2012 and fiscal 2011, respectively.“

This does not explain the $400 million increase from 2008 to 2011. Although sales grew by approximately $700 million from 2008 to 2011, sales dropped in fiscal 2012 back to 2008 levels, while SG&A remained stagnant, presumably for the fixed cost/same-­store sales decrease reasons listed above. If revenue remains around the 2008 levels, it would be worth investigating if Gamestop could bring its SG&A costs down as well.

Next: Conclusion
Previous: Valuing The Stock

Is Gamestop Overvalued? – Valuing the Stock

In the Introduction, I mentioned that future estimates of a company’s profitability are inherently inaccurate because nobody truly knows what will happen in the future. Additionally, the farther into the future you try to guess, the less accurate your guesses will generally be. To compensate for this, financial analysts use the previously noted Time Value of Money principle to “discount” future Free Cash Flow (which we found in the last section). Discounting means that if we want to use future profits to determine the company’s value today, we have to make those profits less valuable because there is a chance the company won’t actually earn those profits in the future.

So the next question is: How much less should future cash flow be worth?

The common technique in finance is to apply a “Discount Factor” or “Discount Rate” to decrease the future cash flows.

The Discount Rate is an annual interest rate, except instead of going forward in time, you’re going backward in time from the future to the present (also known as the Present Value formula). The Present Value formula is:

Present Value Formula

In our Gamestop model below, we find the Present Value for every year into the future we have found Free Cash Flow (“Present Value of FCF” in the spreadsheet). “N” is how many years into the future.

What do we use as the discount rate (“r” in the equation)? This is where we use the Weighted Average Cost of Capital (WACC). A longer definition is in the Glossary, but the WACC represents the minimum expected rate of return an investor in the company would expect the company to earn with the investor’s money. Therefore, discounting by the investor’s minimum expected investment return turns future profits into their present value based on investor expectations.

How do we determine what the WACC should be?

There are some different ways to determine the WACC. In my case, I tried initially to find Gamestop’s WACC using data from similar companies, but the value this produced was too low. You can see this work if you download the Excel workbook and view the “WACC” spreadsheet. The lower the WACC, the higher the stock price, since you are discounting or decreasing the cash flows by this rate. So I manually set the WACC at 8% in the model, which seemed realistically fair.

Applying the Present Value formula onto each future year’s FCF gives us the “Present Value of Free Cash Flow” row in the Excel model.

Free Cash Flow

Finding Enterprise Value:

With the knowledge of what the company’s future profits are worth to us today, we can determine how much the company is worth. The company’s value is called the “Enterprise Value”. Again, a longer definition of Enterprise Value is in the Glossary. Here we can define the Enterprise Value as the sum of the Present Value of Free Cash Flows (in the spreadsheet as “Cumulative Present Value of FCF”) plus the Terminal Value.

The Terminal Value represents the value of the company for all the years beyond our model combined into one amount. This can be determined in different ways. In my model I chose to use the “Perpetuity Growth Method.” Simply put, this takes the last year’s Free Cash Flow in the model and grows it at a small rate indefinitely into the future and then discounting it back to its present value. The Terminal Value requires choosing a “perpetual growth rate”, also known as the rate at which the company will grow forever into the future. This percentage should be low as it’s impossible for company to grow faster than the entire economy forever. For Gamestop, I chose a one percent perpetual growth rate. Based on the Thesis and Supporting Arguments, I do not believe the company will grow very fast in the future, but I did not choose zero growth to keep my model a little more conservative and assume that Gamestop will not go completely bankrupt.

Adding the Cumulative Present Value of FCF and the Terminal Value gives us the Enterprise Value. Congratulations, you have now found the value for the entire company! In my model, I determined that the entire Gamestop company is worth approximately $2.357 billion.

The Final Steps – Finding the Stock Price:

Next we will take the value of the company and determine how much each share of stock gets of that value. Adding the Enterprise Value plus the company’s cash gives us the Equity Value, which is the value of the company which belongs to the shareholders. Gamestop has $635 million of cash in the bank, so added onto the Enterprise Value gives Gamestop an Equity Value of $3.006 billion.

The formula for the stock price is:

Stock Price=Equity Value/Fully Diluted Shares Outstanding

Fully Diluted Shares Outstanding is the number of all the company’s stock. To reiterate in English, the stock price is the total value of the company and its cash divided by the total number of shares of stock that exist. FDSO is the “Shares Outstanding” (shares available in the market) plus new shares of stock that can be created by stock options in owned by the company and its employees.

Gamestop has 126.4 million shares of stock.

Take Gamestop’s $3.006 billion in Equity Value divided by its 126.4 million shares and you find that every share of stock is worth $23.78.

Next: Extending the Research
Previous: The Future