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” →

 
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 (HealthInsurance.com)” →

“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

Two types of Coronavirus investors here:

The ones buying Zoom and Slack quoting Elon

And

The ones buying cruises and airlines and quoting Buffett

— Michael Batnick (@michaelbatnick) March 5, 2020

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” →

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:

Did Textura’s Financiers Also Participate in a Pump-and-Dump?

William Blair and Barrington were the two leading investment banks which offered Textura’s stock to the public. This wouldn’t be a problem if their employees weren’t using their companies to line their own pockets.

As Citron found in an amended SEC filing, a group of William Blair and Barrington employees, specifically Mr. Richard Kiphart and Mr. Arthur Simon, were members of an investment group called ACPP Capital LLC which owned shares (specifically “159,062 shares of common stock and warrants to purchase 16,556 shares of common stock”) of Textura before their employers sold it to the public.

Citron comments on the incredulity:

“Ok so check this out: There was an undisclosed LLC shareholder, owned by individuals from two different underwriters? This is a direct conflict of interest, and the failure to even include this information in the IPO prospectus is like a Wall Street version of a brown paper bag….

Let’s factor in the head of Corportate Development at Textura, who used to be an analyst at William Blair. As a matter of fact he was the boss of the current analyst at Blair who covers the stock – with an ‘Outperform’!”

From Textura’s own SEC S-1 Filing: “Franco Turrinelli has been our Executive Vice President of Corporate Development since January 2010. Prior to joining Textura, from July 1996 to December 2009, Mr. Turrinelli was at William Blair & Company LLC, an investment banking firm.”

So for my less-financially inclined readers, what does this mean?

The bankers themselves owned shares in money-losing company, recommended the company to the general public, sold the stock to them, and got hired by the company in executive-level positions. When/if the company runs out of money to lose, the bankers will have made their millions for bending the truth to the public, who will have lost all its investment.

Michael Nemeoff of the investment bank Credit Suisse First Boston refuted Citron’s analysis of Textura, stating: “We base our opinion on our own research, performed over the last few days, as much of the innuendo that suggests impropriety is based on publicly available information that anyone can find using Google.”

To which Citron and I reply, if you are suggesting we don’t use publicly available information, I guess all that’s left is insider information and listening to whatever the CEO says. Of course, you would expect this kind of response from one of the investment banks which sold Textura’s stock to the public.

“One of its most hilarious ‘disclosure moments’ is how Textura reports the total amount of construction reported in the Lien Waiver system as though it is a meaningful number. They disclose “Client-reported construction value added (billions)” as though it meant anything, boasting of 55.7 billion in “construction value” reported as released from claims using their software. The reality is that the company’s CPM “solution” generated a whopping 22.3 million in topline revenue for 2013.

To offer an example of just how stupid this is: Suppose you ran a pen company. And at the end of the year, you reported, “A Trillion dollars in contracts were signed with our pens!!!” That number is irrelevant at best, or intentional promotional misdirection at its worst.” – Andrew Left, Citron Research

While talking about how a company like Textura even gets funded in the first place, it’s worth noting that during this company’s history, it has received no significant venture capital investment. This is during a time when enterprise software and software-as-a-service companies are raising hundreds of millions of dollars. Hell, even my previously researched company Castlight Health got top-name technology investors. Textura only has a handful of old Wall Street types involved. It’s not like Silicon Valley has anything against the construction industry. In 2012, not too long before Textura’s IPO, a startup named Plangrid raised $1 million in funding from a few of the Valley’s elite.

And while we’re comparing construction-industry technology companies, Plangrid’s website looks a heck of a lot more modern compared to the larger Textura. Not every company needs a modern website, but it looks better to have one if you’re in the software business. Even more disconcerting is that Textura’s “Investor Relations” page looks better than it’s company homepage (this is me speaking subjectively on February 22, 2015), which suggests they are more interested in pitching investors than customers.

Disregarding Executive Sketchy Dealings and Taking Textura at Face Value, How Do the Company’s Finances Look?

Quoting Citron, “You’re telling us that all that money went to build a lien waiver processing system? That’s all they have to show for it? A small software company with 385 employees and revenues well lower than $100K per employee?”

From page 11 of the September 10, 2013 S-1 Filing:

“We have incurred significant losses in each period since our inception in 2004. We incurred net losses of $15.9 million in the fiscal year ended September 30, 2010, $18.9 million in the fiscal year ended September 30, 2011 and $18.8 million in the fiscal year ended September 30, 2012. We incurred a net loss of $31.3 million in the nine months ended June 30, 2013, and as of June 30, 2013, we had an accumulated deficit of $169.9 million. These losses and accumulated deficit reflect the substantial investments we made to acquire new enterprise client relationships and develop our solutions. We expect our operating expenses to increase in the future due to anticipated increases in research and development expenses, sales and marketing expenses, operations costs and general and administrative costs, and, therefore, we expect our losses to continue for the foreseeable future.“

That looks kind of bad but it’s from an older filing. What’s the most recent November 2014 10Q quarterly report have to say?

Revenues For the First Nine Months of 2014: $45.106 million
Total Operating Expenses During That Time: $65.759 million
Net Loss to Stockholders In Nine Months of 2014: -$20.978 million.

Compared to the first nine months of 2013 where Textura lost $42.896 million, last year’s $21 million loss is a slight improvement. But it’s still not a great sign for a company with dwindling cash reserves.

Cash and Cash Equivalents Available as of September 2014: $66.035 million
Accumulated Deficit in Company’s History: -$205.512 million.

I am listing only the first nine months of 2014 because Textura does not announce results from the end of 2014 until this upcoming Tuesday, February 24, 2015.

Examples of Management Mistakes

“Investors could overlook all that if the real Textura was in fact a rapidly growing SaaS outfit, gobbling up substantial market share in a huge addressable market, by offering an integrated suite of software poised to rapidly [sic] that market at very low cost of sales. But the current company is the opposite of a real SAAS company: It offers only one narrow solution (CPS, the lien waiver/payment solution), plus a hodgepodge of small software acquisitions that don’t integrate well, if at all,” Citron explained.

An example of an arguably bad acquisition is Latista. As disclosed in the November 2014 10Q filing, Textura paid $34 million for Latista Technologies in December 2013. In the nine months since the acquisition, Latista earned only $2.172 million in revenue and lost $4.571 million.

It was also revealed the company has some decent severance packages for an unprofitable software outfit:

“In September 2014, two co-founders retired from full-time employment with the Company, and two other non-executive members of management were terminated from the Company. Pursuant to the severance arrangements provided in their respective employment and separation agreements, we recognized severance-related expenses of approximately $1,488 during the three months ended September 30, 2014. This severance expense includes salary, payroll taxes and bonus payments to which the former employees were entitled under their respective arrangements. We expect to pay the severance expense, of which $1,460 was accrued as of September 30, 2014, over the next twelve months.”

Those dollar amounts are in the millions (as in $1,000 is a thousand-thousands). They expect to pay $1.460 million in severance over the next year.

Additionally, page 16 of that SEC filing states that stock-based compensation for employees was $6.405 million in the first nine months of 2014.

How can I get a job, then fired, from there?

Looking Through the Glassdoor

Speaking working at Textura, I hopped over to Glassdoor to see what former employees had to say. For those who don’t know what Glassdoor is, it’s a website where workers can review the companies they currently or previously worked for.

To its credit, as of February 22, 2015, Textura sports an average score of 3.8 out of 5 from 38 employee reviews.

Even the positive reviews reveal insights into problems with the company:

Valuation

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.

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.”

How does one lose $62 million in one year building a website for health data? And how is it still in business?

Castlight’s Income Statement

“I would say there is no one here who can understand some new internet company. I said at the annual meeting this year that, if I were teaching a class in business school, on the final exam I would pass out the information on an internet company and ask each student to value it and anybody who gave me an answer I’d flunk.” – Warren Buffett’s Q&A at the University of Florida in 1998

When I first noticed Castlight and it passed my eyeball test as a terrible stock, I wanted to see if I could possibly value the company. I quickly relented.

Castlight filed its Form 424B4 paperwork to the SEC on March 14 which includes all the required information for a company selling public stock. This document contains the company’s historical performance going back to 2011. Typically a financial analyst will use these SEC filings to do a Discounted Cash Flow analysis (link to my introductory tutorial on the subject), but with a company burning through as much cash as Castlight (and many other internet businesses) the DCF analysis quickly breaks. The primary problem is that, unlike a more mature company, or even a barely profitable one, you can’t even begin to predict the company’s future with any degree of confidence or reliability. The two sub-problems when making those future predictions are projecting future revenue increases and cost decreases. In looking at Castlight, I realized I had few ideas on how either of those line items would look over the next five years.

Here is their slightly organized income statement (numbers are in millions):

The last row, Castlight’s earnings, paints a pretty grim picture of not just three consecutive years of losses, but increasingly large losses. While revenue (row three) has grown substantially, costs (rows five and nine) have grown faster.

Castlight is an enterprise software company, so initial development and sales expenses are likely to be higher than mainstream consumer software. Yet after three years, these numbers clearly show a company that’s been lighting dollar bills on fire with matches in front of large customers for a pittance.

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.”

Competition

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:

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.

Blame

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 loganfrederick@gmail.com.

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.

http://plus.cnbc.com/rssvideosearch/action/player/id/3000266918/code/cnbcplayershare

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] gmail.com are welcome.

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

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:

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.

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

Now that we’ve discussed the business, potential problems, and historical financial performance of Gamestop, we can attempt to predict the future to determine if the stock is under-, over-, or correctly valued in the stock market.

Below is the second half of the DCF Excel spreadsheet with the future projections for Gamestop’s financials and projected Free Cash Flow, followed by an explanation of how these numbers were found.

Future Sales: In your typical DCF model, you can just grow sales every year into the future using the average growth rate I list in cell G3 in the above spreadsheet. In reality, business rarely have revenue every year change by the same amount. Specifically with Gamestop, I chose to have temporary high growth in the near future because of all the new video game consoles being released in 2013 and the pent up videogame demand saved up for this occasion. However, for all the reasons listed in my “Supporting Arguments”, I decrease the company’s revenue in the future. For the specific percentages, I used Gamestop’s best and worst annual growth rates in the past five years.

Cost of Revenue and SG&A Projections: To find Gamestop’s future Earnings Before Taxes, Interest, Depreciation and Amortization, we need to subtract out its future Cost of Revenue and SG&A costs. To predict those costs, at the bottom of the spreadsheet I have included some extra information: The Cost of Revenue growth rate taken from the CAGR column and SG&A as a percentage of Revenue. SG&A as a percentage of Revenue is based on the average ratio of SG&A to Revenue from past years and using that average ratio in the future.

Depreciation and Amortization: Future D&A was set at 2% of future revenue. This is another standard number that you could try and modify if you see major changes in these expenses, but I did not see such reasons. If you compare the future projections of D&A using this “2% of future revenue metric”, you will see it is relatively close to the past values and thus seems like a reasonable assumption.

Capital Expenditures: Future Capex was set at 1.85% of future revenue, which was the average Capex over the previous five years.

Increase in Net Working Capital: This is the most complex part of the Free Cash Flow equation, so I have dedicated a separate post to explaining the details on how to project future changes in Net Working Capital.

The equation for Free Cash Flow is:

EBIAT
+ D&A
– Capex
– Increase in Net Working Capital
=Free Cash Flow.

The reason this works to find the company’s available cash flow:

EBIAT represents the company’s earnings that could be used to pay off any debts in the event of a liquidation (hence why “Interest” is not taken out, interest comes from those debts).

Capex is subtracted because it is a use of the company’s cash. Even though it can be considered cash spent wisely to improve the business, it is still less cash available to the owners (the stock holders).

The Increase in Net Working Capital is subtracted because an increase in NWC, like Capex, means cash has been used to either increase the company’s assets or decrease its liabilities. Both of these are not strictly good nor bad, but they are uses of cash that are not available for the investors to pocket.

However, the remaining cash is available for investors.

Using the steps and descriptions above for each row in the Excel spreadsheet model and every column representing the next five year’s of the company’s operations, we can use the simple math explained above and in the past to estimate future Free Cash Flow.

With our guesses for the company’s future profits, we can now determine what the stock price should be.

Next: The Future
Previous: Net Working Capital

Increase in Net Working Capital: Increase in Net Working Capital is the most complicated of our future projections. This is because to properly find future NWC, you have to predict future Current Assets and future Current Liabilities.

To accomplish this, I added a “NWC” spreadsheet to my Excel workbook:

All of the numbers in the 2008 through 2012 columns were taken from the 2008 through 2012 Gamestop Balance Sheets. The projections for the 2013-2017 values are found by taking the average growth rates or most recent value for the assets and liabilities and using those values or rates in future years.

The spreadsheet provides a visual for what makes up Current Assets and Current Liabilities. In English, they are:

Current Assets:

Accounts Receivables: Amounts owed to the company for products or services it has given on credit to other business or individuals.

Inventories: Inventories are the company’s raw materials and products made or in the process of being made.

Prepaid Expenses: These are expenses paid by the company before receiving the products or services for which it has paid. An example of a prepaid expense is an insurance premium which is paid completely upfront but covers a company or person for some amount of time such as a year. The insurance is a prepaid expense which initially is an asset that will get used over the course of the year, decreasing the asset over that time.

Cash and Cash Equivalents: The company’s cash and assets that can almost immediately be turned into cash, such as commercial paper and Treasury Bills.

Other Current Assets: Assets that do not fall into the above categories but are still assets that can be turned into cash within a year. These kinds of assets are typically non-recurring or not large enough to require their own category on the balance sheet. Some examples of this could be cash paid in advance to suppliers or employees that is accounted separately from the rest of the company’s cash or small investments in other companies or assets the company has made.

Current Liabilities:

Accounts Payable: Payments owed to the company for products or services already provided to a customer. This can be thought of in non-accounting terms as customers’ unpaid bills.

Accrued Liabilities: Expenses such as salaries, rent, interest, and taxes that the company owes but has not yet paid.

Other Current Liabilities: Other types of liabilities that don’t fit into one of the other categories, possibly don’t occur very often, and are due to be paid or worked off within a year.

Assumptions:

Day Sales Outstanding (DSO): DSO tells you how a company is managing its Account Receivables. The lower the number, the faster the company is getting paid by its customers. The equation for DSO is: (AR/Sales) * 365.

Days Inventory Held (DHI): DHI tells you how a company is managing its Inventory. The lower the number, the faster the company is selling or getting rid of its old product inventory. The equation for DHI is: (Inventory/Cost of Revenue) * 365.

Prepaids and Other Current Assets as a Percentage of Sales: This percentage is used to project the Prepaid and Other Current Assets into the future by setting them to a percentage of the future Revenue.

Days Payable Outstanding (DPO): DPO tells you how long it takes a company to pay its suppliers. The larger this number, the longer amount of time the company is taking to pay its suppliers. A larger number is good because it means the company is not rushed to pay its bills and has time to invest its cash into other parts of the business before having to pay bills. The equation for DPO is: (Accounts Payable/Cost of Revenue) * 365.

Accrued Liabilities as as Percentage of Sales: This percentage is used to project the Accrued Liabilities into the future by setting them to a percentage of the future Revenue.

Other Current Liabilities as a Percentage of Sales: This percentage is used to project the Other Current Liabilities as a percentage of the future Revenue.