Books Read in the First Half of 2019

As a reference, my grading scale is (without any one or two star books this time):

Three Stars: Recommended, may cover too niche a topic to get a stronger recommendation for a broad audience, is only high-level coverage of its theme, or just moderately interesting fiction.

Four Stars: Recommended, well-written, and covers material I think most people would find useful or interesting.

Five Stars: Strongly recommended to everyone.

Additionally, I pick one book every six months as the “best book I’ve read” during that time period.

Themes from these six months:

  • Chuck Klosterman: I’ve completed the Chuck Klosterman collection, including his two novels.
  • Alan Lightman: A physicist-novelist recommended by my good friend Ritoban Thakur has a unique voice which bridges spirituality with science.
  • Technology Company Growth and Management
  • Stripe Press: A new publishing company with the goal of advancing economic and technological ideas also puts great care into their uniquely designed and high quality physical book covers.

Three Stars (Recommended)

Sales Engagement: How the World’s Fastest-Growing Companies are Modernizing Sales Through Humanization at Scale by Manny Medina, Max Altschuler, Mark Kosoglow:

Definitely better than Max Altschuler’s growth hacking because it focuses on tactics over tools. It’s still a not-subtle promotional book to sell their sales tool Outreach. To be fair, it does pretty comprehensively cover modern sales automation challenges and opportunities, so someone who hasn’t done sales beforehand would probably get some value out of this.

Let’s Go (So We Can Go Back): A Memoir of Recording and Discord by Jeff Tweedy (Audiobook):

My favorite childhood teacher got me this as part of an audiobook swap. I had never heard of the band Wilco before. For being a professional singer, Tweedy’s reading of his own biography started off flat until he seemed to audibly ease into it.

He’s got some reflective moments that I haven’t heard enough artists talk about, particularly that later in life he felt maybe he could’ve contributed more to the world, maybe become a scientist, if he had a different upbringing or gone to different schools as a kid. That’s the kind of thing I think non-artists suspect but don’t hear very often.

My favorite segments were near the end when both his wife and son get to read their own chapters about living with a rock-star (and all the drug abuse that comes with it). This audiobook was recorded in Chicago and for that it wins extra brownie points.

Killing Yourself to Live: 85% of a True Story by Chuck Klosterman

Killing Yourself to Live tells two stories: A request by his editor at Spin magazine sends Chuck on a road trip in a rented Ford Taurus to places around the country where rock musicians have died (sometimes by their choosing and mostly not) presumably as a way to help readers understand life. Layered on top of this premise is Chuck recounting his love for three women in his life who don’t exactly love him back.

It seems to be divisive among reviewers, depending on which of the two topics (rock ‘n roll or nostalgia for old romance) you care more about. The haters find this book to be a lot of white-dork navel-gazing, and I can’t say they’re wrong. I do wish it had more music history in it myself, although I still learned a fair amount about how many musicians have died in plane crashes and Seattle. I think a lot of those critics aren’t acknowledging a truth: a lot of guys in their late 20s and early 30s (possibly beyond) are probably nostalgic for the women who, five to ten years earlier, got away (probably with good reason). In this regard, Klosterman acknowledges his own narcissism.

If you only want the death-and-music story, there’s his original Spin Magazine story “6,557 Miles to Nowhere”.

Eating the Dinosaur by Chuck Klosterman

The title is probably too obtuse too grab the casual reader (it’s loosely about the idea that time machines are too dangerous for anything more than finding out how dinosaur meat tastes).

However, the theme of this 2009 book is as important as ever. Klosterman himself describes the book as being about “What is reality, maybe? No, that’s not it. Not exactly. I get the sense that most of the core questions dwell on the way media perception constructs a fake reality that ends up becoming more meaningful than whatever actually happened.”

He uses the lenses of Lady Gaga’s award show outfits, the popularity of Mad Men, and the Unabomber’s anti-technology manifesto to view the construction of false realities from a myriad of perspectives. In the decade since this book was first published, this “fake reality” has grown. And it’s not clear if Chuck sees this as a “problem” per se. But it’s certainly the new normal, either for the time being or forever.

Four Stars (Highly recommended for those interested in topic, or generally recommended for anyone)

The Making of a Manager: What to do When Everyone Looks to You by Julie Zhuo

Written by a design director with a decade of experience at Facebook, Making of a Manager provides good comprehensive coverage of management. Filled with examples from her experience, Zhuo discusses delegation, running meetings, and other topics core to the role of “manager”. I strongly agree with her throughline idea of applying the “growth mindset” to her team and surrounding organization. A lot of the material might feel obvious or common-sensical to anyone who has held a management role or put thought into the challenges of the role before. Even in those cases, this is a good book to keep on the shelf as a reference to revisit and make sure your own broader managerial bases are covered in case you are drowned in your day-to-day.

High Growth Handbook: Scaling Startups from 10 to 10,000 People by Elad Gil

Entrepreneur Elad Gil interviewed some of the technology and investment communities sharpest minds to compile this guide to growing a business. Chapters switch between the condensed interviews with experts on each topic with Elad’s own experience. Well-structured by concepts makes it useful for future reference.

Fargo Rock City: A Heavy Metal Odyssey in Rural Nörth Daköta by Chuck Klosterman

This was Klosterman’s first book, published at the turn of the century, and originally intended as an academic textbook on the history of 80s rock music, specifically heavy metal and hair/glam rock. I’m admittedly biased to liking this book; despite being a generation younger than Chuck, I also grew up on this music, heavily influenced by the music of my mom’s youth.

So as a self-identifying fan of glam-metal (Bon Jovi, Cheap Trick, Motley Crue to name a few), Klosterman does a tremendous job contemplating all the things I love and find fascinating about the genre. Many of the chapters are akin to the debates that high schoolers have about music (I mean this in a good way, as the book’s tone reminds me of youthful energy), including, but not limited to:

  • What’s the difference between “heavy” and “hard” rock?
  • Who is the greatest rock guitarist of all time (and is the typical answer of Jimi Hendrix the correct one)?
  • Does the sexism of 80s rock, with its Cherry Pie music videos and groupie culture, say more about the artists or the rest of American culture?
  • What are the greatest rock albums of the era?

In the end though, Klosterman concludes with the most important reason this book needed to exist and why I’m nostalgic for this material: For a generation of American kids, this was an artform that influenced them and briefly dominated American culture. That time should not be forgotten.

Downtown Owl: A Novel by Chuck Klosterman

Downtown Owl tells the story of the small, fictional North Dakota town Owl, not dissimilar from where Klosterman grew up. Clearly his youth informs his characters. The narrative is told in third-person, but follows three protagonists: an angsty teen who semi-subconsciously wants to escape his small town life, a twenty-something woman with the opposite experience of moving to Owl from the big city to start her teaching career, and an elderly man who has lived his life in a place where everybody knows your name. All three leads, and the surrounding supporting cast, are intimately developed, probably because Klosterman grew up around these archetypes.

More than just sharing the lives of these characters, Klosterman uses them as a vessel for understanding humanity. And this is what Klosterman excels at and has built his career. A lot of intellectuals and pseudo-philosophers take an Ivory Tower approach to thinking about people as aggregate abstractions. Klosterman understands individuals in all their strengths and weaknesses. And that’s how you begin to understand everybody.

An Elegant Puzzle: Systems of Engineering Management by Will Larson

Larson’s experienced a lot in his career across many popular software companies: Yahoo, Digg, Uber, Stripe. His essay collection on managing engineering teams covers so many important, under-analyzed professional issues I’ve encountered in my own career, particularly managing employees of different skill levels and thinking in trade-offs. The book is designed to sit on your desk for reference with its concise, topic-oriented articles.

Trillion Dollar Coach: The Leadership Playbook of Silicon Valley’s Bill Campbell by Eric Schmidt, Jonathan Rosenberg, and Alan Eagle

Bill Campbell is perhaps, alongside Andy Grove and Ron Conway, as the most important behind-the-scenes person in Silicon Valley history. Having recently passed, his proteges from the Google executive team have written a biography of Campbell’s life (including his former career as a high school football coach before becoming an executive coach) intertwined with stories from other noteworthy tech people (such as Steve Jobs and the Google founders) about how Bill changed their lives. It’s a book filled with love, admiration, and advice, and the kind of book we’d all probably wish someone would write about us once we’re gone.

Searching for Stars on an Island in Maine by Alan Lightman

Lightman has had a unique career as the first professor at MIT to hold a joint position in both the physics and humanities departments at MIT. Searching for Stars merges both of his worlds into a memoir. From his small island off the coast of Maine, this is the story of one thinker’s attempt to reconcile science, religion, and philosophy in his own mind and on the page. He does this by interpreting past prolific thinkers and tracing the history of human thought. This is a great, thoughtful vacation read.

The Visible Man – A Novel by Chuck Klosterman

What would you do if you had invisibility? Probably not exactly what the villain “Y” does in Klosterman’s second novel. But maybe not as differently as you’d think. The Visible Man is the most horrifying story I’ve read since Lolita, and not as long.

A scientist only known to us as “Y” creates an invisibility suit out of the leftovers of an abandoned government project. The story is told by his therapist, who slowly realizes the implications of an invisible person’s capabilities. Most dangerously, the invisible person can know everything about you. Take the way Hannibal Lecter knows everything about Clarice’s life and personality just based on interacting with her, then remove the need for interaction. The story is a unique cross between The Sopranos and Silence of the Lambs. In a classically Klosterman way, it creates more questions, but the implications here are darker.

Five Stars (Highly Recommend to Everyone)

Born a Crime: Stories of a South African Childhood by Trevor Noah

Trevor Noah is, other than Dave Chappelle, my favorite comedian working today. Like Chappelle, his mix of wit, wisdom, and life experience gives him a searing insight into humanity. His childhood navigating apartheid and his insights that the language people speak creates more racist feelings than skin color were uniquely educational. Where those stories are different from the typical middle-American life, his retelling of his mother’s relationships with different types of men, some absent and some psychopathically abusive, are universal and ones I both related to and greatly respected his even-keeled recounting.

Losing the Nobel Prize: A Story of Cosmology, Ambition, and the Perils of Science’s Highest Honor by Brian Keating

“Another year, another story for humanity” wrote physicist and friend Ritoban Thakur on the Amazon note he paired with this gifted book. Author and cosmologist Keating has written an important memoir on his time in modern academic physics. He explains the history of his research niche (the big bang and cosmic microwave background radiation) while telling his tale of the drama and politics of navigating the science-academia complex. Interspersed throughout the book are three interstitial teardowns of the modern Nobel Prize in Physics: it’s discouragement of collaborative groups, it’s lack of credit sharing across all the grad students and post-docs who contribute to major discoveries, and it’s negatively influential fame and cash incentives. Keating writes with clarity and humor in this teardown of culture’s arguably most famous prize.

Stubborn Attachments: A Vision for a Society of Free, Prosperous, and Responsible Individuals by Tyler Cowen

After listening to Cowen for years as a guest on EconTalk and reading his books before it was cool, it’s been fascinating watching him rise in popularity the past couple years as a sort of economist-to-the-technologists. I say this as a compliment, as he deserves all the recognition he’s now receiving.

Stubborn Attachments is Cowen’s collection of loosely related ideas on how humanity should live, framed in the language of economics and philosophy. He presents many ideas that resonated with me and I suspect they would with most smart people: society shouldn’t be discounting the value of humanity’s future as much as it does, there’s more to value than what we currently measure, and we need better frameworks for being able to make any decisions at all under uncertainty. Better yet, he provides his own starting points for solutions to all of these issues. It is the economics book I wish I’d written.

Whitewash: The Story of a Weed Killer, Cancer, and the Corruption of Science by Carey Gillam

I love a great corporate whistleblower story and this may be the biggest of modern times. Some people have vaguely heard about the company Monsanto and of genetically-modified foods. While this book is not a comprehensive cover of the GMO debate, it may be the best argument against GMOs.

Journalist Carey Gillam uncovers how agriculture technology behemoth Monsanto poisoned the international supply with its bug-killer “Roundup” chemical (scientifically known as glyphosate). The story exploded in the press a couple years ago as farmers who had been in close, consistent contact with the pesticide started developing similar, quickly-moving lethal cancers. Multiple families have successfully sued Monsanto, winning large financial settlements but leaving children without parents.

Gillam digs deeper into how these deaths were allowed to happen and unveils deep corruption at the Environmental Protection Agency, highlighting multiple regulators who had been paid off by Monsanto in the ugliest form of regulatory capture by a corporation. Both the government and company used fraudulent science and the firing of real critical scientists to protect Monsanto’s profitability. Anyone captivated by recent fraud stories such as the Fyre Festival or Theranos will be enthralled by this story. While it’s more technically complex, the stakes are higher as Monsanto and the EPA clearly killed Americans.

Loonshots: How to Nurture the Crazy Ideas That Win Wars, Cure Diseases, and Transform Industries by Safi Bahcall

One of the hardest problems for any organization is resolving the tension between creating the “next big idea” and not destroying itself in the process. It’s the kind of problem that I’ve put a lot of thought into but never formalized a solution. Bahcall has done it here. This is the kind of book where I think “he’s articulated my own thoughts better than I could have” on every page.

Without going into the details, Bahcall has created a model for structuring organizations so they can walk the fine line between innovation and sustainability. He explains how he’s come to his conclusions based on historical examples (the history of the American airline industry, Vannevar Bush’s influence on scientific research, and how England quickly surpassed China during the Industrial Revolution, to give a few samples) and by bringing his background in natural sciences to the field of management. This is one of the best books I’ve read for bringing together multiple fields of thought into a cohesive theory tackling one of the toughest problems in people management.

The Best Book I Read in the First Half of 2019

Einstein’s Dreams: A Novel by Alan Lightman

Not exactly a novel, not exactly a collection of essays; Einstein’s Dreams is a unique combination of both. This is a fictional recollection of Einstein’s life during his “miracle year”, with chapters alternating between Einstein discussing his new physics with friends over coffee and his dreams at night.

It’s these dream sequences that make this book memorable. Each dream is a short story of an alternate reality where humanity has a different relationship to time. How would people behave differently if our lives were longer? Were shorter? Were frozen in time? Were based on how much you loved those around you? These original physicist-turned–writer insights are half of the appeal, with the other half being Lightman’s remarkably poetic prose.

It is the ideal coffee shop people-watching book as it will make you think differently about everyone you see.

The Legacy of Jack Lambert

Everyone has had some hero, or at minimum an influencer, in their life at some point. For a lot of entrepreneurs and technologists of my generation, that inspiration has been Paul Graham. The follow-up question I ask, like reading source papers referenced in an author’s bibliography, is: who was my inspiration’s inspiration?

Graham documented his heroes in an essay in 2008. This was right around the time I first started getting interested in the NFL, primarily due to a ten hour video series NFL Films created documenting the Top 100 Football Players of All Time.

It’s interesting to me that, like many men, one of Graham’s earliest heroes was an athlete.

Jack Lambert, ranked 29th on the NFL Films list of the greatest players in football history, was the middle linebacker behind the 1970s “Steel Curtain” defensive line that won four Super Bowls in six years.

The impact that those 70s Steelers had on America is slowly receding from culture, which tends to happen over time. However, the spirit of players like Lambert influenced Paul Graham who in turn influenced the modern world in ways that are hard to overstate.

Graham wrote of Lambert:

“I grew up in Pittsburgh in the 1970s. Unless you were there it’s hard to imagine how that town felt about the Steelers. Locally, all the news was bad. The steel industry was dying. But the Steelers were the best team in football—and moreover, in a way that seemed to reflect the personality of the city. They didn’t do anything fancy. They just got the job done.

Other players were more famous: Terry Bradshaw, Franco Harris, Lynn Swann. But they played offense, and you always get more attention for that. It seemed to me as a twelve year old football expert that the best of them all was Jack Lambert. And what made him so good was that he was utterly relentless. He didn’t just care about playing well; he cared almost too much. He seemed to regard it as a personal insult when someone from the other team had possession of the ball on his side of the line of scrimmage.

The suburbs of Pittsburgh in the 1970s were a pretty dull place. School was boring. All the adults around were bored with their jobs working for big companies. Everything that came to us through the mass media was (a) blandly uniform and (b) produced elsewhere. Jack Lambert was the exception. He was like nothing else I’d seen.”

Fast forward a decade later. Readers of my book reviews will notice I’ve been on a Chuck Klosterman kick, reading through his collected works. Klosterman also happened to be the narrator for Lambert’s entry into the NFL’s Top 100 of All Time list.

I paired Graham’s and Klosterman’s thoughts on Lambert together because I find it exciting and a bit amazing when two people I consider great in their separate fields both took inspiration from a seemingly unrelated third forebearer.

Below is Chuck Klosterman’s commemoration of Lambert for the NFL Network:

“Over time now there’s kind of become this understanding that small running backs have an advantage because a lot of times linebackers can’t see into the backfield. His height at middle linebacker may have been a positive in the reverse. He may have had a better view of what the offense was doing and that might explain why he seemed to be one step ahead of things. He just seemed to make every tackle.

If the best player in the middle of the field is making all of the plays on the best team, maybe this is the best defender in the league?

On a “Team of the Decade”, I don’t know even who is number two for the idea of being the middle linebacker on that roster.

He was an extremely intellectual linebacker, which I don’t think was the association with him at the time probably because he was toothless, and probably because he looked kind of like a madman. His greatest strength was his mind, so he’s like John Rambo I guess.

He was certainly the most intimidating player on a pretty intimidating team.

It’s possible that Jack Hamm was a greater outside linebacker than Jack Lambert was as a middle linebacker. But I don’t imagine opponents fearing Jack Hamm the way they would fear Lambert. Pretty much every play, the quarterback was staring directly at Lambert, who had not only this very scary appearance, but this incredibly active appearance.

Pittsburgh likes to sort of perceive itself as having a certain kind of toughness, having a certain kind of team. Lambert really represents that, and there’s never going to be a guy that replaces that in Pittsburgh. He will always be perceived as the greatest personification of what Steeler football is supposed to be like. That’s what Lambert represents: the Steelers at their highest point.”

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:

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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.

Glassdoor-Textura-2

Glassdoor-Textura-3

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

Glassdoor-Textura-4

Glassdoor-Textura-5

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.

Windy City Rails 2014 Notes

These are notes I took during the two days of Windy City Rails 2014 Conference. Since I attended on behalf of my employer, Springleaf Financial, my notes are skewed towards ideas that may be applicable in a enterprise setting. For anyone who might randomly find this post, keep this in mind, as the speakers had plenty to say on topics outside of the enterprise application development domain.

Rubinius X by Brian Shirai

  • Get slides
  • Promises in JS in Rubinius / New Concurrency
  • Logan Note: An article on explaining Javascript’s Promises
  • Ruby functions as first-class functions versus “module_functions”
  • Use dynamic or static typing with static type checking if desired
  • Immutable String Type
  • Clarity in the Behavior of object changes. “to_s” vs “to_str” example.
  • Character encoding standardization.
  • All APIs use keywords, no position-significance

Recommendation Engines with Redis – Evan Light – Rackspace

Devise by Lucas Mazza

Upfront Design by Mark Menard

Legal Talk by Daliah Saper

  • Useful for non-corporate work. Advice for freelancers.

Domain Driven by Yan Pritzker of Reverb

Go for Rubyists by Ken Walters

  • Mostly Go, not much for Ruby/Rails
  • Watch if you’re interested in Go or Concurrency ideas

Local Government on Rails by Tiffani Bell

  • Code for America work with Atlanta and Detroit
  • A discussion on sample projects with government, but no big takeaways for corporate work

Functional Languages with Rails by Sean Griffin of thoughtbot

  • Get his slides
  • IO should always be concurrent
  • Concurrency ideas from Scala could go into Ruby/Rails
  • “Rails API is too far removed from HTTP”
  • “We will break Rack”
  • The Matz Tweet agrees with Sean’s point on future of Ruby
  • “Promises” in JS == Futures in Scala
  • Monadic gem

The New Era of Orchestration: From Docket to BOSH to Cloud Foundry by Dr. Nic Williams

  • Orchestration: Automated arrangement, coordination, and management of complex computer systems, middleware, and services
  • Book Recommendation: The Phoenix Project: A Novel about IT, DevOps, and Helping Your Business Win by Gene Kim, Kevin Behr, George Spafford
  • In his consulting experience, CIO concerns for the next 10 years:
    • Reduce time to value
    • Unify access among applications to all data
    • Mobile access
  • Goals for Orchestration:
    • Deploy Quickly
    • Deploy Framework/Language of Choice
    • HTTP Routing to Web Processes
    • Integrate DBs/Services/APIs
    • Logging
    • Simple, fast scaling
    • Automatic Recovery
    • Package assurance/Version control
    • Reproduce production environment for debugging
    • Auditing who/what did what change?
    • Access controls
    • Internal billing/accounting
  • Orchestration should let you focus on being valuable and engineering
  • Use Pivotal Web Service and Heroku until someone says you can’t!
  • Beware DIY Orchestration: No Unix app for the whole list
  • Orchestration is a system, not an app
    • Docker is good, but doesn’t cover the whole list
  • Where Docker is Good:
    • Package control
    • Process monitoring
    • Port and data binding to host machine
    • Dockerfiles, community involvement
  • Weakness of Docker: Across clusters of servers that change is hard
  • Try CloudFoundry: trycf.starkandwayne.com

Meet the SLAs: Rails at Constant Contact by Dinshaw Gobhai

  • Slides at: http://dinshaw.github.io/meet-the-slas/#/
  • Building for Scale from Scratch
    • Don’t Do it
    • Don’t Over-Architect
    • Don’t Prematurely Engineer
    • Don’t Solve Problems You Don’t Have Yet
  • Measure: Ruby-prof and DTrace for Profiling Apps
  • Rails and N+1
    • preload(:association) – Separate Queries for Associated Tables
    • eager_load(:association) – One query with all associations LEFT OUTER joined
    • includes(:association) – Picks one of the above
    • joins – One query with all associations ‘INNER’ joined
  • aRel Gem
    • aRel on Github
    • Example usage and Youtube video in slides
    • Shows how to do anything in SQL in Rails!
  • Serialization: Skip your ORM
  • include? Causes variables to be downcased!
  • Excessive Logging:
    • Don’t log in loops!
    • Logger messages are generated even if your logging levels mean it isn’t saved! Something to be mindful of if speed is an issue.
  • Use Delete instead of Destroy. Destroy instantiates objects, delete just erases the record.
  • Move “Unique” validation to database, not in models. This uses one less Read to the DB.
  • dgobhai@constantcontact.com

Greenscren: Digital Signage Powered by Chromecast

  • http://greenscreen.io
  • Not Ruby/Rails related, but came out of a hackathon at Groupon
  • Could be useful if we want to have apps or pages displaying on TVs in office

Charming Large Databases with Octopuses

  • If application is read-centric, replication can help you get more performance.
  • Replication: Split up database with master and Slaves. Write to master, read from slave. Balances traffic.
  • Sharding: Take a database or table and split among many physical instances.
  • Db-charmer gem:
  • BUT DB CHARMER ONLY MYSQL AND NO RAILS 4 SUPPORT
  • This is where the Octopus gem comes in: Octopus Gem on Github
  • Provides examples of DB Charmer and Octopus in slides

More TDD by Jessica Kerr

RubyLisp by Dave Astels

  • One of Authors of RSpec
  • bitbucket.org/bastels
  • daveastels.com/rubylisp
  • Scheme for Ruby/RubyMotion
  • Interesting but nothing immediately useful for us

Developing Developers by Dave Hoover of Dev Bootcamp

  • Two Pronged Approach to Growing a Company
    • Hiring Already Great People
    • Training People
  • At old company obtiva, started an apprencticeship program
  • Elements of Good Apprenticeship Program
    • Mentor, Team, Owner
    • Sustainable Ratio of Senior-to-Junior People
    • Culture of Learning+Collaboration > Curriculum: Encourage customized learning
    • In the Trenches: Get apprentices doing real work with team
    • Pet Project: Can fill time if team busy, educational, allows for mistakes
    • Milestones: Keep people on track
    • Feedback loops: Most important, should include pairing
  • Company must support Learning > Demanding Immediate Competence

Cucumber Still Relevant?

  • Answering the question: How Does this legacy app work?
    • Docs?
    • Tests?
    • Cucumber!
  • Scenario/Given/When/Then syntax
  • Cucumber bridge between devs and biz
  • Setup->Action->Assertion
  • A shared language between biz and devs. The language words should be decided by BIZ.
  • I was unconvinced.

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.

A Casual Conversation on Tech Valuations

“The Bubble Question” is the title of a recent Fred Wilson blog and the frequently asked question: “Are we in an stock market and/or technology company valuation bubble?”

Fred Wilson is a managing partner at Union Square Ventures, prolific venture capital blogger, and (from what I’ve gathered reading his blog for years) a pretty smart guy. Given his position, he gets asked the aforementioned question quite often and laid out his current conclusive response via blog. The gist of his explanation for the bubble is:

“valuations are at extreme levels because you cannot get a decent return on your money doing anything else…. really just one factor (cheap money/low rates)… is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime. I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies…. It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.”

After having read Fred’s blog and my recent analysis of Castlight Health, my good friend and old Heyzap coworker Micah Facebook asked me for my thoughts on the tech bubble discussion. With his permission, I’ve posted the transcript from our April 24th conversation which contains my simplified explanation of the outrageous tech company valuations we are currently seeing and other thoughts on the internet industry.

Note: After the transcript I’ve included some further references related to points in the discussion. I also realize some comments in the conversations are over-simplified, but my friends/readership fall all along the spectrum of economics knowledge, so I usually opt for over-simplifying and clarifying details for those who ask. Any comments, critiques, or elaborations are welcome at loganfrederick@gmail.com.


Part One: Shortly Before Leaving Work, Micah Asks Me a Question

4/24, 5:10pm – Micah Fivecoate: So, does Fred’s post explain Castlight?

4/24, 5:10pm – Logan Frederick: I haven’t read through his post yet
But Just from the comments
It is a big part of it
I will respond tonight
After I read his article

4/24, 5:10pm – Micah Fivecoate: I don’t understand yet how it’s tech-specific

4/24, 5:10pm – Logan Frederick: Basically the simplified chain is
Fed lowers interest rates -> Means it’s really cheap to borrow money -> So everyone starts borrowing money -> That money is expected to be put to work to earn a return -> But given the economy now, a lot of industries and assets do not look that appealing -> Tech/internet sector looked pretty strong coming out of financial crisis with increased usage and actual revenues/profits from the giants -> Investors with cheap cash view that as the best place to get a return -> All the money goes into tech

4/24, 5:13pm – Micah Fivecoate: Ah, okay

4/24, 5:13pm – Logan Frederick: Even more basic, it’s just two factors: Tech companies look like the biggest growth opportunity compared to all other asset class, and the Federal Reserve policy makes it very easy for investors to get money to invest in tech

4/24, 5:13pm – Micah Fivecoate: So, it’s a combo of free money + tech looking good

4/24, 5:13pm – Logan Frederick: Yeah
That’s really it
If/when Fed rates rise
It will surely hurt tech company valuations
Even as some commenters said it would be a signal the economy is stronger or inflation is higher
But regardless, less money would be available for investment
So some companies might do better with higher interest rates, but overall valuations will be lower in real terms

4/24, 5:15pm – Micah Fivecoate: Wonder what would do better with higher interest rates
I guess any co with lots of cash
or that facilitates loans

4/24, 5:16pm – Logan Frederick: Well assuming rates go higher because of a strong economy, you could reasonably expect that the large tech companies would be doing well

4/24, 5:16pm – Micah Fivecoate: Oh

4/24, 5:16pm – Logan Frederick: The fed interest rate moves
Are more a trailing indicator
“Oh, economy is strong? Then we raise rates”
But your point was right as well to a degree, a company with a lot of cash can weather a rate increase better because it does not need to borrow

4/24, 5:18pm – Micah Fivecoate: So, is the effect to slow change when things are strong, and accelerate change when the economy is weak?

4/24, 5:18pm – Logan Frederick: Yep
That’s the basis of Monetary Policy

4/24, 5:18pm – Micah Fivecoate: cool

4/24, 5:19pm – Logan Frederick: You can continue down the rabbit hole of Monetary Policy theory, but all the research and debates are about what is the best mechanism for maintaining/finding the right equilibrium of economic strength or growth in relation to interest rates
The libertarian/anti-Fed Reserve crowd’s argument boils down to: The Fed does more to deviate us from the right equilibrium than help
In the pre-modern Federal Reserve era (pre-1917 if I have the year right)
Individual banks set their interest rates
I could go on and on, but I am packing up at work
Will respond more after reading Fred’s blog

4/24, 5:22pm – Micah Fivecoate: Cool, I’ll read up a bit on monetary policy in the meantime

4/24, 5:22pm – Logan Frederick: lol Good deal, see ya in an hour

4/24, 5:22pm – Micah Fivecoate: later


Part Two: An hour later with a glass of wine and dinner at Logan Bar and Grill


4/24, 6:16pm – Logan Frederick: I did not realize that this blog post
Was the same one posted a month ago

4/24, 6:17pm – Micah Fivecoate: Oh

4/24, 6:17pm – Logan Frederick: I didn’t fully read it then either
Halfway through, don’t see anything I disagree with and is pretty simple finance
I like Fred
It’s pretty simple finance but his readership is tech folk
So it’s good to post this kind of analysis
So Finished his post
Agree with it all, but it’s only half the story
Which is disappointing

4/24, 6:20pm – Micah Fivecoate: Yeah, it wasn’t clear from his post why the money would be going in to tech

4/24, 6:21pm – Logan Frederick: Well that’s not what I meant by half the story

4/24, 6:21pm – Micah Fivecoate: oh

4/24, 6:21pm – Logan Frederick
But that’s also true
But I filled in that part for you
That you can draw, from his post

4/24, 6:21pm – Micah Fivecoate: yeah
4/24, 6:21pm – Logan Frederick:
If you judge things by growth rate
Tech offers the best right now
And always, really
I don’t like “tech” as a sector term
I prefer “software” or “internet”

4/24, 6:22pm – Micah Fivecoate: oh, makes sense
“tech” isn’t necessarily the same sort of low-marginal cost business

4/24, 6:23pm – Logan Frederick: Well I just mean it as tech is too vague a term
In a recent copy of Intelligent Investor, editor Jason Zweig overlays one of the tech stocks of the 80s (IBM I think) on top of General Motors in the 1920s and it’s the exact same. Because General Motors was the “tech” of that era

4/24, 6:23pm – Micah Fivecoate: hah, yeah

4/24, 6:23pm – Logan Frederick: But that’s semantics

4/24, 6:24pm – Micah Fivecoate: barnes and noble isn’t doing too well with their printing press tech

4/24, 6:24pm – Logan Frederick: Your point is valid too, in that different “tech” companies have different business models
Barnes and Noble has a lot of issues and I should look again at shorting them maybe
It’s scary now that they keep decreasing in market cap, someone will take them over before they go bankrupt (possibly)
Hard to short in that situation

4/24, 6:25pm – Micah Fivecoate: Oh, yeah

4/24, 6:25pm – Logan Frederick: I can guarantee some PE firm has run numbers on them
If it’s a takeover candidate or not

4/24, 6:26pm – Micah Fivecoate: Yea, it’s pretty high-profile

4/24, 6:26pm – Logan Frederick: High profile, really the only monopoly in the space left, even if it is a shitty industry of bookstores
But that’s the job of a PE guy, run the numbers of what their debts are, do they own their real estate locations? What’s the value there?
How many costs can be cut?
If we can get them for $100 or $200 million, can we reconfigure them to spit out enough free cash flow to cover whatever debt they have/we add AND give us a private equity level return?

4/24, 6:35pm – Logan Frederick: I should turn this into a blog post
And write a blog post in response to Fred’s
I did not elaborate on what I meant as “the other half of the story”, which is what happens when interest rates rise again to the levels he suggests in the post

4/24, 6:36pm – Micah Fivecoate: Oh, yeah

4/24, 6:36pm – Logan Frederick: And that’s the sound of the bubble popping
The high valuations will end either when the Fed decides to raise interest rates (by their indications 2016 I think?) or when companies with high valuations fully realize that they can not earn returns on their investments
Whichever comes first

4/24, 6:37pm -Micah Fivecoate: the giant sucking sound of all the money leaving SV

4/24, 6:37pm – Logan Frederick: At least some of it, yes
I’m still a big believer in tech and think software still has a lot of room to run

4/24, 6:38pm – Micah Fivecoate: Oh, are they planning to raise rates in 2016?
looks like
maybe going to 2%ish in 2016?

4/24, 6:42pm – Logan Frederick: But I think people forget that software is meant to improve things and that largely means taking process which cost $100 using humans to cost $10 using machines, but that generally speaking means a lot of software companies don’t need to be as big as companies of old
Paul Graham says as much in one of his essays
The goal should be maximizing profit per employee. Can you have a billion dollar company with only 10 people?
Software shouldn’t require a business to need to be valued at $100 billion
You can replace General Motors with new high tech cars…at a lower valuation
I’m kind of shooting ideas from the hip, but you could vet them out and qualify them where need be, but the general point stands I think

4/24, 6:43pm – Micah Fivecoate: What principle does the rev/employee metric maximize?

4/24, 6:44pm – Logan Frederick: Well from the PG essay he was just talking about software leveraging human talent, that was his point there
I’m sort of adding on that you could make the link that PG’s point implies valuations don’t need to be as big to have as significant an impact/be as disruptive
A five person, $10 million company could hypothetically replace a 10,000, $10 billion company
Craigslist versus the newspapers as an example

4/24, 6:45pm – Micah Fivecoate: Yeah, i guess it’s how you define disruptive

4/24, 6:45pm – Logan Frederick: So then why, taking it a step further, are investors and tech entrepreneurs *seeking* valuations larger than the company is intrinsically worth

4/24, 6:45pm – Micah Fivecoate: Oh, and the profits of the $10B company just dissipate into the market at large

4/24, 6:45pm – Logan Frederick: Intrinsically judged by how much money they actually make over a future time span
Exactly

4/24, 6:46pm – Micah Fivecoate
Shouldn’t the smaller company be able to keep profits as high?
like, costs could go down
maybe the profits would fall because the competition could implement the same software, and there wouldn’t be as much room for differentiation
or just it’s harder to justify to customers such a large profit margin
or is valuation tied in some way to gross revenue rather than net

4/24, 6:49pm – Logan Frederick: If a new software startup has costs of revenue (cost of providing the service) much lower than an old non-software company in the industry, the company won’t keep their price point at the same as old company because their customer’s substitution costs wouldn’t be affected. Their disruption will lower the costs to customers, and then depending on the industry, competition could drive those lower over time
Yeah, I typed that as you typed, but basically you as a new disruptive company would have higher profit margins, but lower prices than your old incumbent

4/24, 6:50pm – Micah Fivecoate: yeah
So you can initially keep the same profit, but lower price due to lower costs
but then other people start competing with you with software
and that’s what takes the valuation down

4/24, 6:52pm – Logan Frederick: Well valuation goes down even before your second step of competition

4/24, 6:52pm – Micah Fivecoate: because they know it’s coming?

4/24, 6:52pm – Logan Frederick: Well no, I take my last statement back
This would be an empirical question, but I would guess most software that very directly replaces an old manual task
Does not have gross profits greater than the old manual business
That’s hard to test empirically I think because most software replaces a cost of an old manual task
So you’d have to say, what were people spending on process A that was replaced with software product B
And cost of B is probably less than A
So in terms of valuation
It’s odd to word it this way
But what was the “valuation” of the dollars spent on A versus the valuation of company B
But I would guess if you did that kind of test
B is significantly lower
And that’s my point of valuation being naturally lower

4/24, 6:55pm – Micah Fivecoate: Weird
It seems like if one company can provide the same service at a lower cost
they should have a higher valuation
Might be running in to some sort of efficient-market fallacy

4/24, 6:56pm – Logan Frederick: I always view valuation in terms of return on investment
If the cost and price are lower
You can have a high ROI and still come up with a valuation number lower than the old incumbent
And then like you said earlier
If the ROI is *that* good
Then competition comes in and keeps everything in check like prices, cost, valuation

4/24, 6:58pm – Micah Fivecoate: Yeah
I guess, I’m thinking if the incumbent charges $100 for a product that costs them $90 to produce
and the disruptor charges $90 for $10 cost
then disruptor should have a higher valuation

4/24, 6:59pm – Logan Frederick: That is true

4/24, 6:59pm – Micah Fivecoate: but it probably just rarely works out so well
and then competition

4/24, 7:00pm – Logan Frederick: And that’s where it’s a case by case basis and where I think the tech industry screws up
I agree with your statement
Maybe half of software companies are like that
And another half, the bad ones, think they are doing that but are really only charging $20 at a $10 cost or charging $90 at an $80 cost, and so shouldn’t have a higher valuation
But because they are “tech” they and others think they should have the same multiples

4/24, 7:01pm – Micah Fivecoate: Hah, yeah

4/24, 7:01pm – Logan Frederick: And that’s part of why you get bubbles
Businesses thinking they can achieve a level of profitability and margins that similar-ish companies have
But really the business is not the same
And they don’t achieve it
And I guess my larger point would be
There is nothing wrong with *not* having the best margins
You just have to accept your okay margins and profits and accept that your valuation will be okay
But in a bubbly environment, every company thinks they will have the best margins, profits, and a valuation that their real margins and profits do not justify

4/24, 7:04pm – Micah Fivecoate:
Makes sense
So, is that purely because there’s too much money that wants in on this market

4/24, 7:06pm – Logan Frederick:
Yeah, so companies raising money can get away with it
If there wasn’t as much money available, investors would be more picky

4/24, 7:07pm – Micah Fivecoate: Doesn’t seem like the risk tolerance would shift with the amount of $ available
maybe it does though

4/24, 7:08pm – Logan Frederick: I could be wrong, but I think it does, although long-term it has been trending toward high valuations and more entrepreneur control, specifically in the computer software and hardware industries. Over decades that may continue.
But I say the risk tolerance does shift
Because VCs, the main drivers of these valuations, have investors themselves
And in weaker economic climates
There is a real possibility of VC investors, the big funds, saying they won’t do as much VC investing
And if VCs are worried about bad returns
They will get more choosey when it comes to investing

4/24, 7:09pm – Micah Fivecoate: Oh, interesting

4/24, 7:09pm – Logan Frederick: I can think of some counterarguments on both the high and low end though
On the high end, you could argue that VCs will still pay whatever it takes to get into the clear winners, the “next Google”
And on the low end, the dollar amounts are so low it doesn’t hurt them to continue this
And that leads into what people have been saying about Series A and B crunches
Companies in the middle of these two places who haven’t proved their worth to VCs that they can earn big returns but need more money than seed rounds can provide
I dunno how valid the Series A or B crunch is based on a few articles I’ve read, but that logic I just laid out would explain why it exists
VCs are just increasingly worried about investments in those stages

4/24, 7:11pm – Micah Fivecoate: Yeah

4/24, 7:11pm – Logan Frederick: Series D is safe
Seed is safe
By VC math

4/24, 7:11pm – Micah Fivecoate: right

4/24, 7:12pm – Logan Frederick: Any other thoughts/questions for me?
That I can come up with half-assed, on the spot answers for


Notes:

  1. Regarding my comment about wanting to maximize revenue per employee from Paul Graham, I tried finding the exact PG comment I had in mind. My memory of it may have been off. His essay “How to Start a Startup” has the closest passage to what I was thinking that I could find quickly:

    “If hiring unnecessary people is expensive and slows you down, why do nearly all companies do it? I think the main reason is that people like the idea of having a lot of people working for them. This weakness often extends right up to the CEO. If you ever end up running a company, you’ll find the most common question people ask is how many employees you have. This is their way of weighing you. It’s not just random people who ask this; even reporters do. And they’re going to be a lot more impressed if the answer is a thousand than if it’s ten.

    This is ridiculous, really. If two companies have the same revenues, it’s the one with fewer employees that’s more impressive.”

  2. My comments at the end about Seed funding and late stage funding being safe for venture capitalists is based on discussion in the past six months on what the media called the “Series A” and “B” crunches. There was debate on whether there was a trend in venture capital of increasing investments in really young or really old companies, but a lack of investment for companies in the middle. Google “Series A Crunch” or “Series B Crunch” for more details.