Machine Zone and The Perversity of Unicorn Lists

horse-58374_640

Machine Zone (MZ) is a Palo Alto-based, mobile gaming startup with a massively popular Top 2 iOS USA app store hit called “Game of War: Fire Age.” [GoW].

MZ describes Game of War: Fire Age as:

“.. a real-time mobile massively-multiplayer online game and parallel chat-speak translation application that translates over 40 languages for its players in real-time, connecting game players around the globe at the same time in a single virtual universe.”

A New York Times reviewer of Game of War’s said:

“The game’s most impressive feature is an instantaneous translation of text-based online chat. If someone writes “MDR” in French (for “mort de rire,” or “dying of laughter”), an English-speaking player sees it as “LOL.”

Game of War is MZ’s only published game to date. We have estimated (see below) MZ’s current annualized revenue run rate at $1.1 Billion based on that game alone. At a valuation multiple of 2.5x, half way between publicly held mobile game companies Glu Mobile and Zynga, we place MZ current valuation at $2.75 Billion.

This is a conservative valuation. According to its CEO Gabriel Leydon, there is third party interest in licensing it real-time chat translation engine. We believe that this technology would be a valuable addition to the likes of Facebook’s WhatsApp and/or Slack.

Yet, Machine Zone cannot be found on any so-called Unicorn lists — startups with $1+ Billion valuations like the one Fortune Magazine recently published. To qualify for such lists, a company must be mentioned in the press as receiving a round of venture capital and a whispered valuation of $1+ Billion.

No matter if the funding and valuation came with “liquidation preferences” that would limit any loss in the investment and skew the implied valuation upward.

No matter if a company like Machine Zone is so profitable early on that it does has not needed any venture capital since a Series B round years ago.

Specifically, CrunchBase reports a total of $13.3 Million in VC funding for MZ, with the last round being a Series B done a full three years ago.VentureBeat reported a total of $16 Million so there could be some $3 Million in angel money not captured by CrunchBase.

At a $2.5 Billion valuation, the VC return would be 156x. MZ’s return compares favorably to the 100x return that VC’s looks for every couple of years to make up for all of the other failed investments in their portfolios.

Machine Zone’s exclusion is not only perverse, it is ironic. Unlike other Unicorns, the public has access to mobile game company “cash register” data supplied for free by analytics companies like App Annie or Think Gaming who record “freemium” game in-app purchases bought through iOS Apple Store or Google Play. Anyone interested in tech would love access to “cash register” trend data of other Unicorns like Uber, Airbnb and Dropbox.

Machine Zone: The $4 Billion Unicorn That Walks the Walk

Machine Zone: The $4 Billion Unicorn That Walks The Walk

Includes:FB, GLU, KING, ZNGA

Summary
  • Machine Zone is a mobile game startup with an estimated revenue run rate of $1.1 Billion and a 2.5x valuation of $2.75 Billion.
  • But, it cannot be found on any $1+ Billion “Unicorn” lists because such lists require venture funding for validation. MZ is so profitable it does not need venture capital.
  • The CEO never talks to the press about an IPO. But recently, the CEO mentioned interest in licensing its real-time, crowd-sourced, scalable chat translation engine.
  • We think that both Facebook’s WhatsApp and Slack and would benefit greatly by this technology. MZ is more than a one hit wonder.
  • This prospect is sufficient to jump MZ’s valuation above the $4 Billion mark.

Machine Zone [MZ] is a Palo Alto-based, mobile gaming startup with a massively popular Top 2 iOS USA app store hit called “Game of War: Fire Age.” [GoW].

MZ describes Game of War: Fire Age as:

.. a real-time mobile massively multi-player online game and parallel chat-speak translation application that translates over 40 languages for its players in real-time, connecting game players around the globe at the same time in a single virtual universe.

This is how the New York Times described the real-time chat translator embedded in GoW:

The game’s most impressive feature is an instantaneous translation of text-based online chat. If someone writes “MDR” in French (for “mort de rire,” or “dying of laughter”), an English-speaking player sees it as “LOL”

GoW is MZ’s only published game to date. We wrote first about MZ in a Seeking Alpha article eight months ago, estimating then that its annualized revenue run rate [ARR] was at $831 Million with a 2.5x valuation of $2.04 Billion. We were the first to establish MZ as a $1+ Billion startup, aka a Unicorn.

Based on Seeking Alpha supplied page view metrics, this article has become slowly over time our top viewed article among the 21 we have written for SA in the past year.

This article is a follow-up. We update our estimates of MZ’s annualized revenue run rate and valuation. We also cite a recent interview given by the CEO where he mentions interest in licensing MZ’s chat translation engine.

We have identified two well known, highly successful companies where chat is core — Facebook’s WhatsApp and Slack, the fastest growing SaaS startup of all time. Both companies would benefit greatly by adding real-time translation to their chat core.

Eight months ago, we derived a $2.04 Billion dollar valuation for MZ. Shortly thereafter, the Wall Street Journal reported that MZ was in talks with VCs for funding that would place a $3 Billion valuation on the company. Nothing materialized.

Based on increased ARR for GoW plus interest in licensing its real-time chat translation engine, we now place a $4 Billion valuation on the company.

Yet, MZ’s name still cannot be found on any Unicorn list such as the one recently featured in Fortune magazine. This is due to the perverse qualifier that the valuation must be come from a financial press article or blog post referencing a VC funding round and a whispered valuation.

No matter if that valuation came from funding with “liquidation preferences”. No matter if a startup is so profitable, as is the case with MZ, that no additional funding is required after a Series B round done years ago.

Besides the perversity of MZ being excluded from Unicorn lists, the exclusion is also ironic. Unlike other Unicorns, the public has access to mobile game company “cash register” data supplied for free by analytics companies like App Annie or Think Gaming who record “freemium” game in-app purchases bought through iOS Apple Store or Google Play. Wouldn’t you like access to “cash register” trend data of Uber, AirBnB and Drop Box?

The availability to the public of game revenue rankings has not been recognized for its place in the democratization of financial investing data. This trend was first recognized by famed fund manager Peter Lynch some 40 years ago.

The trend line goes from Lynch’s observation that anyone could see the financial implications of the L’eggs hosiery racks in grocery stores, to weekend box office receipts published by Variety, to near real time stock prices made available for free by Yahoo and Google Finance.

The line continues with real time audio of quarterly conference calls to transcriptions of these calls on SA (thank you SA!) to App Annie daily revenue ranking charts of mobile games by country.

App Annie even has revenue ranking data of games in “geo-lock” test releases in locations like Canada and New Zealand.

Freely available pre-release data of a game’s revenue potential is a step up from other well know pre-release indicators like out of town reviews of a Broadway-bound musical or reports of the reception of a test item on McDonald’s menus in Australia.

In addition to MZ’s absence from Unicorn lists, there are only a handful of published interviews with CEO Gabriel Leydon. You cannot find an interview where the CEO mentions revenue, valuation or IPO.

MZ is a rare Unicorn that walks the walk, not talks the talk.

This is in contract Kabam, the other mobile game startup identified as a Unicorn (no longer) who has talked the talk, and not walked the walk lately.

Based on our close observation of Kabam’s press over the past two years, we offer this Letterman-like list of the top 5 signs a Unicorn is talking the talk too much:

5. Still has a booth at SXSW five years after first showing

4. SVPs give more interviews than CEO

3. CEO quantifies to press revenue and money in bank

2. CEO’s company pays for naming right to football field of alma mater.

1. CEO now spikes hair with mousse for video interviews.

Now back to how we derive a current valuation for MZ.

The table below presents our derivation of a current ARR of $1.1 Billion for GoW, up from our $831 Million estimate made eight months ago.

Item $ Millions Row Source
Estimated ARR GoW – iOS USA $437 r1 Think Gaming x365
iOS Share of Global Game Revenue 63% r2 App Annie
Android Share of Global Game Revenue 37% r3 App Annie
Sum of Share 100% =r2 + r3
iOS USA share of iOS Global 70% r4 Source: our estimate
Ratio of iOS USA to iOS USA 1.00 r5
Ratio of Android to iOS USA 0.84 r6 = r3 /( r2 * r4)
Ratio of iOS Rest of World to iOS USA 0.68 r7 = (1 – r4) / (r2 * r4)
Sum — Global to iOS USA 2.52 r8 = r5 + r6 + r7
Estimated ARR — GoW Global $1,102 r9 =r1 * r8

The source of MZ’s revenue growth in the past year has been the combination of organic growth in spending by dedicated players plusnew downloads resulting from a $40+ Million ad campaign featuring the busty Kate Upton.

From this you have to subtract the loss of people disgusted by the Upton ads as evidenced by massive amounts of derisive tweeting going on in the last 4 months. The ads themselves, not the ad campaign, has been the only questionable move by MZ since inception.

Indeed, we believe that MZ and its flood of Upton ads embedded in other free mobile games was the cause of an unprecedented, simultaneous #1 ranking of the free (ad supported) and paid versions of the same game, Trivia Crack. This was due to millions of freeloading players willingly forking over $2.99 just to avoid the Upton ads.

(click to enlarge)

Below is a table of calculated price-sales ratios, specifically market valuation / annualized run rates, for the three pure play mobile game companies with substantial sales in the USA: Glu Mobile (NYSEMKT:GLU), King Digital (NYSE:KING), and Zynga (NASDAQ:ZNGA). The range is from a low of 1.83 for GLU to a high of 3.19 for ZNGA.

Glu Mobile King Digital Zynga
$ Millions $ Millions $ Millions
Market Value 3-20-15 534 4,760 2,460
ARR = 4 * 4Q14 Sales 291 2,219 770
Price / Sales Ratio 3-20-15 1.83 2.14 3.19

It should be noted that both KING and ZNGA sported 6+ price-sales ratios at the time of their IPOs.

We think that the midpoint of the figures above — 2.5x current ARR — is the appropriate figure to use in valuing MZ. This would place its current valuation at $1.1 Billion * 2.5 = $2.75 Billion.

But MZ has value beyond the ARR of a single game. MZ is not a one hit wonder.

First, MZ is amazingly “lean” in terms of its operations as measured by ARR / employee. This translates into profitability, something rare among Unicorns.

Below is a table that compares MZ’s head count with two big mobile game companies based in San Francisco — the troubled dog of a company, Zynga, and the stumbling startup Kabam.

Both Zynga and Kabam had a string of failed game releases in 2014. Unless the fortunes of these companies change in 2015, there could 1,000+ unemployed mobile game people walking the streets of San Francisco this fall.

While we are on the subject of head count, the San Jose Business Journal reported that MZ has leased an estimated 140,000 square foot space on Page Mill Road in Palo Alto that used to be Facebook’s old headquarters.

Furthermore, there is an adjacent 140,000 square foot space now leased short term to Nest and Google that may be available to MZ later.

At 250 square feet / employee, this new MZ facility could accommodate an additional 560 employees now with another 560 employees being housed in the adjacent space once Google completes its futuristic new HQ in the Shoreline area of Mountain View.

The other metric of MZ that is amazing is its ratio of current valuation to total VC finding. CrunchBase reports a total of $13.3 Million in VC funding with the last round being a Series B done a full three years ago.VentureBeat reported a total of $16 Million so there could be some $3 Million in angel money not captured by CrunchBase.

At a $2.5 Billion valuation, the VC return would be 156x. At a $4 Billion valuation (see below), the VC return would be 250x. MZ’s return compares favorably to the 100x return that VC’s looks for every couple of years to make up for all of the other failed investments in their portfolios.

We now turn to the case that MZ has value beyond the ARR generated by a single published game.

CEO Gabriel Leydon recently gave a revealing interview to Robert Kolker of Bloomberg Business Week. For us, this was the first interview of any substance that Leydon has given since GoW was released for iOS two years ago.

Leydon may have been asked about revenue, scale, venture capital, and IPO, but evidently he declined to comment. He also did not talk much about the specifics of GoW itself.

Basically, Leydon relishes talking about two things: (1) how hardcore GoW’s fans are; (2) how hardcore MZ’s engineering is.

A Leydon supplied metric on the hardcore GoW fan:

The average player…plays for two hours per day, in 12-minute sessions, 10 a day.

A Leydon supplied metric on MZ’s engineering prowess:

…Game of War accommodates about 3 million users in simultaneous play, with what the company clocked as a 0.2-second response time…. This is the largest real-time concurrent interactive application ever built. There’s nothing even close to it.

For us, the most interesting section of the interview was Leydon’s belief that the MZ’s chat translation technology would be of value to the likes of Facebook (NASDAQ:FB). (specifically,we presume Facebook’s $19 Billion acquisition WhatsApp)

From the interview,

It’s closer to a social network than it is a video game,” Leydon says. “Facebook has pokes and messages and things like that. In Game of War, you have attacks and friends and chats.” Leydon argues that Game of War’s social interplay is far more complex; among other things, Facebook interactions across language borders are limited.

He goes on

Leydon, meanwhile, intends to focus on what his new networking technology can accomplish outside the gaming world. He says dozens of companies have asked to license Machine Zone’s translation engine. Its applications, he says, span beyond gaming and into finance, logistics, social networking, and data analysis.

A more intriguing partner for MZ than WhatsApp would be Slack, the fast-growing collaboration and chat startup.

MZ’s history is a inversion of Slack’s. MZ completes what Slack starts. You could argue that MZ is a doppelgänger of Slack.

Slack started out as Tiny Speck, a startup attempting to build a massive multi-player game. The game was never completed, but a side-project piece of software developed for collaboration morphed into the fastest growing SaaS in history.

MZ produced the hit game that Slack could not complete. As a side-project, MZ built a chat translation engine that fills in critical gaps in Slack’s wild success.

Slack has already invaded software R&D and content creation departments, both requiring close digital collaboration. Slack is now moving horizontally throughout enterprises where these departments are core.

By adding a real time chat translation engine to its offering, Slack could make in roads into globally distributed enterprises that service other globally distributed enterprises.

For example, this might include global insurance companies like AXA and Zurich Insurance that handle insurance needs globally of a company like Exxon Mobil. It might include global banks like Citibank and Deutsche Bank that handle the banking globally for a company like GE or Siemens.

MZ’s chat translation engine could be a global enterprise door-opener for Slack.

This article is tagged with: IPO Analysis

The Bancorp: Continuing Problems With A Discontinued Operation

  • The Bancorp filed a NT 10-K recently notifying the SEC that it had failed to file its 2014 10-K within the allowed 75 days.
  • We believe that the reason for this failure has been a reconsideration of the markdown of the loan portfolio associated with its discontinued commercial lending operation.
  • The Bancorp has until March 31st to file a 2014 10-K. We present the case that the bank will be booking an alarming 5% to 10% additional markdown.
  • As a result, we believe that the stock will drop another 15% in the next week and will test its 52-week low of $7.81 a share.

On October 31, 2014, The Bancorp (NASDAQ:TBBK) announced that it was discontinuing its commercial lending operations. Based on an independent third party review, it set aside for sale a loan portfolio with a fair market valuation of a 6.8% discount from its $1.2 Billion principal.

Two months later, on the next to the last business day of the year when most of Wall Street was home making New Year plans, the bank issued a terse 8-Kstating that it had sold a partial $267.6 Million loan package that had been marked down in October to $213.5 Million. The sale was to a newly created LLC, financed largely by the bank itself, (more on that later) for $209.6, resulting in a small loss on sale of $3.9M.

This end of year transaction caught our eye. We did the numbers and found a huge discrepancy between the overall loan portfolio markdown of 6.8% and the 20.2% markdown of the piece sold in December. The December partial sale implied that the remaining 78% of the portfolio still on the bank’s balance sheet was covered by only a 3.0% markdown.

Below is a spreadsheet, which shows how we arrived at this implication. An earlier version was presented in our January 2015 SA article on The Bancorp.

The Bancorp – Commercial Loan Portfolio Discontinued – Q3’14
Q3’14 12-30-14 Sale Q4’14 Pro Forma
Outstanding Loan Principal 1,222.6 267.6 955.0
Loan Loss Reserve at Time of Discontinuation (44.0)
Additional Markdown at Time of Discontinuation (38.9)
Total Markdown (82.9) (54.1) (28.8)
Fair Market Carrying Value 1,139.7 213.5 926.2
Markdown as % of Principal 6.8% 20.2% 3.0%
Carrying Value as % of Principal 93.2% 79.8% 97.0%

There was nothing in the terse December 8-K to assure investors that the remaining portfolio on its books was marked fairly. Management should have told investors that it had a plan to sell the portfolio in pieces with the most toxic piece sold first.

As a consequence of this lack of communication, the stock dropped 22.8% from $10.89 on December 31, 2014 to $8.41 on February 2, 2015.

TBBK Chart

TBBK data by YCharts

Only during its Q4’14 conference call, thankfully transcribed by SA, did the bank make it clear that it had a plan. It also reassured investors that the remaining 78% piece was fairly marked.

Finally, the CEO Frank Mastrangelo offered investors a time frame during which the bank hoped to complete the sale,

… we will have some of the sales bleed into Q2 although it’s certainly possible and plausible that some will still occur this quarter.

As a result of these February clarifications, the stock has recovered somewhat rising 11.2% to $9.35 a share as of the date of this paper. Fast forward to today (3-24-15) and still no sale. The longer this continues, the greater will be the bank’s problems.

While the problems are general to cases of continuing discontinued operations, we will argue below that they are worse for a highly leveraged, regulated bank like The Bancorp. Furthermore, we will argue that The Bancorp specifically has made a bad situation worse.

Management, including the bank’s former long time CEO Betsy Z. Cohen and its current, long time Board Chairman Daniel G. Cohen have to be held accountable for this continuing problem. The problem can be broken down into interrelated issues with pricing, accounting, and management. We detail below The Bancorp’s problems:

Pricing and Accounting Issues

The speed at which assets are sold is a function of price. Fairly marked assets should sell fairly quickly. In turn, price is a function of terms. Set a high nominal price but offer liberal seller financing and the sale closes faster at the high nominal price. As evidenced by the December sale, The Bancorp will go to great lengths to extend terms to close a loan sale without dropping price below its prior mark (more later).

Lack of time to shop this portfolio or lack of time for potential buyers to perform “due diligence” cannot be the reason for this delay as it has been 5 months since this portfolio was first officially marked “for sale.” The conclusion has to be that our estimated 3% markdown of remaining portfolio is insufficient to close a sale. If it were a matter of having to concede 1% or 2% more, the bank would have done so and booked a small loss in 2015.

For most corporations, conceding an additional 5% to 10% markdown to sell a discontinued operation would be bad, but not catastrophic. Not so for regulated, highly leveraged commercial banks. Especially not so for The Bancorp, who already is at the low end of various bank equity/asset ratios.

The Bancorp’s Q4’14 simple equity/asset ratio was 7.64% (359.6/4,706) Having to close a sale by taking an additional 10% markdown on a $955 Billion loan principal would cause a $95.5 Million hit to the balance sheet. This would represent a 27% reduction in its equity.

Also, taking this kind of hit upon sale now would taint 2015 earnings. The bank would have been better off taking the hit in 2014. But wait a minute… On March 16, 2015 the bank filed something called an NT 10-K – A Non-Filing Notice to the SEC stating why it failed to file its Annual 10-K report within the allotted 75 days.

It now has until March 31, 2015 to submit a final 10-K. Doing this allows the bank to record any additional markdown as a loss in 2014 rather than 2015. The reason given for this failure was that it needs more time to finalize its accounting for the Q3’14 discontinuation event and for the Q4’14 sale of the toxic piece.

Filing an NT-10 is a significant event. It can signal the existence of a major accounting debate between management and its auditors. It also can signal a last minute capitulation and reversal internally over how a company accounted for a prior event.

We have called investor relations at TBBK and left a message, asking for a comment to our estimation that they will be making a significant 5% to 10% additional markdown by March 31st. They did not return our call.

We view the Bancorp’s filing as a signal that by March 31st, they will be recording an additional 2014 markdown loss, thus sparing a hit to 2015 earnings. In light of how long this has dragged on without a sale, our belief is that the bank will be taking an additional 5% to 10% markdown needed to close a cash sale within the next month.

But, this additional markdown will not mark the end of The Bancorp’s continued involvement with its discontinued operation. It had to resort to seller financing to close the sale of the toxic piece in December. See the spreadsheet below of how The Bancorp financed this sale:

The Bancorp Loan Sale – Q4’14 $ Millions
Principal of Loans Sold 267.6
Mark to Market (54.1)
Fair Market Value of Assets Sold 213.5
Loss On Sale (3.9)
Sale Price 209.6
How Walnut Street LLC Financed Purchase % of Finance % Ownership
Equity – AG Mortgage Value Partners LP 16.0 7.6% 51.0%
Sub NR from Bancorp @ 10% for 10 Years 15.4
NR from Bancorp – 1.5% 10 Years 178.2
Total Bancorp Financing 193.6 92.4% 49.0%
Total Financing 209.6 100.0% 100.0%

When asked in the February 2015 conference call whether the bank would resort to seller financing again, CEO Frank Mastrangelo said

It’s certainly not the first option or priority, would we consider it in the right transaction, possibly but just not certain there is going to be a need to do that.

Remember price is a function of terms. You can always get your asking price if you are willing to provide liberal seller financing. If the remaining portfolio does close without significant additional markdowns, our bet is that the bank accomplishes via continuing involvement (off-balance sheet, of course) in this discontinued operation.

Management Issues

Employees can be expected to jump ship when any corporation declares an operation “discontinued.” And if the discontinued operation is “knowledge worker” intensive, as is the case with a commercial loan operation, resignations can result in a significant deterioration in financial metrics.

This has been the case in spades with The Bancorp. On January 8, 2015, the bank’s Executive Vice President, Arthur Birenbaum, who had been in charge of this discontinued operation, handed in his resignation. He had served the Cohen family, founders of The Bancorp, for the last 25 year in various capacities.

Four days later, it was reported that Mr. Birenbaum had been hired by the Cape Bank of Atlantic City to set up a new commercial loan operation in The Bancorp’s home territory of Philadelphia. It can be assumed that since the middle of January 2015, Mr. Birenbaum has been contacting and later hiring loan officers from The Bancorp’s discontinued operation.

This means that for the past 3 months, The Bancorp’s commercial loan operation has had no experienced manager and few engaged loan officers. Surely, this lack of management has increased servicing and collections problems.

Additional disclosure: On Thursday, at the suggestion of our SA editor, I called Investor Relations at TBBK and left a message asking specifically if they intended to make an additional mark down to their discontinued loan portfolio in the range of 5% to 10% by March 31st. They did not return my call and I noted that in the article

Life Lessons From Five Nights at Freddy’s Game

I am not a mobile game player. I am a financial analyst who writes papers on the mobile game industry that are freely available. Up to now I have spent little time thinking about why a particular game is popular.

Monitor Screenshot from Five Nights at Freddy's

Monitor Screenshot from Five Nights at Freddy’s

But, that all changed when I first saw screenshots (see above) of the immensely popular games Five Nights at Freddy’s (FNAF) and FNAF2 by indie developer Scott Cawthon.

The basic premise of the game is that you are so desperate to find work that you begin looking at newsprint ads (a horrific event in and of itself today). You find the following:

Newsprint Ad from Five Night at Freddy's

Newsprint Ad from Five Night at Freddy’s

The job is for a night monitor at a Chuck E. Cheese style pizzeria featuring animatronic characters. You apply knowing full well that Freddy Fazbear’s Pizza had been closed due to foul smells coming from the animatronics. You also know that the pizzeria was the site where five missing children were last seen.

You get the job and your life as a monitor begins.

I choose to describe the job as monitor carefully. Your are a monitor, not a security guard that walks around. It was the specific intent of this game’s developer to have the player sit immobilized for a six hours stretch in front of a computer monitor (see above again) with clickable buttons for a network of cameras placed throughout the pizzeria.

Hmm…sitting in an office immobilized for hours at a stretch monitoring a business. That what I did for years as a general ledger accountant. That’s what securities traders, air traffic controllers, nuclear power plant engineers do.

And now with Cloud, SaaS and especially mobile, business monitoring will be added to just about every employee job description.

Life as a monitor. What’s that like? What life lesson does Five Nights at Freddy’s offer us?

Life as a monitor occasionally involves what gamers call the “jump scare.”

Jump Scare gif from FNAF, Five Nights at Freddy's

Jump Scare gif from FNAF, Five Nights at Freddy’s

Casting an even wider net, Five Nights at Freddy’s is about more than life as a monitor. It is about the mediated life of whether or not what was seen was real.

The mobile game’s heritage are the movies Rear Window and Blow Up. The player in FNAF shares the same issues as Jimmy Stewart and David Hemmings.

Below is a screenshot of a real life jump scare — the stock market Flash Crash of May 6th, 2010 where the Dow Jones stock index dropped 560 points in 4 minutes. On YouTube videos of this event, you actually can hear stock traders screaming each time the graph below added another down bar.

Flash Crash Screen of S&P 500 May 6  2010

Flash Crash Screen of S&P 500 May 6 2010

This choice to use the Flash Crash of 2010 as an example of a real life jump scare was intentional because its represented a false positive of trouble. It was due to a single trader mistakenly placing an order for 4 Billion shares instead of 4 Million shares. The market quickly recovered most of its losses later in the day.

There are two takeaways I get from comparing mobile game jump scares to real life jump scares. There are others you might have and I invite you to share them in the note to this paragraph.

The most important takeaway that I get is that we need to remind ourselves, and our game-playing kids, that game jump scares trigger a “game over” without real consequences or a need to act. The feeling accompanying a game jump scare is a quick adrenaline rush followed by relief.

A real life jump scare triggers initially a “sick to your stomach” feeling that settles into a depression until you honestly assess the possible consequences and begin to act.

The second takeaway for me is that there is a downside to the democratization of monitoring business intelligence data — jump scares (and jump-for-joys?) triggered by false signals of a business’s health.

Professionals who historically monitor business intelligence data have learned not to jump scare. Before reporting a disaster or break-out, they do something called account analysis. They look first for that $10 Million journal entry where the debits and credits are reversed. They look for that booking of a $50 Million order should have been booked as a $5 Million order.

I know that the democratization of monitoring is a net positive for business as well as for society. Democratization of just about anything is a net positive. It’s just that we need to learn to temper the impulse to jump scare when monsters first appear.

The Bancorp: Bad Moon Rising

  • The Bancorp is a Philadelphia area bank whose stock has fallen 50% in 2014 due accounting and regulatory surprises.
  • On top of that, it announced it was discontinuing its commercial lending operations and set aside a $1.2 Billion portfolio for sale with an overall 6.5% mark-to-market discount.
  • An 8-K filed on the last business day of 2014 revealed a partial sale with a mark-to-market discount of 20.2%.
  • Another 8-K filed 3 days ago revealed that the EVP of commercial loans resigned effectively immediately.
  • Until there are assurances from management as to the quality of the remaining portfolio for sale, we rate this stock a sell.

The Bancorp (NASDAQ:TBBK) is a Philadelphia area bank founded in 2000 by the pioneering banker and lawyer Betsy Z. Cohen. A few bullet points from her resume:

  • Second female law professor on the East Coast after Ruth Bader Ginsberg
  • Founded Jefferson Bank in 1974; Sold it in 1999 for $370M
  • Instrumental in financing Philly’s Walnut Street downtown revival
  • Board Member – Aetna US Healthcare, Philadelphia Museum of Art, Bryn Mawr

Since inception, the bank’s Chairman has been her son, Daniel G. Cohen. A few bullet points from his resume:

  • CEO of three publicly-held companies whose market values crashed due to CDO investments
  • CEO, IFMI, 2010-12 when market value crashed 91%
  • CEO, Alesco Financial Trust 2007-10, when market value crashed 87%
  • CEO, RAIT Financial Trust, 2006-9 when market value crashed 98%

2014 was a bad year for The Bancorp as the bank was rocked by a series of surprise accounting and regulatory disclosures resulting in a 50% drop in its stock price.

TBBK Chart

TBBK data by YCharts

First there was an April 18, 2014 8-K disclosure in conjunction with the release of its 1Q14 results that “newly identified adverse classified loans”, caused a one-time addition to its loan loss reserve of $11.8 Million. The next trading day the stock dropped 14.9% from $18.60 to $15.84.

Then there was a June 10, 2014 8-K disclosure that the FDIC found that bank was in violation of the Bank Secrecy Act — namely that reloadable prepaid cards issued by The Bancorp were being used for extensive money laundering. The next trading day the stock dropped 30.3% from $16.36 to $11.40.

On December 1, 2014, there was 8-K disclosure that CEO Betsy Z. Cohen, 72, would be retiring at the end of the year.

Her son, Daniel G. Cohen, 42, remains Chairman of the Board. Four other Board members are Board members of other companies that Daniel G. Cohen has at one time controlled.

We see a “bad moon rising” for The Bancorp in 2015. We see “trouble on the way”.

In its 3Q14 10-Q, the bank announced that was discontinuing it commercial lending operations. Based on an independent third party review, it marked down the portfolio by an additional $38.9M to a fair market carrying value of $1.2 Billion:

” In addition to $44 million in the allowance for loan losses which was net against those loans, an additional $38.9 million expense resulted from the valuation to estimated sales price, which was also net against those loans. “

Here is a 3Q14 conference call exchange, as transcribed by SA, confirming the view of $82.9M as the difference between the outstanding principal and the fair market carrying value of the portfolio at that time.

Paul Frenkiel– Chief Financial Officer

Sure. Yes, those actually are separate, so maybe the easiest, I think the way you are trying to look at it was that at the end of the second quarter we had a reserve of about $46 million. We had some activity during the quarter, so we ended up with the reserve about $44 million and $38 million was basically in addition to that.

Matthew Kelley– Sterne Agee

Got you. So we can really think about it as an $82 million write-down or 7% or 8% of the unpaid principal balance. Is that the right way to think about it?

Paul Frenkiel – Chief Financial Officer

By 38 in addition to the 44 that had accumulated over a period of many years.”

On the next to the last business day of the year, December 30, 2014, the bank issued an 8-K stating that it had sold a portion of its $1.2 Billion commercial loan portfolio:

“The sold loan portfolio had an outstanding principal balance of approximately $267.6 million, which had been adjusted on the books of the Bank to estimated fair market value in the third quarter of 2014 upon the classification of the Bank’s related commercial lending operation as a discontinued operation and the transfer of the related portfolio to “held for sale” status. As a result of the estimated fair market value adjustment, the carrying value of the portfolio, as of September 30, 2014, was $213.5 million.”

Several things about this first sale caught our eye. The first thing was the mark-to-market discount associated with this relatively small piece of the portfolio:

(267.6 – 213.5) / 267.6 = 54.1 / 267.6 = 20.2%

This was way out of line with the overall average discount of 6.5% established just two months earlier.

Second, the sale was not for cash nor to an established third-party. It was for note receivables issued by a newly created LLC with the bank itself as 49% minority partner.

We ask ourselves, “How toxic can the full portfolio really be if this is what the bank had to do to sell just a portion of it?”

Maybe, they planned on an asymmetric sequence of sales, with the very toxic piece cut out first and sold to a related party at a steep discount.

Then they would sell the remaining clean piece with a mark-to-market discount of only 3% to an established third party willing to pay cash for a clean bundle.

But if this were so, why did The Bancorp not include an explicit statement in the late December 8-K of the planned asymmetric sale sequence?

Another 8-K has been just filed by The Bancorp on January 9, 2015 reporting that Arthur Birenbaum, EVP, commercial loans has resigned, effective January 8, 2015.

Investors need to get straight answers to the following questions now or during the bank’s 4Q14 earning conference call:

  • What is the overall mark-to-market discount on the remaining $900M commercial loan portfolio?
  • Can the bank give assurances that the remaining portfolio is fairly valued in light of the 20% mark-to-market discount associated with the piece just sold?

Below is a spreadsheet summarizing our view of the accounting of the two transactions to set aside the commercial loan portfolio in 3Q14 and then to sell the first piece on December 30, 2014.

It also includes a “what if analysis?” as to future mark-downs of the remaining portfolio for sale

The Bancorp — Commercial Loan Portfolio Reclassed as Discontinued Operations – 3Q14
3Q14 12-30-14 Sale 4Q14 Pro Forma
Outstanding Loan Principal 1,282.90 267.60 1,015.30
Loan Loss Reserve at Time of Discontinuation (44.00)
Additional Mark Down at Time of Discontinuation (38.90)
Total Markdown (82.90) (54.10) (28.80)
Fair Market Carrying Value 1,200.00 213.50 986.50
Markdown as % of Principal 6.5% 20.2% 2.8%
Carrying Value as % of Principal 93.5% 79.8% 97.2%
What if Future Sale Markdown as % of Principal 6.5% 20.2% 2.8%
Principal 4Q14 Pro Forma 1,015.30 1,015.30 1,015.30
Future Sale Markdown – Gross (65.61) (205.26) (28.80)
Markdown 4Q14 Pro Forma (28.80) (28.80) (28.80)
Future Sale Markdown – Addition (36.81) (176.46) 0.00
Offset – Reduction in Capital (36.81) (176.46) 0.00
Average Capital 3Q14 377.40
Average Assets 3Q14 4574.57
Bancorp Tier I Average Ratio 8.2%
“Well Capitalized” Bank – FDIC Regulations 5.0%

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.