Netmarble Games IPO: A Fast Fade for Lineage 2?

Netmarble Games IPO: A Fast Fade for Lineage 2?

Lawrence Abrams No Comments

Introduction

Netmarble is the largest mobile game publisher in South Korea.

The company has just secured investor commitments to buy 16.9 Million shares worth $2.3 Billion in a May 2017 IPO on the Korea KOSPI stock exchange.  

This IPO would value the company at $11 Billion based on investor demand at the high end of the offer range of $138 USD / share (or 157,000 Korean Won / share)

This is a very big deal. It would be the largest IPO on the Korean exchange since 2010 and second largest tech IPO in the world in the last two years after Snap and ahead of Line.

We will show in detail below that this is a highly speculative IPO, even for mobile game companies who are often dismissed by investors as being one hit wonders.

This IPO is unlike the disappointing mobile game IPOs of King Digital Entertainment in 2014 and Zynga in 2011 where both companies had enough audited numbers in their S-1s to suggest that their best days were behind them.

On the contrary, Netmarble’s best days are ahead of them.  But, investors are insane to give this company such a lofty valuation based entirely on unaudited revenue numbers of a single new game launched only four months ago.

We will present evidence hinting that early annualized revenue run rates (ARR) for the game have slipped noticeably in March 2017 — the third month since launch.  We predict that once investors realize this, the stock should drop 30+% from its expected IPO price.

Evidence of a Drop-off in ARR

On December 13, 2016 Netmarble launched a mobile role-playing game called Lineage ll: Revolution  (L2R) based on licensed IP from NCSoft’s legendary PC game Lineage. According to app analytics company App Annie, the game immediately rose to #1 on the S. Korean iOS Apple revenue rank charts and has remain so to this day.

 

 Just because L2R has remained ranked #1 on the S. Korean charts for the past four months, and likely will continue to do so for months, it is still possible that ARR has declined by $100s of Millions since release.

This is because there is a severe power function relation in the mobile game industry between ARR and revenue rank. Typically, at the top of the USA charts, there can be a $600 Million ARR difference between the #1 and #2 ranked game, say $2.2 Billion ARR for #1 and $1.6 Billion ARR for #2.

For example, below is a power function we derived in an earlier paper on the Netmarble IPO for top ranked games on USA iOS app store.

For the S. Korean chart now, it is conceivable that the gap between #1 ranked L2R and the #2 ranked Everybody’s Marble, also by Netmarble published on Kakao, could be $700 Million or more.

In January 2017, Netmarble told the Korean press L2R generated $176.6 Million in revenue between mid-December 2016 and mid-January 2017. That translates into $2+ Billion ARR.

Obviously, a $2 Billion ARR is not sustainable for the full year of 2017. This is because TOTAL Korean game revenue (mobile + console + PC) was only $4 Billion in 2016, according to Newzoo.

Netmarble has not made any official full year forecasts for L2R nor for the company as a whole. We do know that official 2016 revenue for the total company was $1.34 Billion.

In March 2017 analysts covering the company told The Korea Times  that they expect revenue to double to $2.7 Billion, largely based on the early success of L2R.  Assuming organic growth of around 25%, this implies that the 2017 forecast for L2R would be around $1 Billion.

We present two pieces of evidence that even a $1 Billion in total revenue for 2017 is unlikely.

The first piece of evidence is an App Annie trend chart showing L2R download rank. Note that while L2R was ranked #1 in downloads for the first month since release, downloads have steadily dropped below #30 by late March 2017.  

It is doubtful this drop off was caused by a drop off in advertising by Netmarble.  It is more likely due to a lack of strong word-of-mouth by early players that this is a great game.

The other piece of evidence of a drop off in ARR comes from a monthly summary report put out by SuperData listing the top grossing mobile games globally for that month.  

For February 2017, SuperData reported L2R was the top grossing game globally.  But, for March, it reported that L2R dropped to #10 (See below)

 

 

Valuing Netmarble Based on Realistic Expectations for L2R

As we stated earlier, Netmarble’s IPO is scheduled for May 2017.  Investors have already committed to buying 16.9 Million shares at the top end of the offering range of $138 USD / share or 157,000 Korean won / share.

This values the company at $11.7 Billion.  Dividing that valuation by analysts forecasts for 2017 revenue of $2.7 Billion,  we arrive at valuation of 4.3 time forward ARR.  This ratio enables comparisons with  market-derived valuation ratios of publicly-held companies. 

For example, in another paper of ours on the Netmarble IPO,  we derived a valuation ratio for Com2uS of 2.61.  Com2uS is a Korean-based mobile game company listed on KOSPI exchange.   Com2uS is much better known than Netmarble due to its global hit mobile game Summoners War.  

While Com2uS is growing slower than Netmarble, its future sales are more predictable. Based on this comparison, we concluded that Netmarble’s IPO was overpriced by 26%.

In the spreadsheet below,  we also break down Netmarble’s 2017 overall revenue growth forecast into estimates of organic growth versus new sales from L2R — which we peg at $1 Billion.

 

 The final spreadsheet presents “what if?” analysis of Netmarble’s value and stock price  if more solid evidence starts showing up indicating that L2R’s 2017 ARR will be closer to $600 Million than $1 Billion.

Note that when revenue forecasts are significantly cut back, there is usually a corresponding compression in valuation ratios.  So, we built into our “what if?” analysis a compression of Netmarble’s valuation ratio from 4.3 to 3.5 times forward ARR.  

Official sales figures will start coming from Netmarble a month or so after the end of its 2Q17 quarter in June 2017.  We expect management to guide 2017 revenue well short of initial forecasts of $2.7 Billion due to L2R’s ARR well below $1 Billion.

The stock should fall well below IPO prices.  We predict a decline on the order of 33% by July or August 2017.

Netmarble IPO: How Greed Destroyed Its Kabam Acquisition

Lawrence Abrams No Comments

Netmarble is the ninth largest mobile app game publisher in the world and the largest in South Korea. In a month, the company is set to raise $2.3 Billion via an IPO on the KOSPI Korean stock exchange.

If successful, the company will be valued at $11.7 Billion and catapult it to the level of Supercell and MZ (formerly Machine Zone) as one of the top 3 most highly valued mobile game companies in the world.

Our analysis of this IPO, indicated that expectations for revenue doubling in 2017 has been fully priced into the IPO price of 157,000 Korean Won  / share or  $138 USD / share (based on conversion of .00088 USD / Won).  We recommended staying away from the IPO, and look for an entry point 36% lower, or around $86 / share USD.  

While doing research on Netmarble, we began to see that the aggressive pricing of its IPO was not the only instance of what we considered to be a pattern of greed as defined by making choices favoring short term gain at the expense of long term gain.

For one, Netmarble had a history of overworking its Korean workers.  So much so that employees pulling “all nighters” before every game patch started calling its highrise HQ in Seoul  “the lighthouse”.  

As Netmarble’s IPO date grew nearer and investor scrutiny intensified, the company changed its work hours policies, saying it would ban “all nighters” and weekend work.

The purpose of this paper is to explore in detail another instance of Netmarble greed:  how it has managed a recent $710 Million acquisition of the Vancouver studio of the fallen USA mobile game unicorn Kabam.

Netmarble has repeatedly stated that its long term growth strategy hinges on growth outside S. Korea.  This includes localizing its Korean hit game Lineage II: Revolution for the Chinese market. It also includes acquisitions of studios in the West with games generating $100+ Million in annualized revenue (ARR)  like Kabam’s Marvel: Contest of Champions (MCOC).

Our interest in Netmarble stems from a long running interest in Kabam.  We have followed the the ups and (mostly) downs of Kabam for the last three years, focusing mostly on valuations based on App Annie app store revenue rank trends. Below is a list of our articles chronicling the fall of Kabam and its causes.  They are available on our blog GloMo Investing:

On October 18, 2016, VentureBeat reported that an unidentified company had made an $800 million offer for Kabam’s Vancouver studio.  That studio had been responsible for the only game keeping Kabam alive at the time:  Marvel: Contest of Champions (MCOC).  

The Vancouver studio also was valued for the game engine behind MCOC and for the hit potential of another game in final development based on Transformer IP licensed from Hasbro. At the time, MCOC was a #9 revenue ranked game with our estimated global annualized revenue run rate (ARR) of $250 Million. We noted at the time that the bid seemed right for a studio + hit game + game engine as long as the two-year running MCOC could sustain a $250 Million ARR.

On December 19, 2016, it was announced that Netmarble was the successful bidder. The bid was later officially pegged at $710 Million based on Netmarble’s IPO filings in late March 2017.

Throughout 2016,  Netmarble talked about an IPO.  It played up its plans to use  the proceeds from the IPO  to buy USA-based companies knowing that the mobile game market in the USA was six times that of S. Korea.  It was especially important for Netmarble to demonstrate its acquisition prowess before its IPO, given that it had narrowly lost a bid for the social casino game company Playtika in June 2016.

What follows is a closer look at the way Netmarble has managed two major software releases since it closed the deal for the Vancouver studio just two months ago. It is evidence of a kind a greed that favors short term monetization over long term player engagement.

The first instance of a disastrous release — the now infamous MCOC Patch 12.0 — was released on March 1, 2017 just one week after Netmarble closed the acquisition on February 23, 2017.  The other was the design and release schedule of Transformers: Forged to Fight (Transformers).  

Even though development of both started before Netmarble took over, the final releases were made on their watch. Netmarble could have stopped these releases, mandated more player friendly designs that would sustain engagement even if that meant less revenue in the short run.  But they did not.

Using the AppAnnie iOS USA app store revenue rank trend line below, we will show the context and likely rationale for MCOC Patch 12.0.  

MCOC was first released 2 ½ years earlier in December 2014.  Five month later in May 2015 the game cracked the Top 10 revenue rank (first red line).

It remained a consistent Top 8-10 revenue rank for a solid year until July 2016 (second red line) when it started a slow fade down to a Top 10-15 for the second half of 2016.  Patch 12.0 went live on March 1st (third red line).  

Player criticism was instantaneous led by a YouTube video entitled “Patch 12.0 is Terrible” by MCOC Youtube channel celebrity Seatin Man of Legends. It quickly spread.    On March 6th, the MCOC development team issued an official apology, said it heard the criticisms, and would issue a fix shortly. Note that on the day of the apology (fourth red line), MCOC broke below #20 first time in two years.

Here is a more detailed App Annie chart for the last year that shows MCOC fade starting in mid-2016:

MCOC Fade from Top 8-10 To Top 10-15

 

You might think that a slight fade from a consistent Top 8-10 revenue rank game to a Top 10-15 game is insignificant. But,  in the mobile game world, there is a strong power function relation between revenue dollars and revenue rank.  

At this high end of the mobile game power function a single digit swing in revenue rank translates into a $20 Million to $40 Million swing in ARR. Using our long-standing metric of 2.5 times ARR for valuing mobile game companies or studios + game engines, a one digit swing in rank translates into a $50 Million to $100 Million swing in valuation.

Below is our reconstruction of global annualized revenue of top ranking games currently on the iOS Apple app store charts as a function of rank. The iOS USA numbers are from Think Gaming,  which we believe are algorithmically derived and smoothed out rather than actual tallies.  

Over the years, we have used this simple rule of thumb to derive global revenue of top ranking games on Apple iOS USA — companies that generally derive the bulk of their revenue in the USA as opposed to Asia or Europe. 

The global mobile game revenue for top ranking USA iOS games can be divided into three equal segments: iOS USA,  Android USA,  and Rest of World.  Thus, global ARR = 3 * iOS USA.

 

Notice that the average ARR of Top 8-10 game is $242 Million whereas the average ARR of a Top 10-15 game is $156 Million, about $100 Million less in revenue and $250 Million less in value based on our 2.5 valuation multiple.

Obviously Kabam was acutely aware of MCOC’s fade and its implications for the value of the Vancouver studio. Also, Netmarble must of been aware when it turned its eye to Kabam after its June 2016 failed bid for Playtika.

Given the extent of the changes involved in Patch 12.0, the development team must have began work about two months after the start of the fade, say around August 2016. As Kabam and Netmarble were closing in on a deal, Kabam must have discussed Patch 12.0 with Netmarble including design choices based a trade-off between increases in average revenue per paying user (ARPPU) and the likelihood of player defection.

 Kabam may even have been savvy enough to prepare several versions of Patch 12.0 with different expected ARPPU  knowing that it would be Netmarble who would make the final decision once the deal closed. Normally, before a major update to a long running game, it is customary for a development team to do two things:

  1. invite key players to test the beta version and solicit feedback;
  2. present a detailed rationale for each change on official forums on the day of the release.

Netmarble did neither.  On March 1st, the final version of Patch 12.0 was released.

There was an immediate shock and outrage by hard core players as evidenced by their vents on YouTube, Facebook, Reddit, various game blogs, and official Kabam hosted forums. Among long running hard core games, the level and breadth of MCOC player outrage was unpresented.

 When we googled “player revolt” plus game name, we could find evidence only of one revolt by players of  MZ’s Game of War: Fire Age.   There have been no noticeable online revolts by players of Supercell’s hit games — Clash of Clans or Clash Royale — nor of players of MZ’s other hit game Mobile Strike.

Based on our reading of these criticisms, we believe that final version of Patch 12.0 was focused to the extreme on increasing ARPPU without giving much weight to player outrage and defection.

First, beyond the questions of objective, there was a major screw-up of core gameplay mechanics that made block and parry unplayable.  

Then, there was what we call widespread “devaluations” of player assets  designed to increase ARPPU.

 It included diminishing the fighting power (“nerfing”) of the most popular characters, or Champions, and providing incentives to buy unpopular Champions by increasing their power (“buffing”).  

Another devaluation occurred by making battle losses more costly in terms of power loss, thereby increasing regeneration costs. Finally, there was fundamental change in the scoring system with no rationale given.  But it appeared to the most experienced players that this change was designed to increase ARPPU.  

Player outrage and talk of organized revolt ended abruptly on March 6th when the company officially apologized and promised rollbacks which did occur with Patch 12.0.1 on March 10th.

In the end, Patch 12.0 and subsequent roll-back likely did nothing to reverse the fade of MCOC.  But it caused irreversible loss in trust by long term players.  Players can never again be sure that accumulated investments made in MCOC won’t be subject to another Patch 12.0 type devaluation. MCOC will never again be a consistent Top 8-10 game.  

Netmarble will likely hold off from making ANY major changes in the next six months to MCOC, leading to player ennui and defection to more engaging games.

Now on the the other instance where Netmarble’s greed led to decisions which caused a new game release by the Vancouver studio to be a bust. Kabam’s Vancouver studio was especially valuable to any acquirer because it had a proprietary  “game engine” called “Fuse & Sparx” thought to be capable of churning out a series of re-skinned MCOC hits.

First up was a game with MCOC-like game mechanics based on Transformers IP licensed from Hasbro called Transformers: Forged to Fight. (Transformers) Below is the countdown to the global launch of the game:

Notice that there was only a two month soft-launch before global release.  Based on App Annie charts, the game struggled in soft-launch and never cracked the Top #100 with any consistency.  

Normally,  a company would add a couple more months of tweaking before making a decision to launch officially or can the game.   Given Netmarble’s May 2017 IPO date, we think that they rushed released a deeply flawed Transformer game causing it irreparable damage as the early word was that it was buggy, slow to load, and freezes.

Even if the game’s bugs could be cleaned up, early players of the game reported that it is “too complex to play”  and there is “kitchen sink” approach to development with a mashup of game genres and a mind-numbing complexity to scorekeeping and purchasing.  

To us, this suggests that the priorities were early monetization over long term player engagement. Below is the revenue rank trend of the game:

 

Our four years of reading App Annie charts suggests that there are no more “late bloomers” in the mobile game world. If a newly released game does not crack the top 50 in the first few days, it will never crack the Top 10. The Transformer game is a major bust for Netmarble.

But worse, it raises doubts about the hit making ability of  Vancouver’s game engine “Fuse and Sparx.”  Could the success of MCOC be due more to the original team that developed it, long since gone,  and not its game engine nor the current team?

The bust of the Transformer game and the fiasco of MCOC Patch 12.0 raises serious doubts about Netmarble’s ability to manage future acquisitions in the West.  

Will Netmarble’s greed once again force newly acquired companies in the USA to release their own Patch 12.0?   

Will Netmarble’s greed force acquired companies in the USA to junk up games similar to what happened with Transformers: Forged to Fight?

Netmarble’s IPO will give the company  $2.4 Billion to make acquisitions of USA-based companies with current Top 20 hits.  This would include the privately-held companies Pocket Gems, Product Madness, and Jam City, a company already with a $100 Million Netmarble investment.

It would also include the publicly-held company Glu Mobile and the Com2uS, a company listed on the Korean exchange, but with most of its revenue coming from its global hit Summoners War.  

Unless Netmarble can change its focus to long term player engagement over short term monetization boosts, we think that they will destroy future acquisitions just like they destroyed Kabam’s Vancouver studio in two short months.

Netmarble IPO: Priced for Perfection

Lawrence Abrams No Comments

Netmarble is the ninth largest mobile app game publisher in the world and the largest in South Korea.

The company is seeking to sell 17 million shares on the Korean KOSPI stock exchange in early May garnering proceeds of between $1.8 Billion and $2.4 Billion USD (all USD figures converted from Korean Won at .00088 USD / Won). Roughly half will be used for new acquisitions and half will be used to retire debt.

This is a big deal IPO by both Korean and USA standards.

It represents the largest IPO in S. Korea in 7 years. It would rank as the one of the largest tech IPO globally in last 2 years.

In January 2017, Netmarble launched a mobile role-playing game called Lineage ll: Revolution based on licensed IP from NCSoft’s legendary PC game Lineage. According to app analytics company App Annie, the game immediately rose to #1 on the S. Korean revenue rank charts.

Netmarble told the Korean press that the game generated $176.6 Million in revenue in the first month. That translates into an annualized revenue run rate [ARR] of $2+ Billion.

Obviously, that run rate is not sustainable. But, even if the game managed to produce $1+ Billion in revenue during 2017, it would place Netmarble in the rarefied company of Niantic, Supercell and MZ (formerly Machine Zone) as the only companies that released a $1+ Billion Dollar game in the last 2 years.

The IPO will be watched closely by the mobile game industry given the poor post-IPO performances of King Digital Entertainment in 2014 and Zynga in 2011.

A case could be made that these IPOs were anomalies and not a fair test of how a mobile game stock is capable of performing. Both Zynga and King Digital had enough numbers in their S-1s to suggest that their best days were behind them at the time of their IPOs.

However, there is absolutely no question that Netmarble’s best days are ahead of it. There is no question that its revenues and profits will soar in 2017 if Lineage II manages to sustain an ARR greater than $1+ Billion.

Lineage II is not all that Netmarble has going for it in 2017. In February 2017, the company completed a $700+ Million acquisition of the Vancouver studio of the USA mobile game company Kabam.

If managed properly (questionable as we will argue below), Netmarble could generate a fresh $100 to $300 Million in revenue from two Kabam game. One is Marvel: Contest of Champions which has been a long running Top 15 revenue rank game in the USA. The other is the recently released game Transformers: Forged to Fight based on IP licensed from Hasbro.

No question, 2017 will be a spectacular year for Netmarble. The Korea Times has reported that analysts there expect Netmarble’s forward 2017 revenue to be around $ 2.7 Billion, a whopping 107% YoY increase. This is a far cry from Zynga’s and King’s anemic post-IPO YoY revenue growth rates of 12% and 20%, respectively.

The question is has all of this been priced into Netmarble’s IPO price and valuation?

Our analysis will show that expectations for revenue doubling in 2017 has been fully priced into the IPO. Netmarble’s IPO is priced for perfection.

Furthermore, there is a pattern of greed on the part of Netmarble’s management that has not served it well. It includes:

While Netmarble’s short term prospects are tied to the performance of Lineage II in Korea, its long term prospects are tied to success in the West.

The company has announced that it intends to localize and release the Lineage game in China but those prospects are uncertain, even with Tencent (TCEHY) as a significant minority stockholder.

The uncertainty is result of China’s recent freeze on licensing new games from Korean companies due to geopolitical tensions between the two countries.

In our opinion, Netmarble’s greedy handling of the Kabam games causes us to believe that Netmarble’s current and future acquisitions will underperform due to employee and player defections.

We start with a summary of the IPO — the expected price range, and the expected post-IPO valuation based on those prices.

The next spreadsheet is our valuation of Netmarble as a multiple of 2017 forward sales. We have been unable to find any official company forward looking revenue statement. If there is one in the Korean version of their S-1, we have found no reference to it by the Korean financial press.

Lacking official numbers, we use $2.7 Billion for Netmarble 2017 forward sales, a number reported by The Korea Times that analysts there expect.

Any lesser number would only increase our estimated price / forward sales ratio (P/S), which is already high. Any greater number would be incredulous as Newzoo has reported that TOTAL Korean game revenue (mobile + console + PC) was only $4 Billion in 2016.

Moreover, given the $4 Billion Newzoo figure, it seem incredulous that there would be enough demand in Korea to sustain any single mobile game at an $1+ Billion ARR.

The next spreadsheet is a comparison of the valuation / forward sales (P/S) ratios of Netmarble — 3.3 — with Com2uS — 2.61.

Com2uS is a Korean-based mobile game company listed on the Korean KOSPI exchange. Gamevil, a smaller publicly-held Korean game company, holds controlling interest in Com2uS.

Com2uS is much better known in the USA than Netmarble due to its global hit mobile game Summoners War. The game was released in the USA in June 2014 and has maintained a remarkably consistent Top 20 revenue rank in the USA for the last two years.

Based on this comparison, we believe that Netmarble’s IPO is overpriced by 26% at its announced price range of $106 to $138 USD or 121,000 to 157,000 Korean Won.

We believe that it would be a buy only around $84 USD or 95,250 Won.

You might argue that Netmarble’s upside potential is higher than Com2uS. That is true. But, we are not talking about financials, but stock prices whose movement is based on perceived and actualized performance that has not already been built into the current prices.

Netmarble is a buy at the announced IPO range if you believe that it will exceed an expected 107% in revenue growth this year. We think not.

Netmarble is a buy if you think it can successfully localize and release the Lineage II game in China in late 2017 or 2018. We say wait a half year before you invest to get a better feel for geopolitics between S. Korea and China.

Finally, Netmarble may be a buy if you believe that the newly released Transformer: Forged to Fight game will become a Top 8-10 hit like its cousin Marvel: Contest of Champions. We think not.

Our four years of reading App Annie charts suggests that there are no more “late bloomers” in the mobile game world. If a newly released game does not crack the top 50 in the first few days, it will never crack the Top 10.

Our reading of the App Annie chart says that the Transformers game is a bust.

(Source: App Annie)

While the Transformer game began development under Kabam, the final architecture and release schedule came under Netmarble’s watch. Both reflect a greediness that we believe has resulted in its quick bust.

The game was rushed into global release on April 5th after a relatively short two month soft-launch shakedown in Singapore and Canada.

Experienced early players of the game report that it is “too complex to play” and there is “kitchen sink” approach to development with a mashup of game genres and a mind-numbing complexity to scorekeeping and purchasing. To us, this suggests that the priorities are early monetization over long term player engagement.

In sum, Netmarble in not a buy at the announced IPO price range. Wait at least six month and evaluate its performance then.

Trumpcare Needs Milton Friedman

Lawrence Abrams No Comments

Trumpcare has focused exclusively on eliminating mandates, reducing tax credits, and rolling back Medicaid expansion to the working poor. But, the consequences of this are an estimated 24 Million people dropping coverage and huge increases in premiums for those who wish to remain covered.

Trumpcare is up for a vote in the House of Representatives and its passage very much in doubt despite a 24 vote majority held by Republicans. Even it passes the House, its chances of passage in the Senate are deemed slim seemingly by design.

To appeal to moderates, Trumpcare needs to preserve Obamacare’s affordability, keep the Medicaid expansion, while at the same find a way to reduce overall budget costs in the order of 20%. To appeal to conservatives, Trumpcare must reduce overall costs in the order of 20% plus eliminate mandates which was a source of affordability by providing cross subsidies between health-risk cohorts.

The only way we see out of this conundrum is a move to consumer-directed healthcare espoused by the late economist Milton Friedman.

While Friedman is probably better known for his voucher plan for schools, he had similar ideas espoused in a paper written in 2001 called “How to Cure Healthcare.” A condensed version has been made available online by the conservative think tank The Hoover Institute.

Friedman’s big idea in 2001 was this:

“Two simple observations are key to explaining both the high level of spending on medical care and the dissatisfaction with that spending. The first is that most payments to physicians or hospitals or other caregivers for medical care are made not by the patient but by a third party — an insurance company or employer or governmental body. The second is that nobody spends somebody else’s money as wisely or as frugally as he spends his own.”

Friedman was no knee-jerk conservative. He made it clear that Federal subsidies to the uninsured was a fairness issue and not some handout. This is because of the unfairness of the current system of giving tax exemptions only to employer-provided medical insurance.

When Friedman wrote his healthcare piece in 2001, the estimate of this tax shelter was $100 Billion. Today, The Brookings Institute estimates this selective subsidy at $261 Billion.

When Friedman wrote this piece in 2001, consumer-directed healthcare with payments made from a Health Savings Account (HSA) was a new idea. He envisioned HSAs eventually as centerpiece of both Medicare and Medicaid through a combination of Federal contributions deposited in HSAs to cover normal expenses supplemented by Federal government single payer, high-deductible catastrophic insurance.

There have been three trends since Friedman’s 2001 article that have made consumer-directed health care so much more a viable option today. Trumpcare should take advantage of these trends.

The first trend — a negative one — is the dearth of Federal Trade Commission challenges to anti-competitive mergers among healthcare insurers and pharmacy benefit managers (PBMs). It is ludicrous today to think that insurance companies and PBMs compete for customers today by working hard to hold down healthcare costs and associated premiums. We have written extensively about the bilateral oligopolies in the drug supply chain and the misaligned PBM business model.

The second trend — a positive one — is the extent to which the Internet, payments technology, and mobile phones have lowered transactions costs — price discovery, evaluation of treatment options, patient advocacy, and payments — associated with the purchase of healthcare. This includes the substitution of the costly paperwork that used to plague HSAs with HSA-linked debit and credit cards programmed to pay only for SKUs certified as reimbursable healthcare costs.

Interestingly, it was Friedman’s colleague at the University of Chicago, the late Ronald Coase, that had the big idea that transactions costs could have profound effects on markets and institutions.

Notice, we said nothing about the need for government mandates for healthcare price transparency similar to the recent bipartisan legislation introduced in Congress.

We have no doubt, as would have Friedman, that consumer-directed healthcare would create such an explosion in provider price transparency as to make regulation unnecessary.

Recently, the U.S. House Oversight Committee Chairman Jason Chaffetz admonished people who complained about increased premiums under Trumpcare. He said they should get their priorities straight and cut back on luxuries like iPhones.

If Trumpcare were consumer-directed, this admonishment would be ironic because smartphones would pay for themselves by helping consumers hold down costs. For example, it is a sure thing that there would be app-based patient advocate services you could summon on a moment’s notice upon being admitted to a hospital. All bills would be run through the service. Consultants would be available 24/7 to review proposed treatments.

Indeed, we would argue that under consumer-directed healthcare, a portion of a smartphone’s expense should be a deductible.

The third trend — a positive one — is the exponential growth in venture-capital funded startups focused on healthcare price discovery, cash-only drop-in clinics, lab tests for early detection of cancer, low cost step-therapies, etc. All of these services are in a symbiotic relation with consumer-directed healthcare.

We would like to mention just two of the many healthcare startups out there with services focused on enhancing consumer-directed healthcare. Both would thrive if Trumpcare were based on Milton Friedman’s ideas.

One is a basic healthcare clinic just starting up in San Francisco called Forward. The innovation here is an out-of-pocket only subscription business model of $1,800 a year billed annually. They do not accept insurance. This type of clinic is made-to-order for consumer-directed healthcare.

The other startup we want to mention is the crowd-sourced price discovery website Clear Health Costs. Here is just one screenshot to give you some idea of its value to consumer-directed healthcare.

Screenshot from Clear Health Costs Website

Again these are just two of the hundreds of healthcare startups that would make consumer-directed healthcare a viable alternative to Trumpcare as initially designed.

We conclude below with a table outlining how Obamacare, Trumpcare, and Trumpcare + Milton Friedman would address major issues:

Trumpcare + Milton Friedman

The Bancorp: An “Extend and Pretend” Loan Operation That Never Ends

Lawrence Abrams No Comments

Advice First — Then Analysis:

Coinciding with a new CEO Damian Kozlowski, The Bancorp (TBBK) has been forthright in taking additional markdowns on it discontinued commercial loan portfolio. But, this has resulted in three successive quarters of unexpected losses followed by double digit percentage declines in its stock.

This article will present the case that these quarterly losses will continue throughout 2017 culminating in the need once again for a private placement to shore up its status as a “well capitalized bank” per Dodd-Frank.

The stock is NOT long term buy.  Nor is it a short at this time as there will be value funds like the bank’s 5th largest shareholder, Fuller & Thaler (of  behavioral finance fame) that will jump in when the stock falls below $4.75 / share.

At best, it is a short term trade with buys made AFTER quarterly announcements of losses and sells one month later as value funds complete their accumulation.

Analysis

Systemic problems with mortgage loan operations — originations and modifications — are flows which are capitalized into a long-dated assets or stocks.  Correcting bad origination practices, or changing the flows, does not change the prior stocks created by the flows.  

There were systemic problems with the origination and securitization of subprime residential mortgages a decade ago.  The process was corrected. But financial institutions, mostly the Federal Reserve Bank, still have a good portion of those troubled assets on their books.  The flawed origination process was stopped years ago, but the troubled loans still produce losses to this day.

Here is the analogy of the subprime debacle a decade ago to The Bancorp’s “continuing problems with a discontinued operation”:

On October 31, 2014, The Bancorp (TBBK) announced that it was discontinuing its commercial lending operations and set aside for sale a loan portfolio with a principal of a $1,124 Million. During the Conference call, the former CEO Betsy Cohen stated that  “…we do anticipate those sales being completed within the next 120 days.”

The flow process ended. But, two years later the bank still has nearly half of its loan portfolio either on its books or off-loaded to a non-consolidated, self-financed LLC.

There have been surprise loses due to markdowns / write-offs for the past three quarters.  During the 3Q16 conference call, the new CEO Damian Kozlowski sought to reassure rattled analysts by claiming  

“We believe this (markdown) is not systemic. We believe this is a one-time item.”

During the 4Q16 conference call, when pressed about another private placement in late 2017, the CFO Paul Frenkiel said,

So right now we’re fairly comfortable we can work our way to a higher capital base without raising additional capital at this time.

At the end of this unusually long and testy call with analysts (a first!),  CEO Kozlowski wearily pledged,

“I want to wind it down as quickly as possible…”

The purpose of this article is question all of those statements.

Summary of Our Past Work

We have written a number of papers for Seeking Alpha on The Bancorp’s “continuing problems with its discontinued operations.”  There are two basic points we have tried to make:

  1. The portfolio was not fairly marked initially because “fairly marked assets sell fairly quickly.”
    1. The Bancorp: Bad Moon Rising (January 2015)  
    2. The Bancorp: Continuing Problems with a Discontinued Operation (March 2015)  
    3. The Bancorp: Why the Continuing Delays in Filing Its 10-K (May 2015)
  1. Once the bank began to take additional markdowns, the hits to equity brought it close to going below the Dodd-Frank standard of a “well capitalized bank”.
    1. The Bancorp: Private Placement Needed To Shore Up Status as ‘Well Capitalized Bank (August 2016)
    2. The Bancorp: Oversold Says Richard Thaler’s Behavior Finance Fund (September 2016)

We have also written an accounting paper The Bancorp: A Test for Post-Enron GAAP which challenges the bank’s election not to consolidate the LLC created to off-load the most toxic portion of the loan portfolio.

Systemic Problems With The Bancorp’s Operations

Thankfully, the new CEO Damian Kozlowski has eradicated one systematic problem that plagued the bank in the past: a slowness to book markdowns / write-offs.

But,  we have identified two other systematic problems  related to specific bank operations.

The first systemic problem is the bank’s approach to what it known as  “troubled debt restructurings” — described by the bank in its latest 10-Q  as “loans with terms that have been renegotiated to provide a reduction or deferral of interest or principal because of a weakening in the financial positions of the borrowers.”

It turns out that the bank’s commercial lending operations had a practice of “extend and pretend” or “kicking the can down the road” which can disguise the true quality of a “performing loan.”

The classic example of turning a non-performing loan back into a performing loan is to modify the terms to allow for interest only payments for a number of years followed by a huge balloon payment at the end.  Shades of subprime mortgage debacle of a decade ago?

Evidence of the bank’s practices comes from interviews with former employees found in court documents (p.25-29) connected with a class action suit by investors suffering losses for the class period January 2011 through June 2015.

Here is detail explanation (p.27) of the practice from one former bank employee “CW3”

For instance, CW3 stated, “rather than actually calling the loan or forcing a liquidation or calling it what it is, sometimes the action that was taken was funding new money to pay the existing loan down, that was delinquent.” CW3 stated that another technique Bancorp used to “try to turn nonperforming loans into performing ones” was to “switch up” a loan’s amortization, which changed the cash flow and decreased required payments.

That class action lawsuit was settled out-of-court by fake do good lawyers for a paltry $17.5 Million or 15.5% of the $112.5 in total stock market losses claimed by  the plaintiffs.  Worse, the settlement was covered by The Bancorp’s insurance (see 3Q16 10-Q p.32) and so there was no hit to the bank’s financials.

The second systemic problem was the way the bank has wound down this discontinued loan portfolio.  

The most toxic portion was sold off first to an unconsolidated LLC accompanied a bare-bones 8-K sneakily filed the day before New Year’s Eve 2014. Two years later in 4Q16, The Bancorp finally provided enough detail to support our early 2015 assessment of the toxicity of  this off-balance sheet portfolio. (see spreadsheet below)  

With the most toxic portion removed, the bank has spent the last two years getting rid of the cleanest portions.

About 25% of the principal has been payed off / paid down. The bank touts this as a success. But, this means that the borrowers with the best finances and opportunities to refinance are off the books.  

The corollary is that the remaining borrowers have little ability to pay down and have relatively high loan-to-value (LTV) precluding them from refinancing with another lender at a lower interest rate.  

The remaining portfolio on the bank’s books has been shopped around to every regional bank in the Mid-Atlantic region for the past two years.

In 2Q15, loans totalling $150 Million were “cherry-picked” by the Cape May Bank, NJ ($102M) and another unidentified bank.  In 3Q16, a loan package of $65 Million was “cherry-picked” by the First Priority Bank, Malvern PA.

What is left is stuff no regional bank in the Mid-Atlantic would touch.  It’s like they say —  never shop at the farmer’s market at the end of the day as it’s all been picked over.

A Comparison of the Two Loans Portfolios

Below is a spreadsheet comparing the remaining portion of bank’s two loan portfolios in terms of

  • % markdown of remaining principal
  • % non-performing
  • % of initial principal that has been paid-down / off

And, in a later spreadsheet

  • A “reverse engineered” disaggregation of average % markdown overall into average % markdown by performing class  

This data comes from the end of the bank’s announcement of its 4Q16 results.  After two years of providing next to nothing, the bank suddenly discovered financial transparency.  This was likely due to a crescendo of pressure from investors coupled with a new CEO realizing that financial transparency (not the same as GAAP) is best in long run for the bank.

There are three statistics in the spreadsheet below that confirm our suspicions made two years ago that The Bancorp’s strategy was to bundle the most toxic and unsellable loans first and off-load them to an unconsolidated LLC which it obviously had to self-finance as no third-party would partner with them otherwise.

The first piece of confirming data was a 41% AVERAGE markdown of the LLC portfolio despite 77% of loan principals classified “performing.”  What a joke!  The incongruity of these two statistics confirms the meaningless of  “performing” as a sign of loan quality when a loan operation engages in  “extend and pretend.”  

Obviously, a lot of the so-called “performing” loans had been modified to interest only with a balloon payment after a number of years. And the non-performing loans probably involve skipped balloon payments rather than skipped flat payments according to a normal amortization schedule.

With no more “extend and pretend” possibilities, or refinance because the borrower is “underwater” with a current loan-to-value (LTV) > 100%, the endgame here is foreclosure followed by Chapter 7 or Chapter 11 followed by sheriff’s sale.

This sequence is similar to the loans largely responsible for The Bancorp’s losses in 2Q16 (The Schuylkill Mall in Frackville, PA) and 3Q16 (The Fashion Square Mall in Orlando, FL).

A third telling statistic is the difference in % paydowns / offs.  Here 62% of the bank’s original portfolio was paid down / off versus a paltry 6% for the LLCs portfolio.  

A high % means that the bank’s portfolio contained a lot of borrowers with spare cash to pay and/or appreciating assets — low current LTVs– that provided opportunities to refinance at lower interest rates.

A low % means that the LLC portfolio contains a lot of borrowers with interest first loans with no spare cash to paydown and depreciating assets — “underwater” LTVs > 100% — that provides no opportunity to refinance.

An Estimate of Future Losses

The commercial lending operation was discontinued in 3Q14, but it wasn’t until 2Q16, coinciding with a new CEO,  that The Bancorp finally began to account for the deterioration in the loan quality in the two portfolios.

Below is a chart of the FY16 discontinued portfolio markdowns and LLC note write-offs.

The Bancorp uses mark-to-market accounting for the portfolio still on its books, taking account of specific events like the 3Q16 foreclosure and subsequent Chapter 11 filing of The Fashion Square Mall in Orlando, FL.

The accounting is entirely different with the off-balance sheet portfolio in the LLC.

The LLC itself uses mark-to-market accounting internally per GAAP.  But because the LLC is unconsolidated and overwhelming financed by notes taken back by The Bancorp, the bank uses note valuation accounting here.

Note valuation affords the bank discretion in models and interest rate parameters chosen to calculate discounted present value of the notes.   This variability in possible valuations was discussed at length during the  4Q16 conference call.

All of this is evidenced in the difference between 4Q16 LLC write-off of $13.2 Million discussed during a January 31st private call with analysts and $25 Million write-off discussed February 10th during the 4Q16 conference call.

Below is our estimate of addition mark-to-market markdowns for both portfolios.  The caveat is that our estimated markdowns for the LLC portfolio are internal to the LLC.  Whether or not they are reflected in the opaque, discretion-laden note valuation model used by The Bancorp is another matter.

The key to our estimate is a disaggregation of average % markdowns supplied by The Bancorp into markdowns by performance type.  The Bancorp helps us do this for the portfolio still on their books.

They disclosed an average 41% mark for subclasses like shopping malls which are laden with non-performing loans versus a average 5% mark for subclasses laden with performing loans.  

Tellingly, the bank did NOT reveal marks by subclass for the LLC portfolio.  But, simple tie-out math dictates that the components that weight the LLC  41% average be higher than the components that weigh the bank’s 15% Average.

We could see the LLC booking  $30+ Million yearly markdowns for the next 3 years.  Again, there is a caveat that what the LLC books internally according to mark-to-market GAAP  is not the same as what The Bancorp books as changes in discounted present values of notes from an unconsolidated LLC (now insolvent according to my reconstruction of its 4Q16 balance sheet).

In any case, the losses will not end soon and will plague the new CEO Kozlowski for the next three years despite his 4Q16 pledge  “I want to wind it down as quickly as possible…”