Finance

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…”

Product Hunt Will Become The Launch Pad for Acquihires Under AngelList

Lawrence Abrams No Comments

Product Hunt: The Launch Pad for Acquihires

Product Hunt: The Launch Pad for Acquihires

If the tagline for AngelList has become “The LinkedIn for Startups”, will the tagline for Product Hunt become “The Launch Pad for AcquiHires”?

To me, the acquisition of Product Hunt is another signal of the narrowing of business models for standalone apps. Product Hunt was never in the running to scale enough to attract advertisers. The referral fees from Amazon for purchases of makers’ products launched on Product Hunt never really took off.

I suggested that the Product Hunt team morph to become paid, virtual, consultants to Fortune 500 companies looking for world class UX. http://glomoinvesting.com/an-alternative-business-model-for-product-hunt/

I said that they should become the McKinsey of the “Software Eats World” World, starting with becoming the premier consultant for Slack implementations.

Instead, they are headed down the path of becoming part of Angel List’s talent pool for hire. A more curated, nuanced LinkedIn. IMHO, this is a sad day.

Kabam: An $800 Million Bid That Is Both Lifeline and Death Knell

Lawrence Abrams No Comments

Kabam (Private:KABAM) is a mobile game startup based in San Francisco that had early success at developing games based on movie IP licensed from major studios like Disney’s Marvel studio, Warner Bros., and Lionsgate.

Beginning in 2014, Kabam started timing new releases to coincide with the releases of mega-hit movie sequels like Fast and Furious and the Hunger Games. The games had no long-term engagement value and “freemium” revenue plummeted within a few months after release. The result was a disastrous string of five failures and one success.

The one success was Marvel: Contest of Champions, a massively multiplayer online (MMO) game developed by Kabam’s Vancouver studio. It is the only game currently producing significant revenue and has a reportedly generated revenue totaling $471 Million since its late 2014 release. In July 2016, we wrote an article for SA saying that ” Kabam would be dead today” had it not been for the Marvel game.

On October 18, 2016, Venturebeat reported that Kabam received an unsolicited offer of $800 Million for its Vancouver studio. A day later the Wall Street Journal reported that Kabam has received multiple bids between $700 Million and $800 Million from Asian and U.S. gaming and media companies.

The bids are an opportunity that Kabam’s Board of Directors cannot refuse and represents both a lifeline and death knell.

The $800 Million bid implies a special value for the Vancouver studio of 100+ developers because our estimated (see derivation below) value of the whole company is at $775 Million, which, in turn, is below the previous $1 Billion valuation attributed to it by Alibaba in August 2014 when it invested $120 Million in the company.

We would be comfortable with the argument, presented in more detail below, that this “cherry-picked” bid implies minimal value for the company’s founders and C-suite executives based in San Francisco and Beijing. We would be comfortable with the argument that the work-in-progress and underlying game platforms coming out of Kabam’s other studios in San Francisco and Beijing, but not Los Angeles, also have minimal value.

In terms of return on investment, we will argue below that the proceeds from $800 Million should be paid out to stockholders rather than reinvested in either the Beijing or San Francisco studios.

In the rest of the paper, we will provide detailed answers to the following questions:

(1) What is current valuation of Kabam as a whole?

(2) Why might it be hard for Kabam to peel off the Vancouver studio?

(3) Who the likely bidder?

(4) What is likely to happen to the rest of the company?

What Is The Current Valuation of Kabam as a Whole?

Compared to other tech companies, valuation and revenue forecasting of mobile game companies is an order of magnitude easier due to the fact that analysts have access to monthly download and revenue rank data provided by such app analytics companies as App Annie. It is equivalent to the 1970s era of pure play movie studios where analysts had access to weekend box office data published by Variety.

We have developed a methodology for valuing and revenue forecasting of pure play mobile game companies based on three pieces of data (1) IOS Apple USA app store game revenue rank published by App Annie; (2) an estimate of a power function relation between annualized global revenue run rate (NYSE:ARR) and IOS Apple USA revenue rank; and (3) “market-derived” valuations of pure play mobile game companies as a multiple their ARR.

We have used this methodology to publish a number of articles on SA:

Kabam: A Mobile Game Unicorn No More?, July 2016

Kabam’s IPO Plans are Kaput, January 2015

Machine Zone: IPO or What?, July 2014

Zynga Is A Dog Without A Top 10 Mobile Hit, June 2014

Klab: An Undervalued Japanese Mobile Gaming Stock, June 2014

Mixi: A Rare Undervalued Mobile Gaming Stock, May 2014

We start with a screenshot of the revenue rank trend for Kabam’s Marvel game since its release in late 2014.

 

 

 

 

 

 

 

 

 

 

It shows 12 month run between mid-2015 and mid-2016 as a steady #5 to #10 revenue rank game. Based on an average #8 ranking, we estimate that this translates into a $350 Million ARR.

However, the graph reveals some slippage since mid-2016, possibly because of the Pokemon phenomenon. Because of the power function relation between revenue rank and revenue, a single digit slip to an average #9 ranking translates into a $250 Million ARR, which we use for our current valuation below.

This recent slippage is the kind of insight available to financial analysts of the mobile game industry that is unmatched elsewhere in the tech business world. Can you imagine having access to similar trend lines for Uber, Airbnb, Palantir, or Pinterest?

In terms of what multiple of ARR to use for valuing Kabam, we offer the latest “market driven” multiple for a pure play mobile game company. This is the June 2016 Tencent acquisition of Softbank’s 84.3% ownership of Supercell for $8.6 Billion. This put the full 100% valuation of Supercell at $10.2 Billion.

Even though Supercell is a private company based in Finland, it is required by law to report annual revenue to the government. In 2015, Supercell reported revenue of $2.326 Billion based largely on its hit games of Clash of Clans, Hay Day and Boom Beach. Now with the addition of #6 Clash Royale, we estimate that Supercell’s current ARR at $2.9 Billion, implying a valuation of 3.3 times ARR.

However, Supercell is a very profitable company with multiple hit games and an employee headcount reportedly less than 200. Kabam is currently a one hit game company with a current total ARR of around $310 Million and current employee headcount of around 689. Supercell’s ARR/employee is $14.5 Million, which is 32 times that of Kabam’s $.45 Million ARR/employee.

Since the mid-2016 slippage in the Marvel game ARR, we believe that Kabam is no longer profitable on a EBITDA basis and now is very likely running cash flow negative. With the IPO window closed, and tellingly, no new VC investments in two years, a $800 Million bid for the Vancouver studio is a lifeline that its Board cannot refuse.

There is no way you can value Kabam at Supercell’s 3.3 times ARR. We believe our often used 2.5 times ARR is appropriate here. We estimate Kabam’s current valuation at $775 Million, just below the reported top bid of $800 Million for the Vancouver studio.

 

 

 

 

 

 

 

 

Why might it be hard for Kabam to peel off the Vancouver studio?

The Vancouver studio started out as Exploding Barrel Games, which Kabam acquired in early 2013. The terms were not disclosed. The studio had 35 developers at the time and it was this core group that developed the gameplay engine for the Marvel game.

The CTO of Exploding Barrel Games was Jeff Howell. He is still with Kabam and has gone on to become Kabam’s first CTO. According to aKabam press release of his appointment in Nov 2, 2015, ” he also will continue to lead the development and implementation of Kabam’s proprietary technology engine “Fuse & Sparx.” (cute…Fuse & Sparx…then Kabam!!) Kabam also has announced that the Vancouver game engine would be deployed company-wide as the platform of all future MMO game development.

The bid obviously has to include CTO Jeff Howell and the game engine. Kabam has announced a planned 1Q17 release of a MMO game based on Transformer IP licensed from Hasbro. This game is currently in development at its Vancouver studio. The question is who gets the Transformer game? If Kabam retains the rights, how can it continue development at one of its other studios without the help of CTO Howell, the Vancouver team, and a copy of the game engine? These decisions will occupy Kabam’s Board as much as the actual bid amount.

Who the likely bidder?

The Wall Street Journal article mentioned that Kabam has multiple bids from Asian and U.S. gaming and media companies. The obvious guesses are the USA console gaming companies Electronic Arts or Activision Blizzard looking for a $1 Billion MMO mobile game to rival those of Supercell and Machine Zone (Private:MZ). Softbank is an unlikely bidder as it has been raising cash by shedding mobile game assets to make up for the losses of its Sprint acquisition. China’s Tencent would be another guess, although we think that Alibaba would be uncomfortable selling to its arch rival.

We would like to offer another likely bidder that has “one degree of separation” from the Vancouver studio and could seamlessly step in and run the studio. That company is the Tokyo-based gaming company Nexon (OTC:NEXOF) listed on the Tokyo stock exchange (T:3659). Nexon, founded in Korea in 1994, moved to Japan 12 years ago, went public 5 years ago, and is growing 20-25% a year. It currently has 4 of the Top 10 mobile games on the South Korean app store charts.

Nexon’s CEO is Owen Mahoney who has been VP of Corporate Development at Electronic Arts from 2000-2009. Nexon’s estimated 2016 revenue is around $1.7 Billion USD. Mahoney has said that Nexon is focused on expanding its mobile presence in the West. While the $800 Million price tag for the Vancouver studio would be a stretch for Nexon, the acquisition would be good fit.

Here is where the “one degree of separation” comes in. Two co-founders of Exploding Barrel Games — its President Scott Blackwood and General Manager Heather Price — plus the Kabam VP that led the Exploding Barrel Games acquisition — Chris Ko –left Kabam in 2015 to start an independent mobile game studio called The Game Studio. The studio is based where? Vancouver. Their mission is what? AAA mobile game developer. And who has recently signed on to become its global publishing partner? Nexon.

It would make perfect sense, and be almost a fairy-tale ending, if Nexon purchased Kabam’s Vancouver studio and re-united it with its original leadership led by creative director Scott Blackwood.

What is likely to happen to the rest of the company?

Kabam’s website lists eight on its Board of Directors with the majority of five being VC partners of investing firms. The VCs are in control here so founder and C-Suite job security would not be the dominant factor in this decision. Given the dearth of tech IPOs generally in the past two years, there is pressure on the Kabam’s Board to accept a bid, regardless of the difficulties it might present for the future success of the remaining company.

As we said earlier, the bid price is the least of Kabam’s Board worries. We discussed earlier the thorny issue of how to peel off the Vancouver studio and its game engine without crippling development in the rest of the company going forward.

A more thorny issue is what to do with the $800 Million cash, assuming it is cash and not stock. The basic decision comes down to return on investment with the choices being stock repurchase versus reinvestment in the remaining three studios.

Crunchbase has reported that Kabam has received a total of $244.5 Million from investors — $120M from Alibaba, and the remaining $144.5 Million from venture capitalists. Given the hunger for realized returns by VCs these day, we believe Kabam’s Board has to return a minimum of 2X to investors or $489 Million sooner than later.

In our opinion, we don’t see much remaining at Kabam that merits an investment, (details below) assuming the Vancouver game engine and the rights to the Transformer game goes with the winning bid. A minimum 2X payout still leaves $311 Million, which is way too much to reinvest in the company. We could see the company keeping only $150 Million, and paying out another $150 Million.

The company has announced only one other game in development — a MMO game based on Avatar IP licensed from James Cameron, the film maker who gave us Avatar, Titanic, Alien, and Terminator. The game is being developed by Kabam’s LA studio. It is scheduled to be release in conjunction with the release of Avatar 2 movie. It is not clear what game engine is behind this development.

On the one hand, investing in any creative project based on James Cameron IP seems like a winner. But, Cameron is known for being very fickle. The release date for Avatar 2 has been in a constant state of flux and has been pushed back another year to December 2017.

Also, it is hard for us to conceive Avatar as a MMO battle game like the hit games from Supercell or MZ. Avatar seem better suited as MMO role playing game, which does well in Asia, but not so well in the West.

Also, who’s to say that Cameron might change his mind and want a VR game instead of a MMO mobile game? Still, saving the LA studio of 80+ developers and reserving plenty of cash for the Avatar game seems like a good investment.

We have no clue what Kabam’s Beijing studio of 200+ is doing these days. The spectacular failure to localize the Marvel game for the Chinese market puts it at the top of our list for closure. This includes exits for two of Kabam’s co-founders — long time studio head Michael Li andHolly Liu who moved to Beijing in 2015 to help manage the studio.

The Chinese Marvel game did hit #1 on the Apple iOS China download charts — for one day. And Kabam cajoled Dean Takahashi of Venturebeat into writing an article with this headline: “How Kabam Self-Published Its Marvel Mobile Game in China — and Hit #1”

But, the game never caught on and has been on a steady downtrend with a current revenue rank around #250 on Apple’s iOS China app store.(see chart below).

 

 

 

 

 

 

 

 

 

 

The failure of Kabam to localize the Marvel game has reduced the likelihood that its leading investor Alibaba, or any other potential Chinese investor, to pour more money into the company.

Finally, what should Kabam’s Board do with its San Francisco HQ run by CEO and co-founder Kevin Chou and its studio numbering 279+ developers and support personnel?

The studio itself is responsible for three of the recent failed releases. Plus, we have argued that the cause of Kabam’s failure to release games with long-term engagement value has been a short-sighted, “talk the talk” culture coming out of its San Francisco HQ.

CEO Chou has admitted as much now saying that the company is focused on “bigger, bolder, fewer” game releases. But, in our opinion, he still doesn’t understand what it takes to create long-term player engagement. He thinks it is through mobile games with AAA console graphics including 3D. In our opinion, it is through “metagame” starting with a real-time, crowd-sourced chat translator similar to what MZ (formerly Machine Zone) developed three years ago.

For these reason, we could see the $800 Million bid as the death knell of Kabam’s San Francisco operations with a massive layoff numbering 250+ coupled with golden-parachute exits by CEO Kevin Chou and COO Kent Wakeford. Kabam could then downsize its HQ and relocate it in LA with the company headed by President of Studios and Chief Creative officer Mike Verdu.

The Bancorp: Oversold Says Richard Thaler’s Behavioral Finance Fund

Lawrence Abrams No Comments

Summary

  • On September 29th, The Bancorp will hold a special meeting of stockholders to vote on a $74 Million secondary offering.
  • The terms and conditions are an insult to existing institutional investors and there is evidence that The Bancorp genuinely fears that a NO vote might win.
  • If a NO vote wins, the deciding votes will come from a hedge fund run by the famous behavioral finance theorist Richard Thaler.
  • If a NO vote wins, we predict that the stock will pop up 10% or more.

On September 29th, The Bancorp will hold a special meeting of stockholders to vote on a $74 Million secondary offering.

The terms and conditions are an insult to existing institutional investors and there is evidence that The Bancorp genuinely fears that a NO vote might win.

If a NO vote wins, the deciding votes will come from a hedge fund run by the famous behavioral financial theorist Richard Thaler.

If a NO vote wins, we predict that the stock will pop up 10% or more.

 In response to the subprime mortgage meltdown a decade ago, the US Congress passed the Dodd-Frank Act of 2009-2010 which, among other things, required FDIC-insured banks to maintain a Tier 1 leverage ratio (capital / average assets) greater that 5%.

This means that a relatively small (e.g. 5%-10%) mark down of a major asset class — whether it be loans outright or collateralized debt obligations — could wipe out a third or more of a bank’s capital. This would almost always cause a bank to fall below the Dodd-Frank standard for a “well-capitalized bank”.

Falling below the Dodd-Frank standard would trigger an existential crisis for the bank, forcing a merger or a private placement, often coupled with a massive shake-up of management and the board.

The Bancorp (NASDAQ:TBBK) has a two and a half years running history of erratic mark-to-market accounting of troubled commercial loans, followed by a series of moves to avoid falling below the Dodd-Frank standard for a “well-capitalized bank.”

We have documented The Bancorp’s problems in three previous articles for Seeking Alpha: The Bancorp: Bad Moon Rising (January 2015); The Bancorp: Continuing Problems with a Discontinued Operation (March 2015); and The Bancorp: Why the Continuing Delays in Filing Its 10-K(May 2015).

We have also published a recent accounting article called The Bancorp: A Test for Post-Enron GAAP that analyzes its late 2014 decision not to consolidate an LLC formed to buy the most troubled portion of its discontinued commercial loan portfolio.

Even though approved by its outside auditor Grant Thornton LLP, we believe that this decision is not in compliance with GAAP and have requested another review by the FDIC and the Federal Reserve Bank.

On July 28, 2016, The Bancorp announced a $31 Million loss for 2Q16, largely due to an unexpected $32 Million in loan mark downs / note write-offs associated with its discontinued commercial loan operation. The Bancorp’s balance sheet had been spared of any hits since the bank first announced the discontinuation of commercial lending operations on October 30, 2014.

During the Conference Call, one analyst quipped, “.. maybe you guys ripped the Band-Aid off this quarter..” and went on to say he was unsure whether these losses were a one-time event or the beginning of a more forthright examination of the valuations of these troubled loan portfolios.

The 2Q16 surprise loss and follow-up conference call sent The Bancorp’s stock down 14% the next day.

Two weeks later on August 8, 2016, The Bancorp announced a $74 Million private placement of new stock with two new investors accompanied by terms and conditions suggesting that the bank was desperate to get a deal done. In particular, the new stock was priced below market at $4.50 a share and the two new investors each were offered a board seat.

We wrote in an SA article that this private placement was a defensive move motivated by a desire to reverse a downward spiral toward the Dodd-Frank standard rather than a positive move to acquire more capital to support more loan-making activity.

We also speculated that the bank’s existing institutional investors would be angered by the terms and conditions because they had invested comparable amounts over the past few years at prices in the $10 to $20 a share range with no offers of board seats.

On August 26th, The Bancorp issued a DEF 14A Proxy notice of a special meeting of shareholders to vote on this secondary offering. The date set was September 29, 2016 at company headquarters in Wilmington, DE with stockholders on record at the end of the day on August 15, 2015 eligible to vote.

In order to hold this meeting, a quorum of ½ of total outstanding shares — 18.9 Million of 37.8 Million total shares on record — must be cast in person or sent in by proxy. At its December 2015 annual meeting, a total of 29 Million votes were cast for the slate of Board members up for re-election. Average tally per Board Member was 25 Million YES, and 4 Million NO.

We think that the total votes in the upcoming special election will exceed 30 Million with 15 Million NO votes needed to stop this secondary offering from going through. The secondary offering can be stopped if at least 6 of the largest institutional investors (see list below) vote NO.

We think the “tipping point” votes will come from its newest and largest institutional investor, the behavioral finance fund Fuller & Thaler Asset Management. (more on them later)

A NO vote would mean that The Bancorp would have to look elsewhere for additional capital to shore up its status as a well-capitalized bank. Another private placement with new investors seems unlikely. A merger with another bank, possibly forced by the FDIC and Federal Reserve Bank, would appear to be the only option left.

In sum, The Bancorp’s Management and the Board would face an existential crisis with a NO vote on September 29, 2016.

While majority NO votes going against Management recommendations are rare, nevertheless there is evidence that The Bancorp’s Management and Board genuinely fear that a NO vote might win.

The evidence for this is an unprecedented flurry of positive PR announcements issued by the bank during the past month. This includes token open market purchases of shares by Directors and Officers, a “cherry-picked” sale of loans from the discontinued portfolio, a inconsequential deal with a Fintech startup, culminating in a vague cost-reduction and layoff announcement:

8/17 — 10,000 shares bought in open market by Director Bradley.

8/24 — 26,000 shared bought in open market by Chief Administrative Officer Leto.

8/26 — a “cherry-picked” new $65 Million sale of discontinued loans to First Priority Bank.

8/29 — 1,000 shares bought in open market by Chief Operating Officer McFadden.

8/29 — 20,000 shares bought in open market by Director Kozlov.

9/9 — 2,000 shared bought in open market by Chief Operating Officer McFadden.

9/14 — deal to front online banking startup VARO Money.

9/15 — a cost-reduction plan with no specific headcount or reserves booked for severance.

There is also evidence that institutional investors have a heightened interest in the outcome of this special election. First, on the August 15th cutoff date to be eligible to vote, an unprecedented 1.9 Million shares were traded suggesting a large institutional investor really wanted in. (see chart below)

ychart-of-tbbk

We are not sure, but the August 15th trading activity could have been based on inside information of the cutoff date, because we can find no prior public announcement of that August 15th date.

Second, a NASDAQ listing of The Bancorp’s institutional investors on record as of June 30, 2016 reveals an intriguing new, and now largest, investor. This new investor is Fuller & Thaler Asset Management– a hedge fund run by Richard Thaler, a University of Chicago professor now famous for theories on behavioral finance and “nudge”.

Thaler believes that behavioral economics can uncover cases where the “efficient-market” hypothesis is not working.

A Forbes article on Thaler’s investment strategy said that investing in companies with bad management accompanied by negative sentiment actually led to above average returns. The Bancorp would seem to be a perfect test for Thaler’s theories.

Thaler’s 2.2 Million share accumulation of The Bancorp stock during 2016 suggest that Thaler believe that negative sentiment has gone too far (led by us!) and that TBBK is in an oversold position.

The question is how will Thaler vote his 2.2 Million shares in the upcoming special election? And will the stock pop or drop with a majority NO vote? (We would love your take on these questions in the comments section.)

We think that Thaler will voting NO on the private placement. Also, we believe that the existential crisis caused by a NO vote will be overlooked by the stock market as it will be the first step in getting rid of bad management (fundamentally, the Chairman Daniel G. Cohen) and reversing the negative sentiment.

We predict that TBBK will pop 10% or more IF a NO vote wins. With Management and Board on the way out, the stock become a buy because its current price of $6.00+ a share is 15% below its current tangible book value of about $7.00 a share.

The Bancorp is not the only one facing an existential crisis here. As a financial analyst inclined toward exposing badly managed and overvalued companies, is our mission in life to create opportunities for outsized returns by behavioral finance investors like Richard Thaler?