Archives June 2014

Markit IPO: Buy the Moat and Be Better than Buffett

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Summary:

• Markit’s IPO is set for Wednesday, June 18th. It is a buy. Its core product are prices and indices that facilitate the buying and selling of credit default swaps.
• Its biggest threat is its own Board of Directors – a bank cartel which wears multiple hats as supplier, customer, dominant shareholder, and underwriter.
• We use a game theoretic approach to analyze Markit’s prospects, suggesting that this moat’s moat is a doomsday machine defense.
• Even at our estimated trailing P/E ratio of 30, it is a buy.
• In doing so, you will be able to brag that you outdid Buffett because you are buying the moat instead of a company with a moat.

“In business, I look for economic castles protected by unbreachable moats.” – Warren Buffett

Markit’s (MRKT) core product are prices that facilitate the buying and selling of credit default swaps (CDS) – insurance on complex heterogeneous debt called asset-backed securities (ABS) and collateralized debt obligations (CDO).

They also have created a series of branded indices, representing particular classes of ABSs and CDOs, much like the S&P index, that are traded. This includes the well- known brands Markit CDX™, iTraxx®, and iBoxx®

Their business is impenetrable, with both definitions of this adjective applicable: (1) impossible to enter; (2) impossible to understand.

So, don’t spend too much time trying to figure out what Markit does or poring over their financials, which I will summarize below. Just buy it. (Swoosh)

For those financial wonks that want a deeper dive, I recommend a paper by Robert E. Litan called “Derivatives Dealers Club” published by The Brookings Institute. Needless to say of a Brookings-sponsored publication, the conclusions are anti-laissez faire.

By adding Markit to your portfolio, you will be able to tell friends you outdid Warren Buffett’s mantra of buying companies with moats, because you just bought the moat.

Indeed you will be buying the mother of all moats, as Markit protects a cartel of twelve of the most powerful banks in the world who make lucrative commissions brokering over-the-counter [OTC] two party trades with an estimated yearly value of $57 TRILLION DOLLARS in 2011.

Markit acts as a moat for the bank cartel by refusing to sell its data to entities who wish to start up a CDS exchange as an alternative to the banks’ less transparent, more lucrative OTC way of doing business. The reason Markit refuses is…guess?

The bank cartel owns a dominant share of Markit’s stock and sits on its Board of Directors.

Another reason to add Markit to your portfolio is that you will be adding a rare buy-and-hold stock that will around three decades from now and still be appreciating.

You can have confidence in a buy-and-hold strategy for Markit that you can’t have for tech stocks with alleged moats as evidenced by the performance of the likes of Intel, Microsoft, Cisco, and Oracle.

In some ways, Markit is similar to bond rating companies. A 30 year buy-and-hold strategy seems reasonable given these founding dates: Standard & Poor’s (1860), Moody’s (1909) and Fitch (1913). CDS will last as long as bonds and so too will the data analytics companies that first rate these financial instruments.

We wish to address now the threats to Markit’s financials. In other words, what is this moat’s moat? We think the primary threat is not the government, or potential competitors, but its own Board of Directors.

As we will summarize below, Markit is profitable with the latest FY2013 GAAP profit margin of 15.5% and an adjusted EBITDA margin of 44.4%  (See F-1 filed with the SEC in conjunction with its IPO).

But, we ask ourselves, given its critical role in the smooth functioning of a $57+ Trillion market, why is Markit not more profitable?

The answer starts with the fact that a dominant share of Markit’s stock is owned by twelve of the largest banks in the world who both broker CDS trades and supply Markit with ongoing trade data.

Markit’s financial engineers then slice and dice this data creating synthetic prices and indices, whose value is in reducing the price discovery costs of those who buy and sell CDS. Markit then licenses its products back to banks and other financial institutions including hedge funds.

The banks wear an unprecedented 4 different hats when relating to Markit: Supplier / Customer / Stockholder and Board Member / Underwriter.

From Markit’s F-1 on reducing the banks’ rights to sit on its Board:

“Reduced engagement from these financial institution customers after this offering due to their loss of a right to designate a member of our Board of Directors, or the reduction in the level of their equity ownership in us in connection with or following the completion of this offering, may cause them to reduce or discontinue their use of our products and services, their desire to work with us on new product developments or their willingness to supply data and information services to us..”

From Markit’s F-1 on customers as shareholders as underwriters:

“We have historically earned a substantial portion of our revenue from and have worked on new product and service offerings with financial institution customers that are also our shareholders. For the years ended December 31, 2011, 2012 and 2013, 43.8%, 44.7% and 42.6% of our total revenue, respectively, was generated by payments from financial institutions or their affiliates that are also our shareholders, some of which are underwriters of this offering.”

There are 3 groups who are a threat to Markit: (1) its own Board of Directors; (2) government antitrust regulators; and (3) data analytics competitors. We have no real insight into Markit’s strategy for (3).

But, Markit’s defense for threat (1) and (2) comes straight out of game-theory whose foundation is based on the work of John von Neumann and John F. Nash (A Beautiful Mind).

The defense is known as “the doomsday machine” defense, a form of Nash equilibrium in which neither side, once armed, has any incentive to initiate a conflict or to disarm.

What Markit can do is let potential threats know that if attacked, Markit will trigger a “doomsday machine” with mutual assured destruction [MAD], an acronym first coined by the great John von Neumann and made popular by the movie Dr. Strangelove.

We have become familiar with a particular application of this defense called the “too big to fail” defense that these same banks used to persuade the Federal Reserve Bank to buy its distressed ABSs and CDOs back in 2008.

Markit can turn the tables this time and use this defense against its Board of Directors.
For example, in response to a Board (bank cartel) refusal to approve a large price increase to customers (same bank cartel), Markit CEO could respond by having its systems engineers delay transmission of data, halting multi-billions of dollars of CDS trades.

The same doomsday defense is available both to Markit and its Board should governments try open up CDS trades to any newly formed, more transparent exchange as an alternative to the opaque, more lucrative, OTC trading favored by the banks.

The threat comes as a suggestion that, while imperfect, OTC trading is a known quantity. Moving CDS trading to a transparent exchange might wreak havoc on world financial markets with resulting MAD.

Compared to a game-theoretic approach to Markit’s prospects, a financial analysis of its IPO is downright dull.

Markit is very profitable, but not insanely so given its “mother of all moats” position. Its top line growth has slowed since the crisis of 2008. But, as a believer in the Minsky theory of the inherent instability of capitalism, I am confident that Markit can look forward to a “Minsky moment” every 10 years or so.

Some analysts have said that Markit’s profit levels and margins are in decline. But they are looking at GAAP figures, not EBITDA, which is on the rise.

Markit has been doing a lot of investing lately in businesses outside its core. This has resulted in poor cash flow and substantial amortization that cut GAAP numbers. Markit explicitly states that it does not intend to pay a dividend in the foreseeable future.

There is also the question of its incorporation in Bermuda, but the implications of this are beyond our expertise.

The IPO will not yield any cash for Markit as it consists totally of stock of existing shareholders. If successful, there is likely to be follow-on offerings of new stock because Markit needs cash to continue diversification through more acquisitions.

It could also be part of its doomsday machine defense as by expanding its shareholder base, it can point to more innocent bystanders that will be destroyed if attacked.

For example, it has reported that the Canadian Pension Plan Investment Board plans to invest up to $450M in this IPO. Markit could use more civic-minded stockholders like this as they could rally them in defense should anti-trust regulators encroach.

The IPO is slated for Wednesday, June 18, 2014 and is expected to be priced between $23 and $25 a share. At the mid-point price of $24, we have estimated that Markit’s trailing price-earnings ratio will be 30. The IPO price is not cheap.

But, how often do you get an opportunity to one-up Buffett by buying a moat instead of a company with a moat?

The following graphs based on its F-1 summarize Markit’s financials for the last five years.

Revenue and Profit

 

Margins

 

EPS Trends


Kabam: Mobile Gaming Company IPOs after King and Zynga

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Kabam is a San Francisco-based mobile gaming company with three hit games each of which has reportedly grossed over $100 M since launching.  In a recent interview with the Wall Street Journal, Kabam’s CEO Kevin Chou disclosed that

“Kabam has raised $125 million from investors including Canaan Partners, Redpoint           Ventures, Intel Capital, Pinnacle Ventures, Google Ventures and SK Telelcom                     Ventures. The company increased revenue 100% to more than $360 million in 2013           and expects to generate between $550 and $650 million in 2014.”

Chou said that it “is still gunning for an IPO despite King Digital Entertainment’s (KING) disappointing debut”.

A similar sentiment might have been elicited a year ago from King Digital’s CEO to the effect that King was gunning for an IPO despite Zynga’s (ZNGA) disappointing debut in 2011.

The US mobile gaming industry cannot afford another disappointing IPO.

I am a fan of the US mobile gaming industry. I think the long term prospects are bright. But, the industry has a problem. The problem is NOT that the financials are hit-driven and spiky. The problem is a bad track record of pricing and timing of IPOs.

Right now Kabam and Palo Alto-based Machine Zone are two mobile gaming start-ups with hit games and yearly revenue run rates exceeding $500M. Both are very profitable and deserve to go public.

Like King, these two very successful start-ups are sitting on plenty of cash — estimated at roughly $200 M to $300 M each — generated from these hits. The need for an IPO is not for working capital or even for acquisitions.  The need is to provide liquidity to existing investors and employees with stock options.

There are important lessons from the disappointing IPOs of King and Zynga to be considered ahead of the next IPO:

(1) Don’t price (buy) a mobile gaming IPO at much more than 2 time trailing price-sale ratio.

(2) There is a small window to go public (buy into) successfully. It is between month 4  and month 7 during which a hit game is consistently among Top 10 on the iOS Apple store US revenue ranking charts.

The purpose of this article is to present data and charts supporting these two lessons. First, we present a comparison of IPO and current trailing price-sales (P/S) ratios of King and Zynga.

Trailing PS

(Source King F-1 and Zynga S-1)

King went public at the pinnacle of success of its “Billion Dollar Club” game Candy Crush Saga. At the time of its IPO in early March 2014, its Q/Q revenue was flat for 2 quarters.

Zynga went public on the cusp of the transition from PC browser-based games accessed from Facebook to native smartphone games downloaded from app stores. Its stock has dropped 66% since the IPO, caused by the multiplicative effect of declining revenue and a declining P/S ratio.

Based on these two disappointing post-IPO performances, I believe that the next mobile game company IPO should be priced with a reasonable assurance of stock appreciation post-IPO. It should be a win-win, not a win-lose transaction between existing and new investors.

The current trailing P/S ratio of King is 2.23. I think that 2.23 is a win-win standard for pricing the next mobile gaming IPO.

The Wall Street Journal reported that in July 2013, Kabam employees sold $38.5M worth of stock in a private transaction that implied a $700M valuation for the company. According to the Wall Street interview cited above, Kabam estimates that its 2014 revenue will be between $550M am $650M. (We peg it at the low end due to the declining revenue trend in its latest hit game The Hobbit: Kingdoms of Middle-earth.)

Priced reasonably at King’s current P/S ratio of 2.23 and a current yearly revenue run rate of $550M, Kabam’s IPO value would be $1.23B, up nicely 75% from the previous valuation 2013.

A more reasonable pricing of an IPO is not enough. Timing of the IPO matters. The rising revenue trajectory of a hit game is not likely to last beyond 12 months. And while great gaming companies like Kabam, Machine Zone, King, and Supercell have demonstrated an ability to launch multiple hits, the launch dates are often a year or more apart. Mobile gaming companies have just one small window a year to go public.

We review first the timing of the King IPO in light of the disclosed financials in it pre-IPO SEC filing summarized below:

screen shot 2014-02-18 at 6.59.53 am

(Source King F-1)

People were horrified when they first saw this graphic depicting flat Q/Q revenue just before the IPO in March 2014. There was a sense of impending doom. And sure enough the stock dropped 16% the day of the IPO.

In hindsight, the time for King to do their IPO would have been in 2Q2013 (June-August) giving management and IPO investors a full 6 months of rising financials.

Before I evaluate the best time for a Kabam IPO, we need to present the results of an one of my earlier papers where I estimated the relation between a specific game’s revenue ranking on app store charts and its dollar revenue. I use revenue ranking charts for iOS Apple Store in the US which are available for free from App Annie.

Occasionally, publicly held companies like King (for the Saga series) and Glu Mobile (for Deer Hunter 2014) have reported quarterly revenues for specific games. This allows an exact correlation with the App Annie revenue rank at the time. Below is a depiction of the Zipf-like power function relation between app store revenue and revenue rank for 4Q2013 with 4 actual data points:

Power Function

Looking ahead to Kabam’s prospective IPO, we believe that it would be best for them to do it when they have a Top 10 hit on the rise. This would give them at least one game with a rising quarterly run rate of $50M or a yearly run rate of $200M.

Kabam seemed to have an amazing window to go public between January and April 2013. It had not one, but two Top 10 hits: Kingdoms of Camelot: Battle for the North at the pinnacle of its success and a rising star in The Hobbit: Kingdoms of Middle-earth. The Hobbit was just cracking the Top 10 at the end of the window in April 2012.

Kabam’s run’s rate in 1Q2013 was at least $100M. And there was some significant revenue upside post-IPO. Of course, no one knew for sure during 1Q2013 that the rest of 2013 would be so good for Kabam. But, a mobile game that cracks the Top 10 and stays there for 4 month is a sign of some “addiction” and I think that Kabam executives and board members knew that 2013 would be year of rising financials.

Trailing revenue by Kabam’s own account was around $180M for 2012. Valuation of the hypothetical IPO at our recommended 2.23 P/S would have only been only $400M.

Remember, the above the reference to an actual private sale in July 2013 valuing the company at $700M. Assuming a trailing revenue run rate at the average of 2012 and 2013 = (360+180)/2 = $270 M,  the implied trailing P/S at the time of this private transaction was only 2.59 — greater than my suggested standard of 2.23, but less than King’s later IPO value of 3.76.

Maybe, it was premature for Kabam to go public in 1Q2013 with such a good year ahead of itself in 2013.

But, those venture capitalists, employees with stock options, and IPO investors would be holding stock in a company with rising revenue and profit throughout 2013. Trailing revenue at the end of 2013 would have been $360 M. With an increasing post-IPO P/S of, say 3, Kabam would have been valued at $1.08 B by the end of 2013.

Kabam management and board would have been celebrating New Year’s 2014 with a bunch of happy stockholders and employees as the stock would have appreciated 250% post-IPO. And importantly, stockholders would have the liquidity to reduce their holding  if they had a bad feeling about King IPO later in 2014.

Alas, Kabam missed a great window of opportunity to go public between January and April of 2013.

It is easy to second-guess management and the board.  The big negative at the time was the performance of ZNGA’s stock post-IPO.  The stock went from an IPO price of $10.00 in November 2011 to a high of $14.50 in March 2012 only to fall 86% during 2012 to a low of $2.09 in November 2012.  Ouch!

Maybe as a consolation for missing a golden (bears) opportunity, Kabam’s 4 cofounders – all UC-Berkeley alumni, paid the University $18M in December, 2013 for stenciling a big KABAM on the gridiron at Memorial Stadium.

Furthermore, as the charts show below, Kingdoms of Camelot has continued to fade and now is only a Top 50 game. The Hobbit has remained amazingly strong, but shows just enough fade this past month to suggest that the IPO window has closed for Kabam in 2014.

Not to worry, Kabam still has plenty of cash and cache. Its management can see the Kabam name on the Cal football field as they watch their beloved Bears get crushed once again. So what, they are living proof that the industry is not plagued by one-hit wonders.

If Kabam’s existing investors are impatient for an IPO, Kabam has plenty of cash from its hit games to pay millions in dividends.   King did this did this before its IPO, paying out $500 million in dividends in the style of a private-equity dividend recap.

And, it was last week that the Wall Street Journal  reported  that Kabam has struck a deal with Lions Gate to develop mobile games based on the hit movie “Hunger Games”.

It is likely that the next big Kabam hit will be launched in conjunction with the 3rd installment of the Hunger Games scheduled for release in November 2014.  Given their track record for developing hits, I expect a Kabam IPO in 1Q2015.

Kingdoms of Camelot: 2013

Kingdoms of Camelot 2013 Battle for the North ®   Rank History   App Annie

The Hobbit: 2013

The Hobbit  Kingdoms of Middle 2013earth   Rank History   App Annie

 Kingdoms of Camelot: January – May 2014

Kingdoms of Camelot 2013 Battle for the North ®   Rank History   App Annie

 The Hobbit: January – January – May 2014

The Hobbit  Kingdoms of Middle 2013earth   Rank History   App Annie