Shorting Bankrate
THINK OF THE LAST TIME YOU BOUGHT A HOUSE or refinanced a mortgage. How did you decide on where to get your mortgage? Many mortgage shoppers who compare quotes online discover a stunning array of choices.
This development has placed consumers in the driver’s seat when it comes to choosing a loan. Since banks have few tools to differentiate their money from their competitors’ money, they usually compete by offering the lowest possible interest rate.
At the right price, or interest rate, nearly anyone can get a loan for nearly anything these days. The Internet offers endless information from every imaginable bank, credit union or auto finance company.
The value of interest rate information is hard to define. We can safely assume it’s not very valuable when it’s freely available from multiple sources, and dozens of media channels clamor to offer the same information — in return for a small commission from bankers.
This business model is fairly simple. It’s the business model of Bankrate, Inc. (RATE: NASDAQ). Just like AutoTrader.com funnels car-shopping traffic to car dealers for a fee, Bankrate directs Web traffic to mortgage brokers and bankers for a fee. This is how Bankrate makes its money. It generates sales leads for bankers in exchange for “per click” fees.
Considering that Bankrate does little more than publish interest rate data, why should its stock sell for so many times its earnings? Could such a Web site have a lasting competitive advantage? Why couldn’t sites with far larger audiences — like MSN Money, Yahoo Finance or Google Finance — chip away at Bankrate’s core high-margin business?
More importantly, since Bankrate’s customer base is in the midst of a nasty downturn, is it reasonable for the 17 analysts covering RATE to expect 150% earnings growth in 2007 and 20% earnings growth in 2008? I don’t think it is.
Bankrate exhibits several traits of what you want to look for in a short sale:
- An expensive stock price
- A contracting customer base
- A history of making value-destroying acquisitions
- Aggressive accounting
- A very generous stock option program.
An Expensive Stock
Bankrate is a pricey stock. Given its stratospheric valuation, the market expects Bankrate to deliver blistering sales growth as far as the eye can see. Keep in mind that making a profit on the short side of Bankrate stock isn’t a bet that business will fall apart overnight; a successful short sale only requires the market to lower its expectation of Bankrate’s growth potential just a bit.
In my view, the market is paying way too much for this business, given the numerous threats to Bankrate’s rapid growth story. Googling the word “mortgage” turns up a very long list of Web sites offering quotes, with Bankrate in the middle. LendingTree, E-Loan, Quicken Loans and even ABN AMRO and Wells Fargo are listed above Bankrate’s site.
It’s hard for Bankrate to make the case to its core advertisers that most of the leads it delivers to them aren’t simply generated in a random fashion. So I don’t buy management’s case that it can gradually raise prices for its leads over time. Bankrate will remain at the mercy of whatever its big bank customers are willing to pay per “click lead.” Also, the more Bankrate tries to raise prices, the more competition it will invite.
As Internet users grow more sophisticated over time, it’s reasonable to expect that loan shoppers will search more and more Web sites for quotes. The growth of shopping for loans online benefits the consumers of loan information far more than it ever will the producers of this information.
A Series of Value-Destroying Acquisitions
Acquisitions often serve as a convenient distraction when a high-growth business starts to slow down. In December 2005, Bankrate paid $10 million in cash to acquire FastFind and $30 million in cash to acquire Mortgage Market Information Services and Interest.com. These acquisitions added mostly “goodwill” to Bankrate’s balance sheet, yet have been quite disappointing. Goodwill is the difference between the total purchase price and the acquired company’s book value.
Despite having high hopes for FastFind, management is struggling to integrate it, discovering just how tough it is to compete in the “qualified leads” business. Companies like LendingTree and LowerMyBills.com dominate this business.
Bankrate now has $135 million in cash on its balance sheet, and management intends to use it to fund future acquisitions. Given its track record of spending cash on value-destroying acquisitions like FastFind, this should not be viewed as a positive.
It’s important to note that the Bankrate did not generate this cash from its business operations; rather, a $90 million chunk has been sitting on Bankrate’s balance sheet earning interest since the company raised it in a May 2006 secondary stock offering — an offering in which insiders took the opportunity to sell $16 million worth of stock.
This is hardly a vote of confidence in the strategy of raising cash to fund acquisitions. Why did insiders sell $16 million worth of stock if they really expected this pile of cash to be put to work in a value-creating manner? Shouldn’t they have held onto these shares if the opportunities they talk about are so wonderful?
When a company uses its expensive stock as acquisition currency, it’s easy to create acquired growth, especially when organic growth (growth in the existing business) slows down. Investors shouldn’t be fooled into thinking that these two types of growth are the same.
Aggressive Accounting
Not only have acquisitions been disappointing and masked decelerating organic growth, but the sheer size of them in relation to Bankrate’s business allowed management plenty of leeway to adjust various accounts in financial statements.
Perhaps the most glaring sign of poor earnings quality is depicted in the following chart. Up until the most recent quarter ending in June, accounts receivable (A/R) had been growing significantly faster than sales for a long time.
This is a classic sign that earnings have been getting a boost from aggressive accounting practices. Without getting into the details, it indicates some combination of the following:
- Bankrate’s customers may be demanding better payment terms.
- Customers may be delinquent in paying Bankrate for services rendered (i.e., defunct mortgage brokers like New Century could stiff Bankrate in bankruptcy court).
- Bankrate’s revenue recognition practices may be too aggressive.
None of this would be good for shareholders.
A Generous Stock Option Program
One share of Bankrate stock is a claim on the cash per share that the company ultimately generates. Thanks to an egregious stock options program, the number of shares outstanding is expanding rapidly, so the cash flow per share faces a major head wind.
To help illustrate this effect, think of a pie sliced into 100 pieces. One share represents one slice of pie. Now imagine that next year’s pie is sliced into 107 pieces. One share still represents one slice of pie, but this slice is noticeably smaller than last year’s slice. Each year, more and more slices are made, so the slices become smaller and smaller.
Bankrate’s cash flow is sliced up and served to more and more shareholders each year. The company has issued options to its executives at an average annual rate of 7% of outstanding shares over the past three years. As a company controlled by the board and management, this policy is likely to continue. It’s obvious that executives are enriching themselves at the expense of shareholders, because net income must grow 7% per year just to keep earnings per share growth at 0%.
These are all clues of a stock that is on its way down. Keep an eye out for companies like this and you will be sure to spot many more short options. You’ll need to do your research, but symptoms of a good short rarely ever lie.
Regards,
Dan Amoss, CFA
January 18, 2008
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