Description

Consensus thinking seems to be – FNGN is a scalable business with high incremental margins that may (or may not) justify a sky high multiple (60x GAAP EPS, 17.5x a highly adjusted EBITDA) depending on thoughts about secular/cyclical growth/headwinds. In our opinion, consensus is wrong. The company is pretty much an outsourced call center for 401k advice with a little bit of software – not an asset manager with fixed costs. While there are some advantages to scale, costs are basically tied to customer count and variable… ie don’t expect any operating leverage.

Accounting practices make operating margins look LOWER than they are, revenue growth better than it is and, most importantly, give investors unjustified hope that margins will increase as revenue grows. What’s the accounting issue? A large portion of COGS are fees remitted back to plan providers. If FNGN explicitly disclosed remittances or didn’t account for subadvisory and direct advisory revenue in different ways – it would be clear that operating margin = incremental margins (excluding S&M expense) and projections for significant margin expansion are unrealistic.

To make the accounting adjustment we think is appropriate, you have to look at historical MD&A disclosure. Each year FNGN gives you the $ increase in remittances in its discussion of “cost of revenue”. Make an estimate about the 2009 remittances, add up annual $ increases and you get a good number for remittances and effectively net fees received. We think $20m in 2009 is right number considering: 1) trends in remittances as % of total COG growth; and 2) Other COGS as a % of total COGs. See below:

Looking at the adjusted numbers, it’s pretty clear that adjusted operating margins are consistently around ~50% and incrementals are no higher despite an incredible operating environment over the last few years.

* Take notice of gross margin compression

* For those of you that are curious about what happened in 2014… Co-founder, CEO Jeff Maggioncalda retired at the age of 46 in the 4th quarter 2014 on a very, very high note

* For those that want to quickly bridge our operating profit # with reported EBITDA of $93m in 2015. Their number included: 1) $23m in stock comp; 2) $6m of direct response advertising; 3) $5m of depreciation; 4) $5m of capitalized software amortization; 5) $3m of acquisition related expenses; 6) $2m of amortized deferred sales commissions. We believe the majority of these charges are real and should not be backed out

So what’s the right way to think about normalized operating income for core FNGN? That depends on steady state sales and marketing (S&M) expense assumptions. In each of the last 4 years – which were pretty good years – FNGN lost 15% of its EOP AUM to voluntary or involuntary cancellations (churn). Considering trends in cancellations, increased market nervousness, management commentary and actions including the acquisition the Mutual Fund Stores acquisition (more on this later), we believe churn is picking up just as it’s becoming more expensive to acquire new AUM. FNGN forward looking business is getting squeezed. In 2015, churn represented 74% of new enrollment AUM, up substantially from prior years (57%, 61%, 68% in 2012, 2013 and 2014). Based on 2016 EBITDA guidance of $110m and implied EBITDA of $70m for core FNGN… the problem seems to be getting worse. Even using pretty bullish estimates for AUM growth, etc… we struggle to see normalized Op Income for core FNGN above ~$55m.

* Apologize for using operating income rather than EBITDA. There is just so many different ways to slice and dice EBITDA that it’s easier to just use operating income and let people add back whatever they want.

* Look at how much harder it has become for them to raise money (S&M expense/new enrollees or enrollment AUM)

* 2016 guidance was for ~$110m in EBITDA with an estimated $40m from the Mutual Fund Stores (announced at market lows, so***)…. But that means ~$70m from FNGN core, which would be down $23m from 2015. Don’t know if that’s coming from higher S&M expense or more margin pressure. Guessing a little of both

* 2017 assumptions underlying estimates are as bullish as I can imagine

So with a business stuck earning ~$55m in EBIT valued at ~$1.7b, what does management do? It makes an acquisition and issues overvalued equity. In the 4th quarter 2015, FNGN bought the Mutual Fund Stores for ~$500m (8.5m shares @ ~$30 + ~$250m in cash) or 12.5x EBITDA. While the deal is obviously accretive and masks continued operational challenges in its core, the Mutual Fund Store is the exact opposite of what FNGN purports to be – a physical store that sells mutual funds? We hope the Mutual Fund Store name alone might lead investors to ask legitimate questions of FNGN’s forward looking strategy. Like: 1) Why deviate from such a “scalable model” to grow the business? 2) Is growth S&M expense (as opposed to maintenance) NPV positive? 3) How do you replace your best customers (old people with large account balances) when they retire? With young, small account customers?

How do we think about valuation? We put the company into 4 buckets:

* Cash:                                $100m

* Core FNGN:                     10x $55m Op Income = $550m. Or 16x net income. Quite generous

* Mutual Fund Stores:     $500m or what they paid for it. Probably quite generous

* Growth FNGN:                Growth S&M expense of $15m per annum. $150m… Hard to say exactly, but we think there is evidence that optimistic scenarios need to be made to assume these new customers are NPV positive.

Target Price: $1.3b/62m = ~$21… or lower

Eventually the market is going to wake up to the truth about FNGN and the multiple is going to contract. Maybe the Mutual Fund Store makes people realize this might not be the growth company it purports to be – maybe not? Maybe its continued weak results? Until then… you get to deal with a highly promotional management team, crazy non-gaap adjustments, and promises that operating leverage will emerge once its “investment phase” is complete. For those cynical as us… the company’s founders are Bill Sharpe & Joseph Grundfest

Catalyst

continued weak results driven by unprofitable S&M spend, potential warburg exit