2023 | 2024 | ||||||
Price: | 50.00 | EPS | 0 | 0 | |||
Shares Out. (in M): | 1,900 | P/E | 0 | 0 | |||
Market Cap (in $M): | 100,000 | P/FCF | 0 | 0 | |||
Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
TEV (in $M): | 0 | TEV/EBIT | 0 | 0 | |||
Borrow Cost: | General Collateral |
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Obviously the stock has started to react at the open today to the below thesis, after we already completed our write-up. But still posting to share with those that are curious about what’s unfolding:
Concerning: Charles Scwab has similarities to Silicon Valley Bank
As people are focusing on which regional banks are potentially next to go the way of Silicon Valley Bank, we are concerned many are missing the weakest of the large financial institutions: Charles Schwab.
Currently, with its assets marked to market value, we think the fair value Charles Schwab’s tangible equity is negative. The company’s aggressive accounting over the years has given it similar dynamics to Silicon Valley Bank.
The Silicon Valley Bank Case Study
Silicon Valley Bank’s failure provides insight into SCHW’s current woes. Between 2016 and Q1 2022, Silicon Valley Bank grew its deposit base from $40bn to $200bn. Part of these deposits (liabilities) are typically invested in treasury securities and agency-backed mortgages (assets) in case they need to be liquidated when customers choose to make withdrawals from their checking or savings accounts.
These assets are sensitive to interest rate movements: longer duration securities decline in value when interest rates rise, and shorter duration securities are relatively less sensitive. Silicon Valley Bank held 95% of these securities in >10 year long-duration maturities, which have among the highest sensitivities to rising rates.
The accounting for these securities depends on a rather arbitrary decision by management teams to classify them as either “available-for-sale” (AFS) or “held-to-maturity” (HTM) securities. AFS securities are reported on the balance sheet at fair market value, the price one would receive if the securities were sold on the open market at today’s prevailing price. Meanwhile, HTM securities are reported on the balance sheet at their original cost basis. These classifications have important implications on the calculation of a financial institution’s true equity value:
With interest rates rising in 2022 (the 10-year treasury moved from 1.5% to 4%), the fair market value of SVB’s securities started to decline. In fact, as early as Q3 2022, the fair market value of SVB’s tangible common equity was already negative.
At the same time, clients were withdrawing their deposits from $200bn down to $173bn, which continued happening in Q1 2023. At any point, a run on the bank would cause SVB to be a forced seller of all its securities at market value (an effective margin call) to meet its deposit withdrawals. Last week this happened, when nearly $44bn of withdrawal requests were made in 1 day when SVB customers panicked and asked for their money back.
Application to Charles Schwab
Charles Schwab is arguably in a similar situation. While many are currently distracted by the banks who had the most tech and start-up exposure, like PacWest and First Republic, a similar situation has risk of occuring at this much larger financial institution. Similar to SVB, SCHW has significant exposure to the more interest rate sensitive, longer duration securities. Most recently, 72% of SCHW’s securities are in >10 year maturities and 97% cumulatively are in >5 year maturities.
Conversely, companies like Interactive Brokers chose not to pursue long duration investments and are in a far superior position. When asked about this in July 2022, Thomas Petterfy stated:
Jefferies Analyst: Hey. Good afternoon, guys. This is actually [ph] Jun (24:01) subbing in for Dan. I just wanted to ask what the recent hike in interest rates and the prospect of sort of more to come. How are you guys thinking about sort of the duration and the makeup of your investment portfolio? And to kind of like generate higher returns?
Thomas Pechy Peterffy, Chairman, Interactive Brokers: No, we are not. And that's the kind of risk that we do not want to take.
As a result, for IBKR, the fair value and carry value of their assets and liabilities are fairly close together:
As interest-rates have moved up, the fair value of SCHW’s securities portfolio has declined. In fact, as early as Q3 2022, just like SVB, the fair market value of SCHW’s tangible common equity turned negative.
At the same time, like SVB, clients have been pulling their deposits out of SCHW, down from $465bn in Q1 2022 to $367bn in Q4 2022. While SCHW has argued that they are at the ending stages of cash sorting, at any moment, when depositors realize SCHW’s precarious position, Charles Schwab risks encountering a similar run as the other financials, which would cause it become a forced seller of its securities (the effective margin call) to meet deposit withdrawal requests. If the withdrawals exceed the amount of their AFS portfolio, SCHW would have to start selling its HTM portfolio at a loss. The probability of this occurring has risen significantly since SVB’s implosion, making SCHW a poor risk/reward at its current valuation. We think when depositors’ game theory starts setting in, a variety of negative outcomes are possible.
Comparing SCHW’s financial position with other financial institutions shows the relative predicament they are in:
And when incorporating the fair value of SCHW’s other assets and liabilities:
While SCHW is in a better position than SVB and FRC, with only 21% (or ~$71bn at high risk of departure) of uninsured deposits, versus 9% and 67% respectively for SVB and FRC, if depositors panic, the company is still in a precarious position. It simply comes down to game theory.
Aggressive Accounting by Management
In 2020, management arbitrarily reclassified $135bn of HTM securities to AFS. Why?
Because at the onset of the Covid-19 pandemic, when interest rates dropped (the 10-year treasury fell from 2% to 1%), this boosted the fair market value of the company’s securities. Since AFS securities are marked to market on the balance sheet, SCHW recognized a $7.2bn increase in the value of its equity that year.
Conversely, in early 2022, when interest rates started to rise, SCHW would have recognized mark to market losses if it held it as AFS securities, and so management conveniently moved $105bn of AFS securities back to HTM, at cost. This action dented the blow felt on SCHW’s book value, and allowed the company to play with its capital ratios.
We are a bit skeptical of management’s assertion in today’s press release that HTM maturities are actually mature at par when management moves them freely:
Further of note, even as Silicon Valley Bank discloses the fair value of their HTM securities on their balance sheet, SCHW chooses not to, instead disclosing it in their footnotes:
“Opting out of AOCI” to Hold Less Capital
Instead of choosing to hold themselves to a higher capital requirement and protect investors with a greater buffer, Charles Schwab’s management chooses to opt for excluding AOCI from regulatory capital. Had they held themselves to the higher standard of peers like JPM, they would be in a significantly better financial position:
“Capital requirements for Category III banking organizations include the generally applicable risk-based capital and Tier 1 leverage ratio requirements (the “standardized approach” framework), the minimum 3.0% supplementary leverage ratio, the countercyclical capital buffer, which is currently 0%, and the stress capital buffer. As discussed below, starting in 2022, CSC, as a large savings and loan holding company became subject to the stress capital buffer requirement, which applies to risk-based capital ratios (CET1, Tier 1 Capital, and Total Capital). Under the revised capital requirements, Category III organizations are not subject to the “advanced approaches” regulatory capital framework and are permitted to opt out of including accumulated other comprehensive income (AOCI) in their regulatory capital calculations. CSC made this opt out election, and commencing with the first quarter of 2020, excludes AOCI from its regulatory capital. Category II organizations are not permitted to opt out of including AOCI in their regulatory capital calculations and have additional requirements for calculating risk-based capital ratios and risk-weighted assets.” (SCHW 10-K, 2022)
Cracks Forming
Deposits have started to shrink by $100 billion in the past 9 months, with unknown impacts following SVB’s collapse. Shrinking bank assets, little excess cash to absorb further outflows, and higher funding costs are all pointing towards deteriorating business fundamentals for the company.
Insiders have sold shares in February:
2/28/2023: Nigel Murtagh, Chief Risk Officer - 10,796 Shares - Price: $80.22
2/16/2023: Charles Ruffel, Director - 5,176 Shares - Price: $80.88
2/14/2023: Charles Schwab, Chairman - 28,775 Shares - Price: $80.65
2/13/2023: Charles Schwab, Chairman - 95,030 Shares - Price: $81.03
2/8/2023: Charles Schwab, Chairman - 62,500 Shares - Price: $81.54
2/7/2023: Charles Schwab, Chairman - 62,890 Shares - Price: $81.07
2/6/2023: Charles Schwab, Chairman - 62,890 Shares - Price: $80.02
2/6/2023: Charles Schwab, Chairman - 125,780 Shares - Price: $80.10
2/3/2023: Charles Schwab, Chairman - 129,030 Shares - Price: $79.76
2/1/2023: Charles Schwab, Chairman - 121,066 Shares - Price: $77.84
Once investors realize how little of a buffer SCHW’s management team has decided to operate with and the precarious position that has put the company in, we think the premium valuation that SCHW currently trades at no longer holds. At 6x-10x earnings, SCHW should trade at $26 to $43. And this is assuming no impairment in book value or earnings, which is a real possibility.
Investors realizing the accounting movements SCHW has done the past few years, and the mark-to-market negative equity value that SCHW currently has.
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17 | |
Ok 8.3x, but it'll prob be 10x by its anniversary. Nice idea. | |
16 | |
Really well done here. Understand wanting to take the quick gains. Anything that keeps you from continuing to own this? Feels like it's working. TAM is very large. | |
13 | |
Light62, thanks a lot for arguing the opposite side. How does the Blue Cross Blue Shield Federal Employee Program affect your suspicions about the product's efficacy? It would seem that there would be a healthy amount of rigor applied before granting 5.3MM lives access to a new diabetes management platform that's essentially powered by Livongo. | |
11 | |
thanks for the feedback from the blogger. a lot of this is "he said / she said" stuff which is difficult to argue against, but it is always good to understand the other side. it seems like the short thesis here is that mgmt is promotional. i agree that the company is promotional. they are a silicon valley based company with silicon valley VC's behind it. most young saas companies are promotional. Many SAAS companies pitch their sales based on ROI that is usually higher than what the end customer actually achieves. i talk to many customers of saas and i have to say that the percentage of companies that are satisfied with LVGO is much higher than the average SAAS company out there. difference here is that LVGO is in the wellness space and so is covered by healthcare analysts who care a lot more about the claims being perfectly accurate than tech investors. from talking to PB desks who have a more realtime estimate for short interest, the short interest has now climbed to 45% of the float. it is up significantly since i posted the idea despite the stock rising 19% since then. I know you covered but I think it is quite risky to short this stock now in front of management presenting at several upcoming conferences and in front of a quarter where TCV will likely be good again given the large federal contract that was announced. afterall, management is promotional. I usually stay away from promotional management, but i think that in this case, it is actually a potential catalyst given the high short interest and no obvious short term issue.
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9 | |
LVGO announced on Monday it was awarded a contract with the Blue Cross and Blue Shield Federal Employee Program ("FEP"), which is part of the Federal Employees Health Benefits Program ("FEHBP") and covers ~5.3m federal employees, retirees and their families out of the ~8 million people covered under FEHBP. This is a 2-year agreement which will launch the Livongo for Diabetes program on Jan 1 2020, and is expected to add ~25K members in 2020 and grow to ~45K members in 2021.
This expected enrollment is higher than the original 20-30K first estimated by Livongo in its S-1 and the 2Q19 earnings release. We think this development highlights the general conservatism of management. LVGO expects the contract will account for $20-25m of revenue in 2020 and $30-$35m of revenue in 2021, and helps de-risk revenue expectations. Sell-side has not revised their numbers as of yet.
The stock had a positive initial reaction, closing +18% after the announcement. The stock has since sold off and is now only +8% above pre-announcement. Short interest has actually increased to 35% of float. | |
8 | |
We asked the company about the questions posed in the link you shared. Given what you said, we were surprised with how quickly they responded to our questions and their directness. With respect to your blogger himself, they noted that the blogger had approached them a number of years ago and solicited compensation to endorse LVGO on his site. They obviously declined, and since the post you referenced, he has been unwilling to respond to their requests to engage in discussion. They claim he has been paid in the past by one of their competitors and is running a pay-to-play scheme. We noticed that he is very promotional of the Validation Institute on his site. It turns out he is listed as a certified consultant/broker for the VI (https://validationinstitute.com/certified-professionals/), which offers a certificate program starting at $1195 (https://validationinstitute.com/certification/). In a prior post, he trumpeted the benefits of the CORA Pro certificate course while simultaneously cherry-picking a couple points to disparage LVGO (https://dismgmt.wordpress.com/2019/05/23/questions-to-ask-livongo-before-signing-with-them/). We find his motives at best ambiguous. Needless to say, numerous 3rd party consultants have raised concerns to LVGO about this blogger and his claims.
While we understand that the clients may not be performing tightly rigorous analyses and may also be somewhat biased because they are justifying a decision they recently made, the vast majority are saying that they are seeing their total healthcare costs across their diabetic population come down even after incorporating LVGO’s cost, comparing pre-launch to post-launch costs. It’s possible LVGO may not have been the only change they made or that their diabetic population may have somehow structurally changed post-launch or other confounding factors have materialized, but the general feedback has been positive and most are willing to be reference clients and seem happy with their decision to go with LVGO.
We think it is arguable whether the statement “Livongo for Diabetes program delivered an $88 per member monthly reduction” is mis-leading in suggesting causation and, frankly, is a minor semantics issue in light of the savings that clients are reporting. LVGO has only used this language in a handful of press releases, and we haven’t seen any more-aggressive causal language from the company.
In addition to the clients we mentioned in the prior post, we just spoke to a client that has achieved >70% enrollment and has been a client since 2017. He believes that the ROI on LVGO is 1.8x based on comparing the same cohort pre-launch vs. post-launch. His savings came from less urgent care, less episodes of diabetic shock and decreased episodic care. He was adamant that LVGO works. We acknowledge the selection bias here, but given the high enrollment rate the <30% unenrolled would have to be pretty bad for overall ROI to be negative.
Curious if your negative view is based on any customer checks or if it is mainly based on the blogger you cited?
We acknowledge that from a design standpoint, a better way to perform a conclusive, controlled study to prove efficacy would be to have volunteers randomly assigned to LVGO test and non-LVGO control groups. This approach doesn't seem very realistic in the context of live clients (imagine being an employee not chosen for the test group). LVGO could have performed a study outside their client base, but it's not clear that the time required and the extra cost (volunteers would have to be provided the solution for free for the length of the study) would have produced much of an incremental benefit.
Regarding the questions around reduced inpatient admissions, the analysis in the blog (and w/r/t the chart you provided) compares admissions related to diabetes to total commercially insured people/the general population. This seems apples-to-oranges to us. 90% of the population does not have diabetes, and presumably there were no non-diabetics included in LVGO’s studies. Hospitalization stats would look much different for the diabetic population. To be clear, we are still waiting on a more direct answer from the company but as your blogger states, “in all fairness to LVGO, they don’t promote the inpatient admissions result anymore.”
The premise of blogger’s Question 3, “if I’m seeking to reverse diabetes in my population,” makes us wonder if your blogger even understands what LVGO does. LVGO helps diabetics manage their chronic conditions and has never focused on reversing diabetes. Consequently LVGO hasn’t focused on measuring weight loss or reduced insulin use in the context of diabetes (improved compliance with LVGO actually results in an initial increase in the use of test strips and insulin). In fact, the question reads almost like an endorsement of Virta Health, whose strategy is to actually reverse diabetes by encouraging dramatic lifestyle changes and nutritional ketosis – perhaps the competitor endorsed by your blogger referenced by the company?
LVGO’s study very clearly addresses the obvious concerns around selection bias and other unobserved confounders through the use of propensity score matching: “the comparison group of people with diabetes who were not enrolled in the Livongo program was selected using 1:1 propensity score matching on covariates including age, gender, Charlson co-morbidity index and pre-program medical spending with the Livongo program population to reduce the bias due to confounding that could be found in an estimate of the treatment effect.” In simpler terms, members and non-members were matched on a 1:1 basis based on the characteristics described in a way that makes them “look” similar and consequently provides a valid comparator group in an observational study design. Our conversations with a highly experienced statistician from the FDA confirm that propensity score matching is a standard and appropriate technique for the study. In addition, instrumental variable analysis was used to control for unobserved confounders.
Regarding the other questions posed by your blogger in Question 5, they seem like red herrings and more fear-mongering to entice readers to cling to the “truths” graciously revealed by him. With respect to the JAMA Internal Medicine study cited that suggests there is "no statistical difference between patients who do not self-monitor their blood glucose multiple times per day and those who do self-monitor their blood glucose multiple times per day in glycemic control, nor evidence of effects on health-related quality of life, patient satisfaction, or decreased number of hypoglycemic episodes," there is a difference between “structured checking” and just self-monitoring multiple times per day. The ADA has guidelines on how people with diabetes should use structured checking as a way to get insights into their glucose control. There is a lot of supporting literature to show the effect of structured checking on glucose control (https://www.ncbi.nlm.nih.gov/pubmed/22464874), which your blogger failed to point out. LVGO’s messaging through digital and human coaching is centered around educating members on the benefit and insights from structured checking. The company agrees that random checks provide limited insights into glucose control. | |
7 | |
I'd be interested to know what the customers are doing to evaluate whether LVGO works or not and whether it's a rigorous analysis or just a simple - LVGO using employees are outperforming non-LVGO using employees (which is going to lead to a massive selection bias).
It sounds like you have a good rapport with the company - I think a great way to get more clarity would be to ask them the questions posed in the link I provided in my original post. If they provide substantive answers please let me know because, in the past, they've been unwilling to engage on these questions (which strikes me as a big red flag) - they are fully aware of the concerns and the post.
That said, I agree that there might be enough momentum here that these concerns won't matter (at least for awhile) but at this point I think the concerns about efficacy are becoming more widely known and if they break out I think it puts the company on the defensive and throws a wrench into DCF's making bet #2 harder to pull off. Personally, I doubt the sell-off has been primarily due to the disappointing guidance (I've seen the analysis you provided on bookings growth vs. revenue timing several times - it doesn't seem to me like the company has failed to get the message out there). This thing's down from the $40's post IPO and was falling even before the earnings release. | |
6 | |
its a risk but also an opportunity. express scripts is likely LVGO's most important channel partner today. however, note that Cigna actually invested in LVGO before they completed their acquisition of express scripts. also, there is generally staying power with these partnerships. if the relationship is ended and customers decide to keep LVGO after the initial term of the customer contract expires, it is our understanding that cigna/express scripts do not get their revenue share. from our checks, omada has a good product for pre-diebetes and LVGO has a better product for diebetes, so it is possible that both actually coexist within cigna/express scripts. | |
5 | |
Gross margins are 70%. The strip cost is in cogs. Ebit is negative cause of OPEX similar to many fast growing SAAS. Given the LTV to CAC, you want them to spend a lot on sales and marketing. Part of the opportunity here is that tech investors dumped it after the lack of guide up for this year and healthcare investors are not used to valuing very high growth recurring revenue businesses that are losing money near term. Many of the companies in the chart above are also losing money on the ebit line and some even have lower gross margins than lvgo. | |
3 | |
We have talked to 8 lvgo customers. Many of them were very large self insurers. They all basically said that the product worked and is producing savings. They also said that their employees are much more satisfied with it than what they were previously using to manage diebetes. Simple things like not having to constantly buy new strips vs just having them automatically sent to you made a big difference. That being said, we do acknowledge that the company may be being overly promotional (most growth companies at this stage are). We also talked to someone from a large consulting firm that set up the partnership with Lvgo. He was pretty optimistic about the market’s growth but was admittedly a bit more skeptical than the customers we spoke to about effectiveness. He said some customers had positive savings and others didn’t see it. He didn’t tell us that the product didn’t work however. The most negative check came from a large insurer that was the most skeptical. He frankly seemed skeptical of any digital health company and is arguably a potential competitor to lvgo longer term. However, he also said that there are many product lines that they offer that have questionable efficacy but still are $1b revenue companies. While he questioned the efficacy, he thought that there was a lot of momentum for lvgo in the market place. We also talked to a former executive of lvgo who was the most bullish but she was arguably biased. We put the most weight with the checks with the actual customers and users of the product. Those were clearly positive, but after your message, we will do more. We also take comfort from the numbers - 96% renewal rate when the avg contract is 18mos, high NPS scores, very high bookings and revenue growth relative to sales and marketing spend, etc. maybe digital health is just different, but if the product was bad, I don’t think the numbers would look like that. There is definitely high skepticism about digital health. that makes lvgo’s sales and marketing efficiency even more impressive.
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2 | |
I'm short this and have been for awhile. It's not as clear to me that this product works as your write-up (and the company's promotional material) make it seem - see https://dismgmt.wordpress.com/2019/08/26/are-livongos-outcomes-real/ for more details. Frankly, I think the product doesn't seem to work (at least not nearly as well as advertised)*. That's not to say this can't be a good investment; however, I think the bet is much less attractive than the one detailed. I think you're making two bets: 1) Patients like the product even though it doesn't work and HR departments/insurance co's are so desperate to show they're trying to contain H.C. costs that the business does well regardless of its ability to actually lower H.C. costs. Keep in mind how long this relationship would need to sustain itself for a DCF to justify the current valuation (a question for Mason - how much of the DCF value is post 2030?). 2) Investors bid this up on the basis of (what I think are) non-applicable SaaS-type quality criteria (LTV/CAC) vs. a SaaS valuation framework (P/S vs. growth) and a greater fool bails you out. Those may be good bets and are things I'm monitoring for my short. That said, I think this company is going to be on the defensive given the serious questions about efficacy.
*Just one thing that jumps out to me as hard to fathom: How can a diabetes coaching app drive a 66% reduction in in-patient hospital spending? What % of in-patient admissions are even tangentially related to diabetes? Which of the following are:
I’m pretty sure I can come up with 33% of spending just in the top 20 conditions (47.7% of total inpatient spending) that aren’t going to be solved by improvements in someone’s glycemic control. | |
1 | |
thanks for the write up. how do you think about the esrx relationship post cigna merger? cigna is an investor in omada. |
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