Today, we’re exploring another financial newsletter within the Substack community:

The Sleepwell Strategy

Per the newsletter’s about page, Sleepwell is a generalist and curious investor who studies investment strategies, industries, and companies that tickle their fancy. They leverage a unique background of music, engineering, and finance to thoughtfully study potential investments. Although they don’t have a set publishing schedule, Sleepwell’s content is worth exploring nonetheless.

In a recent edition of DD, I recommended one of Sleepwell’s pieces on perspective — specifically, what equity investors can learn from the fixed income side of things. But I’ll share a couple more to get you started.

#1: A superb explanation of conviction and its necessity in the world of investing.

The Sleepwell Strategy

The Raw Material of Long Term Investing

The following piece was inspired by a Tweet and a few people that encouraged me to write it. It took me longer than I thought, and I shamelessly borrowed a few great ideas from fellow investors I admire. As always, thank you for reading, subscribing and sharing…

Read more

5 years ago · 21 likes · 5 comments · Sleepwell

#2: Music Streaming Royalties 101

Having covered the Sports & Entertainment industry during my investment banking stint, this one hits close to home. While I don’t have any data to back the claim, I can confidently say the vast majority of people don’t understand music rights. Read this if you want to know what goes on behind the curtain (or album).

The Sleepwell Strategy

Music Streaming Royalties 101

“Music royalties are a complicated subject” might be the mother of all understatements. In this piece I will try to cover the basics of streaming royalties in the U.S., by walking through the process of creating a song, producing it, distributing it and monetizing it. Each of these steps are important to understand who the players are…

Read more

5 years ago · 33 likes · 10 comments · Sleepwell

Thanks for reading. Don’t forget to hit the heart button.

If you haven’t subscribed already, you can do so here.

Today’s spotlight rests above a promising player in the electric vehicle industry — an automaker that’s never produced an all-electric vehicle.

Fisker Inc.

If this is your first time with us, feel free to subscribe here. If you enjoy today’s newsletter, please hit the heart button at the end of the report.

Free stock research

Now, without further ado...

What is Fisker?

Fisker Inc. (FSR) is an American electric vehicle automaker founded by Henrik Fisker and Geeta Gupta-Fisker (no relation — just kidding, they’re husband and wife). You could argue that a more apt description is “soon-to-be” EV automaker because they haven’t produced a single all-electric model yet. 

But that hasn’t stopped investors from clamoring for shares.

Fisker went public via a SPAC merger in October 2020, opening at $9.25 on its first day. Since then, its stock peaked at $31.96 — but it’s down to $14.53 as of yesterday’s close.

Why are people buying Fisker stock?

Although it hasn’t produced an electric vehicle, Fisker (the company and the couple) isn’t new to the auto industry. In 2008, Fisker Automotive debuted one of the first luxury hybrid vehicles: the Karma. 

The Karma was a low-production model (only about 2,500 models were produced), but it was well-received by the car community. Top Gear named the Karma its Luxury Car of The Year in 2011. Production of the Fisker concluded in 2012 when the company’s battery supplier went bankrupt. 

Additionally, before launching Fisker Automative in 2007, Henrik worked at BMW, Ford, and Aston Martin; he’s credited with designing numerous luxury cars, such as the BMW Z8, Aston Martin DB9, and Aston Martin V8 Vantage. 

A decade and a half later, Fisker is back — and it’s entering the all-electric space, which has been a hotbed for investor capital over the last few years. 

Fisker’s first play? The Ocean.

What is the Fisker Ocean?

The Fisker Ocean is a mid-size electric SUV that boasts 545 horsepower and 350 miles of battery range. Its MSRP ranges between $37,499 and $69,900, depending on the option (Sport, Power, and Extreme) and excluding any tax rebates. 

However, Fisker will also offer a unique leasing option under its Flexee program. Ocean-leasers will have indefinite contracts, meaning someone could return an Ocean one month into their contract — or one year, three years, five years, and so on. (There is a 30,000 annual mile limit though.) Pricing for an Ocean lease starts at $379 per month with a one-time $2,999 initiation and activation fee. In case you’re curious, you could own the Sport edition for roughly 91 months (or 7.5 years) before surpassing its MSRP. 

But you won’t find the Fisker Ocean on the road for some time — production doesn’t commence until November 2022. 

How does Fisker make money?

They don’t...yet.

At least, nothing substantial — it earned $21,000 in Q2. So, the better question is: “How will Fisker make money?”

The Ocean, among other veiled vehicle projects, will be the primary driver. 

As of August, approximately 62,500 people had registered an account on the Fisker app, while more than 17,500 had paid a $250 deposit (90% refundable) to reserve an Ocean. Assuming 100% retention and all purchases are the base model, that’s $656.2 million of future revenue. While a perfect retention rate is unlikely (i.e., every reservation converting into a sale), we’re also excluding additional reservations up until its November 2022 launch. 

Fisker expects 25,000 reservations by the end of 2021 and 50,000 by the end of 2022. So far, Fisker has managed to amass its Ocean reservations without spending any money on marketing campaigns. The first major campaign will launch this November at the LA Auto Show. 

In terms of production, Fisker plans to exceed 5,000 Ocean models per month in 2023, which would help surpass its initial forecast of 40,000 models for the year. 

Who will manufacture Fisker cars?

Not Fisker. 

The company will implement an “asset-light” business model, designing and marketing its vehicle lineup while leaning on established manufacturing companies and their plants for production. The company has dubbed this concept-to-production process “Fisker Flexible Platform-Adaptive Design” (FF-PAD). Doesn’t exactly roll off the tongue, but it’s expected to reduce costs by $2 – $4 billion relative to the traditional Original Equipment Manufacturer (OEM) platform.

The Ocean — as well as another unnamed model — is being developed by Magna Steyr, an automotive manufacturer in Austria that has produced vehicles for BMW, Mercedes Benz, and Aston Martin. Magna has a vested interest in Fisker’s success, as it acquired a hefty number of warrants last October, representing a 6% ownership of Fisker at the time. The two parties finalized a long-term manufacturing agreement in June. 

Here are Henrik Fisker’s comments on the partnership during the company’s latest earnings call:

[The agreement] covers planning and launch phases, annual volumes, complete assembly costs and quality metrics over the program's entire lifecycle. It covers all facility investments, a clear path to startup production in November 17, 2022, and a rapid ramp up to full gun rate production for quality vehicles in 2023.

Fisker expects its FF-PAD program to not only accelerate the development of new vehicles but also ensure the latest technology is incorporated into upcoming models. 

Today, if you buy a brand new vehicle, most likely that technology was selected three, four years ago. But in our case, we have brought it as close as 18-months before we launched the vehicle, that's probably similar to some electronic industries like the smartphone industry.

Speaking of smartphones, earlier this year, Fisker announced a similar arrangement with Foxconn, the Taiwanese manufacturer that produces the majority of Apple’s iPhones. Together, Fisker and Foxconn will design and produce two vehicles by 2025, the first of which has been labeled Project PEAR (Personal Electric Automotive Revolution). This model is intended to be a cost-conscious alternative to the Ocean with a starting price under $30,000, excluding incentives. 

In total, Fisker plans to offer four vehicles by 2025, including the Ocean. The company is targeting an annual volume of 200,000 to 250,000 units by the end of 2025; this would represent about 1% of the total addressable market (TAM).

Additionally, Fisker has partnered with Electrify America and Allego, EV charging infrastructure companies in the U.S. and Europe, respectively. 

How is Fisker funding its operations?

Designing, producing, and marketing a vehicle isn’t cheap. Where is this money coming from? 

For starters, equity. The company’s reverse merger with Spartan Energy Acquisition Corp. netted Fisker $976 million after transaction fees. Thus far, this capital has easily funded Fisker’s operations and capex. Through the first half of 2021, Fisker’s operating cash burn was $56.9 million, not including $64 million of intangible asset purchases related to the Ocean’s production. As of June, Fisker still had $962 million of cash and equivalents on its balance sheet thanks to additional equity financing.

That cash balance doesn’t include the net proceeds from Fisker’s $667.5 million convertible notes issuance in August. Naturally, the “convertible” nature of this debt tends to give investors pause — at some point in the future, these debtors could convert the obligation to shares of FSR, which would create an influx of additional shares and dilute shareholder value for everyone else.

That said, it’s worth noting that this debt has high dilution floors. Also, the company has expressed its intention to pay off these bonds with cash beforehand, but that’s by no means a promise or guarantee.

The conversion would take effect in tiers; there isn’t any dilution until shares hit $32.57, which would represent a premium of 124% relative to Thursday’s close. 

In other words, its stock would have to significantly appreciate before reaching the conversion’s strike prices. 

What does Wall Street think?

Wall Street is somewhat mixed, but the consensus rating is “Overweight” for FSR with an average price target of $22.22 — an implied return of almost 53%.

Can Fisker take over the Luxury EV market?

There are so many potential road bumps between now and the Ocean’s November 2022 launch. Fisker hasn’t proven that it can deliver on this asset-light model. Any design or production hiccups would adversely affect Fisker’s ability to deliver models on time. On top of that, reservations aren’t guarantees of sales. It’s one thing to put a $250 deposit down now, it’s another to drop another $37,000+ a year from now. 

That said, consumer interest is clearly there — 17,500 reservations at $250 a pop, without any marketing, is nothing to sneeze at. It’ll be interesting to see how high reservations jump once the company starts promoting the Ocean.

Assuming Fisker can market successfully and deliver on its asset-light model, near-term profitability wouldn’t be a farfetched idea. 

Although Fisker could hit a few snags leading up to the Ocean’s launch (and afterward in terms of maintaining production and meeting demand), we’re bullish on Fisker from a long-term perspective.

Thanks for reading. Don’t forget to hit the heart button if you enjoyed today’s report.

If you haven’t subscribed already, you can do so here.

Sources

1. Investor presentation

2. Earnings call transcript

3. 10-Q

Years ago, Robinhood users only had access to a handful of select U.S. stocks. The app’s early backers would showcase their commission-free trades and free stock rewards — a rarity at the time. Robinhood was small and unknown. 

Those days are gone. 

The COVID-19 pandemic ushered in a new wave of investors — and new, fun ways to invest. First-time investors flocked to Robinhood’s user-friendly platform, which boasts trendy imagery and vibrant color schemes. 

Robinhood is still a small fish in a big pond, but it’s hardly an unknown company anymore. 

Today, Robinhood will become a public company, trading under the ticker HOOD. If you’re considering investing in HOOD’s initial public offering (IPO), we’ve compiled diligent answers to several relevant questions, including:

1. What does Robinhood do?

2. Who uses Robinhood?

3. How does Robinhood make money?

4. What are payments from order flow?

5. Is Robinhood profitable?

6. Why is Robinhood’s IPO unique?

7. What’s the risk of buying Robinhood’s IPO?

8. What are Robinhood’s operational risks?

9. Is Robinhood’s growth sustainable?

What does Robinhood do?

Founded in 2013, Robinhood started as a niche retail brokerage. It’s credited with being the first platform to offer commission-free trades (circa 2015 when it launched its app). Now, users can use Robinhood’s platform to:

• Trade U.S. listed stocks and ETFs, as well as related options and American Depositary Receipts (ADRs)

• Invest in offering prices of select IPOs

• Trade cryptocurrencies

• Trade fractional shares

• Make recurring investments

• Make cash transactions via Robinhood-sponsored debit cards

• Trade on margin (must have a Gold subscription)

• Access professional research (must have a Gold subscription)

Who uses Robinhood?

Robinhood’s primary demographic is new and inexperienced investors — which, historically, has been an untapped market. Let’s look at some key customer stats:

• As of March, Robinhood had 18 million funded accounts.

• From January 2015 to March 2021, first-time investors represented more than 50% of Robinhood’s funded accounts. 

• As of March, the median age of Robinhood’s customers was 31; approximately 70% of the company’s Assets Under Custody (AUC) belonged to customers between the ages of 18 and 40. 

Much like the fabled Robin Hood storybook character, Robinhood (the company) targets people who are more likely to be limited by systemic barriers; the company specifically cites expensive commissions, minimum balance requirements, and complicated paperwork. 

In that regard, Robinhood disrupted the financial services industry with its commission-free trades (which is now the norm) and gamification of investing (which made investing “fun”). That disruption has been particularly evident over the last 18 months, as Robinhood’s total funded accounts skyrocketed from 5.1 million to 18.0 million — a 252% increase. 

But there’s a reason first-time investors aren’t as sought after by the financial services industry: they aren’t nearly as profitable for brokerages. 

As of March, Robinhood had $80.9 billion of AUC across 18 million funded accounts. By comparison, Charles Schwaab had $6.69 trillion of client brokerage assets spread across 29.6 million active brokerage accounts at the end of 2020. 

So, Robinhood’s client accounts hold a rough average of $4,500, while Charles Schwaab’s client accounts typically hold more than $225,000 each. 

It pays to target the wealthy. 

How does Robinhood make money?

Robinhood’s commission-free trading model revolutionized the industry. But to be a viable business, the company has to make money from trades somehow. 

That somehow is payment for order flow (PFOF). Instead of charging investors a fee for every trade they make, Robinhood gets a rebate from market makers like Citadel Securities, LLC — who accounted for 34% of Robinhood’s revenue in 2020. 

During FY20, PFOF accounted for 75.1% of Robinhood’s total revenue. In the first quarter of 2021, that contribution increased to 80.5%. Note that the company refers to PFOF as “transaction-based revenues.”'

Although much smaller, Robinhood has two other sources of revenue. 

• Net interest revenue: the net earnings made from lending securities to users (e.g. for short-selling purposes). 

• Other revenues: monthly subscription revenue from Robinhood Gold, which puts professional research behind a paywall. 

Here’s an overview of Robinhood’s sources of revenue:

What is payment for order flow?

First, it’s important to understand what a market maker is. 

Market makers are firms that continuously quote both sides of a transaction: the price they’re willing to pay for a stock (i.e. the bid) and the price they’re willing to sell a stock for (i.e. the ask). The difference between the two prices is known as the bid-ask spread. These firms are integral to the investing process because they help keep markets liquid. 

When retail investors make trades through a broker (such as Robinhood), the broker sends orders to a market maker to execute the trades. In exchange, the market maker pays the broker a rebate for the volume activity (and, indirectly, insight into buy/sell orders). The rebate is based on a percentage of the bid-ask spread. This is how the PFOF model works.

PFOF is not illegal, rare, or exclusive to Robinhood’s business. Since commission-free trades are the norm, other firms use this model too. However, there are inherent problems with the PFOF model — problems that could jeopardize its legality down the road. We’ll come back to this.

Here’s a more detailed overview of the PFOF model and its nuances. 

Is Robinhood profitable?

Yes, Robinhood is a profitable company as of its latest fiscal year. In FY20, Robinhood generated a $7.4 million profit, resulting in a profit margin of less than 1%. This was driven by the sizable increase in funded accounts and trading activity that coincided with the pandemic. 

However, Robinhood’s General and Administrative expenses for the year were $294.7 million — a 244.7% increase relative to 2019. So, were they just paying their employees more or what? 

Partially. 

Share-based compensation (a non-cash expense) was $24.3 million in FY20, so if we add that back, their net profit doesn’t look as minimal. However, the predominant catalyst was $105.5 million of expenses related to legal settlements and reserves. We’ll come back to this. 

The first quarter of 2021 is a longer story. 

Robinhood would’ve made a $47.5 million profit in the first quarter of 2021 if you back out a hefty non-cash expense — a $1.5 billion change in fair value of its convertible notes and warrants liability. This expense relates to emergency funding that took place during the meme stock frenzy earlier this year. 

Stocks like GameStop and AMC attracted extreme levels of demand from retail investors — to a point where Robinhood limited transactions involving these companies. Naturally, this sparked outrage among Robinhood’s tribe.

Robinhood faced a liquidity crunch, as it scurried to secure enough capital to back the flurry of trading activity. Within a week, it raised $3.55 billion of convertible notes, which convert into common stock as soon as the company completes its IPO. Robinhood also compensated the convertible noteholders with warrants to purchase additional equity in the company. 

All said and done, the massive $1.5 billion change in fair value expense is more so an accounting anomaly; Robinhood raised quick capital to remedy a dire situation at the cost of diluting its future share value. 

We’ll also address the bigger potential risk of this situation a bit later.

Why is Robinhood’s IPO unique?

Per the company’s prospectus, Robinhood expects to allocate anywhere from 20-35% of its common stock to retail investors. But not just any retail investors — specifically Robinhood customers. 

Robinhood is allowing its customers (through the Robinhood app) to sign up for early access to HOOD’s IPO, which will be $38 per share.

Why is this significant?

Let’s walk through an example of a recent IPO. I’m a believer in Airbnb, so I bought shares on the day ABNB started trading. By the end of the day, ABNB was up 112%. So my investment was up 112% too, right?

Wrong. ABNB more than doubled from its listing price of $68 — an entry point that’s almost always reserved for institutional investors or individuals with ridiculous fortunes. Not normal people like you and me. Shares of ABNB opened on the market at $146 and closed under $145. Not exactly a 112% return.

So, Robinhood’s IPO tactic is significant because it enables its customers (some of them, anyway) to get their hands on the listing price of $38 instead of the price it eventually opens at on the market. 

What an incredible marketing tactic. 

Is Robinhood the only brokerage that offers early access to IPOs?

No, it’s not uncommon for brokerages to grant their customers access to IPOs before they hit the market. However, brokerages typically reserve this benefit for wealthy clients. For instance, Fidelity requires customers to have hundreds of thousands of dollars in assets to participate. 

In that sense, what Robinhood is doing is mostly unique — it removed a barrier to entry. (We say mostly because SoFi offers its members access to traditional IPOs too, so long as they have $3,000 in brokerage accounts.)

What’s the risk of buying Robinhood’s IPO?

By offering so many shares to the general public, Robinhood’s price could be extremely volatile in the opening days/weeks/months of trading — more so than the usual IPO. 

Why? Generally speaking, retail investors tend to have shorter outlooks relative to institutions and are more tempted to trade during volatile periods. Considering a lot of individuals will want to make a quick profit — especially since Robinhood’s IPO is being hyped as a major risk in the media — there could be some crazy price swings. 

Although Robinhood does have a policy that discourages “flipping” (selling to make a quick profit), the penalty is minimal and not even guaranteed:

Like any investment you make, you can sell the shares you received through IPO Access at any point in time. However, if you sell IPO shares within 30 days of the IPO, it's considered "flipping" and you may be prevented from participating in IPOs for 60 days. This policy applies to all IPOs offered on IPO Access.

Offenders “may” be temporarily banned from participating in IPOs. 

What are Robinhood’s operational risks?

Robinhood smells funny. You don’t have to do much digging to uncover some grave details, particularly regarding recent and looming regulatory risks. Before we dive into those though, I want to share an interesting tidbit that’ll make more sense once you read further. 

Who do you think was the most compensated employee of Robinhood in 2020? We’ll give you three guesses. 

The company’s CEO, Vlad Tenev?

No, but that’s an understandable guess. 

Well, then it must be Robinhood’s Co-Founder and Chief Creative Officer, Baiju Bhatt? 

Incorrect, guess again. 

Well, Robinhood is in financial services, so the CFO...Jason Warnick?

Nope, not even him.

The title of “highest paid” goes to Daniel Gallagher, Robinhood’s Chief Legal Officer, and it’s not even close. 

Of course, you would expect a long-time asset and legal expert to be well compensated, especially in a heavily regulated industry. Except Robinhood hired Gallagher in May 2020. He made $30 million for seven months of work. 

Gallagher has been busy.

Robinhood has a concerning history of regulatory issues

On page 27 of the company’s prospectus, there’s a table that breaks down Robinhood’s Adjusted EBITDA — a non-GAAP metric calculated by the company. In essence, a company tries to make its earnings look better under “normalized” conditions by adding back extraordinary expenses and non-cash items. This is normal. 

The last line item of this particular chart isn’t normal — it’s for $101.6 million and it’s titled: “Certain legal and tax settlements, reserves and expenses.” It has a staggering footnote. 

Here’s a summary of the footnote for 2020 activity:

1. $65 million settlement paid to the SEC (on a neither admit nor deny basis) following the SEC’s investigation into Robinhood’s best execution and PFOF practices, as well as statements concerning its sources of revenue.

2. $26 million charge for potential resolution of March 2020 outages (when investors were locked out of their accounts), approving ineligible traders for options trading, and misleading customers regarding margin trading. Collectively, these are “the FINRA Matters.” 

3. $10 million charge for potential resolution of a New York State Department of Financial Services (NYDFS) related to anti-money laundering and cybersecurity-related issues. 

The FINRA Matters were settled for roughly $70 million in June on a “neither admit nor deny” basis. Stroking a $70 million check hardly sounds like they’re denying it. You can read the details behind the settlement here, but the company was pretty much recklessly neglecting its fiduciary responsibilities as a brokerage. 

Per the company’s amended prospectus, Robinhood expects to settle with the NYDFS for $30 million. In short, the company wasn’t compliant with anti-money laundering regulations and other cybersecurity requirements. You can read more about it here. 

You want to know what got a good laugh out of me? The immediate next page after these concerning statements is a colorful, nonsensical drawing of astronauts floating into a bizarre, fictional galaxy. As if to say, “Nevermind the settlements, look at these pretty colors!”

Now, let’s unpack the $65 million settlement with the SEC, as it ties back to our earlier discussion about PFOF.

Brokerages have a fiduciary responsibility to their customers — they’re supposed to follow “best execution” practices for trading activity. In other words, if investors buy shares of ABC company, the brokerage is expected to pick the market mover with the tightest bid-ask spread because this is the most inexpensive route for the customer. However, the higher the spread, the higher the broker’s fee. They’re systemically incentivized to go against their fiduciary responsibility. 

In May 2019, the SEC investigated Robinhood’s best execution and PFOF practices, concluding that customers experienced lower execution quality and that Robinhood made misleading statements about the extent of its PFOF practices. This led to the $65 million settlement. 

Robinhood has had a hard time fulfilling its fiduciary obligation. 

PFOF is under heavy scrutiny from industry regulators and public officials due to its inherent conflict of interest. It’s already banned in the U.K. and Canada, which gives governing bodies a precedent to outlaw the practice. 

Robinhood could face a major existential crisis if SEC restricts this method.

If PFOF is eventually limited or banned as a practice, Robinhood management said, “Robinhood and the industry would adapt.” However, Robinhood is in a much worse position to do so relative to its peers since the company isn’t anywhere near the scale of its competitors. 

If PFOF is banned, it seems more likely that competitors will poach Robinhood’s customers rather than the other way around. 

Brand image and customer retention concerns 

As we mentioned above, first-time investors account for more than 50% of Robinhood’s customers. Customers aren’t locked into long-term contractual agreements, so they’re free to close their accounts at any time. 

While Robinhood’s total funded accounts increased in the first quarter of 2021, so did its account transfers to other brokerages — 206,000 accounts collectively holding $4.1 billion elected to move to another firm. 

In all likelihood, this was a result of the meme stock craze and Robinhood’s decision to limit trading of certain stocks. Robinhood can ill-afford to lose customers if it expects to expand, let alone maintain, operational growth and profitability. 

Is Robinhood’s growth sustainable?

That’s the billion-dollar question. 

Robinhood made a fortune from what many have referred to as a casino-like stock market over the last year and a half. The pandemic issued a new wave of risk-thirsty investors and even armed them with free government-sponsored cash to play around with. However, this environment is temporary. 

There are plenty of routes Robinhood can take to continue growing its platform while simultaneously increasing the lifetime value of its customers. For instance, the Robinhood Gold membership grew significantly since the end of FY19, from 0.2 million to 1.4 million as of March 31; Robinhood Gold offers far more transparency and stability compared to transaction-based revenue. 

Further, during the company’s virtual roadshow, Tenev expressed an interest in expanding into retirement accounts, "We are interested in building more account types, including IRAs and Roth IRAs, we've been hearing that a lot from our customers. We want to make first-time investors into long-term investors." Tenev also mentioned a desire to expand into international markets. 

There are opportunities for growth, but the operational and regulatory risks sitting in Robinhood’s way are quite formidable.

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Sources

1. Robinhood Prospectus

2. Robinhood IPO: Looking Under The HOOD (Seeking Alpha)

3. Robinhood IPO: Still A Bad Bet For Investors With Alarming Risk (Forbes)

Welcome to the newest segment of Due Diligence: Social Spotlight.

We’re shining a light on the backstories and fundamentals of social momentum stocks, otherwise known as “meme stocks.” This cultural phenomenon typically targets companies that could experience short squeezes and gamma squeezes, which are technical by nature. However, we want to provide insight into the fundamentals of the underlying businesses.

Forewarning: Our goal is to be objective and simply provide facts with insightful commentary — we aren’t sunshine pumpers or doomsayers. Note that our analysis is from a fundamental perspective and does not opine on potential technical events or risks.

Today, we’re looking at Clover Health (CLOV). 

What Does Clover Health Do? 

Clover Health is a tech-focused health insurance company. Clover’s proprietary software — the Clover Assistant — provides data and insights to physicians so that they can make more informed decisions, which should lead to better patient outcomes and lower health care costs. 

The key question is how?

Clover is an insurer, granting it access to a robust database of health information, including claims, medical charts, labs, pharmacy, electronic health records, and socioeconomic data. This is where the “tech-focused” aspect comes into play. Using a centralized platform, the company ingests, cleans, and synthesizes this health data to produce clinically-focused models. In turn, the platform (i.e. the Clover Assistant) provides data-backed suggestions to physicians at the point of care. 

Here’s an example of the Clover Assistant’s interface for the end-user (i.e. physicians), per the company’s investor presentation.

How Does Clover Health Make Money?

While Clover could dabble in commercial insurance in the future, the company’s revenue is almost entirely derived from government-sponsored payments. Clover also makes commissions from reinsurance agreements (less than 1% of revenue in FY20). Currently, Clover offers Medicare and Medicare Advantage plans — let’s start with the latter. 

Medicare Advantage

The Centers for Medicare & Medicaid Services (CMS), a government agency, pays Clover for each of its Medicare Advantage members in the form of monthly premiums. In turn, the company assumes the risk of medical expenses and administrative costs. The Patient Protection and Affordable Care Act (ACA) requires Clover to spend at least 85% of premiums on healthcare services, covered benefits, and quality improvement efforts. Practically speaking, the company’s gross profit margin for Medicare Advantage premiums is capped at 15%. As a result, the onus is on the company to accurately predict, price, and manage medical costs to ensure profitability.  

Relatively speaking, the company’s membership is still quite small — as of March 31, the company had 66,348 Medicare Advantage members across 108 counties in 8 states — but most members are concentrated in two metro areas of New Jersey. The company expects its Medicare Advantage membership to reach 68,000 to 70,000 members by the end of FY21. 

Medicare

Direct Contracting is a newer Medicare model that commenced earlier this year. Participating insurers — known as Direct Contracting Entities (DCEs) — receive stable monthly payments from CMS. In turn, DCEs can use these payments to (1) invest in technological innovation and analytical tools, (2) increase staffing and resources, and (3) reimburse providers. Clover elected to assume 100% of the risk and, therefore, 100% of savings or losses (less a small percentage discount payment to CMS, in the event of savings). 

The company only recently gained authorization to offer original Medicare plans (April 2021) through its Direct Contracting program, so Medicare membership data hasn’t been released yet. That said, the company anticipates somewhere between 70,000 to 100,000 beneficiaries by the end of FY21. 

So, long story short, Clover plays a pretty pivotal role in the health care process — albeit in a very small area of the country. That’s all well and good, but why are so many short-sellers targeting Clover? 

Why Are Short-Sellers Targeting Clover Health?

Although Clover Health was founded in 2014, it only recently completed a reverse merger with a special purpose acquisition company (SPAC) by the name of Social Capital Hedosophia Holdings Corp. III. What a name. Chamath Palihapitiya, a venture capitalist, was one of the SPAC’s most notable sponsors. 

The combination closed on January 7, 2021; Clover started trading on the Nasdaq under the symbol CLOV the next day. 

Almost one month later, a research firm — Hindenburg Research — released a lengthy report alleging that Clover Health engaged in misconduct and misinformation. 

While the report digs into a variety of alleged issues, the “lead story” relates to a Department of Justice investigation:

“Critically, Clover has not disclosed that its business model and its software offering, called the Clover Assistant, are under active investigation by the Department of Justice (DOJ), which is investigating at least 12 issues ranging from kickbacks to marketing practices to undisclosed third-party deals, according to a Civil Investigative Demand (similar to a subpoena) we obtained.”

The report then divulges a scanned image of the Investigative Demand that outlines the 12 issues:

Since short sellers aren’t required to disclose their positions, it’s impossible to determine exactly who’s shorting Clover Health and for what reasons, but this report is widely believed to be the initial catalyst. 

How Clover Health Responded

The report pressed Clover Health to answer 18 questions. The next day (February 5), Clover’s CEO Vivek Garipalli and President Andrew Toy issued a response. While you can find each question and answer in the public filing, we’ll share the first one, as it directly relates to the DOJ investigation. 

1. Did Chamath and/or Clover know about the ongoing DOJ investigation? If so, why was it concealed from investors?

Chamath and Clover were fully aware of the DOJ inquiry.

To be clear, Clover does not believe it is, or has been, in violation of any rules or regulations related to the inquiry.

We went through both an IPO and de-SPAC due diligence process, and this subject received extensive focus and attention. Consistent with the views of Clover’s outside counsel, Social Capital’s outside counsel, and independently retained outside counsel of third parties, including IPO underwriters’ counsel, we concluded that the fact of DOJ’s request for information was not material and was not required to be specifically disclosed in our SEC filings.

How could a DOJ inquiry not be considered material information? As heavily regulated organizations participating in Medicare Advantage, Clover and its peers receive frequent requests for information from regulatory bodies. These are typically confidential. We promptly respond to these requests as and when they come in. As the short selling firm points out, the DOJ also often reaches out to ex-employees, including by civil investigative demands, as part of their information-gathering process.

• Clover Health believes it has made all appropriate disclosures, which were reviewed and vetted by outside counsel to all parties.

• Clover has not received any civil investigative demands or subpoenas from the Department of Justice.

• Clover has received a request for information from the Justice Department, to which, as we do with all requests from regulatory bodies, we responded. This was on a voluntary basis.

• Clover has conducted a detailed review of matters potentially addressed by the DOJ request for information and has concluded that it is in compliance with all laws and regulations material to its business.

• Up until the publishing of the short selling report yesterday morning, Clover was unaware of any other ongoing investigations of the Company, its officers, or any companies with which they are affiliated.

• Following the report yesterday, Clover received notice of an investigation from the SEC. We believe this inquiry is based on the short selling report issued yesterday morning.

Since the report was released, Clover Health has steadily attracted more and more short sellers. (It also didn’t help that the company’s year-over-year net loss nearly doubled in 1Q21.) CLOV experienced a sizable bump in short interest — the number of shorted shares relative to the total number of outstanding shares. Here’s a visual overview from MarketBeat.

It became a prime candidate for meme stock status — and meme stock investors did not fail to deliver. On June 8, shares of CLOV spiked by as much as 109% and claimed the highest trading volume on U.S. exchanges for the day. 

Financial Overview

So, with the backstory on the table, how does Clover Health look from a financial perspective? Since Clover only recently become a public company, we don’t have much history beyond the last two fiscal years and the first quarters of this year and last year. 

We’re going to focus on the company’s operating results, as opposed to its bottom line (net income), for a couple of reasons: (1) it’s more indicative of the company’s operational health and viability and (2) Clover’s net income is muddled by fair value adjustments of warrants and gains/losses on derivative instruments (both of which are non-cash). 

Revenue highlights

• As we mentioned earlier, practically all of Clover Health’s revenue has been generated by Medicare Advantage premiums. Going forward, Medicare will factor in too. 

• Other income includes reinsurance agreements and interest income (which we don’t really view as revenue, but this is how the company reports it).

• In FY20, Clover’s membership increased by 36.3% to 58,056, which drove the premiums increase of 45.7%. 

• In 1Q21, Clover’s membership increased to 66,300, again driving the increase in net premiums earned.

Expense highlights

• The bumps in premiums are positive signs, but the bigger concern is the company's operating expenses. We’ll address “net medical claims incurred” (i.e. health care costs) in the “key performance metrics” section.

• The SG&A line includes salaries, benefits, general, and administrative expenses — pretty much the company’s overhead. From FY19 to FY20, SG&A remained relatively steady. In 1Q21, that figure ballooned by 109% year-over-year to $104.6 million — that said, $42.7 million of that is related to stock-based compensation, which is a non-cash expense. This expense was tied to the company’s reverse merger. 

Key performance metrics

Clover tracks the efficiency of its business model by comparing net premiums earned to its net medical claims incurred. This metric is known as the medical care ratio (MCR), which pretty much calculates the gross profit of the company’s Medicare Advantage plans. If the ratio is less than 100%, the Clover Assistant platform is doing its job — premiums exceed health care costs. If the ratio is above 100%, there’s a problem and the company is guaranteed to generate a loss (at least until it rolls out additional insurance offerings and revenue sources). 

The last two quarters indicated a problem, as Clover’s MCR was 109.3% and 107.6% in 4Q20 and 1Q21, respectively. In its earnings release, management attributed the steep ratios to higher levels of COVID-19 specific care and related costs. Clover stated that normalized MCR — which nets out the impact of COVID-19 — would have been 89.5% for 4Q20 and 95.4% for 1Q21. 

Similarly, FY20’s normalized MCR would have been 90.5%. 

Regardless, it’s a concerning trend — especially since the company expects normalized MCR to be between 94% and 97% in FY21. This suggests that actual MCR will be higher than 100%, meaning Clover’s medical claims expenses alone exceed its primary and only legitimate source of revenue. 

Liquidity and capital resources

Clover Health’s operations burn through cash (almost $93 million in the first quarter of 2021 alone), however, Clover’s business combination with the SPAC generated plenty of capital ($666.2 million of net proceeds) to sustain losses — at least, for the time being. As of March 31, the company had cash, cash equivalents, and short-term investments of $683.6 million. 

From a debt perspective, Clover had a $26.1 million term loan outstanding and $20.8 million of convertible notes at the end of the quarter, which are minimal relative to the company’s cash on hand. 

Primary Clover Health Strengths

Market potential. Despite generating a new revenue record of $200 million in Q1, Clover barely makes a dent in the Medicare Advantage market, which is expected to reach $590 billion by 2025. The potential for growth is there. 

Additional revenue sources. The company needs to scale its premium earnings to be able to absorb overhead and other operating expenses. It’s working within tight margins thanks to federally mandated spending requirements. Clover is branching into the Medicare market with its Direct Contact program, which will provide predictable revenue to the company. Although it will be required to spend most of its Medicare premiums on innovation, staffing, and quality of care improvements, it should help the company expand its platform and increase its membership. 

Liquidity. As of March 31, Clover had $683.6 million of cash, cash equivalents, and short-term investments on its balance sheet. Moreover, the company has minimal debt and, thus, minimal debt expenses. 

Primary Clover Health Risks

Note that these are operational risks and have nothing to do with the stock’s short-term volatility. 

Deep losses. As of today, Clover is not a profitable company. It’s also not close to becoming one. The company anticipates the continued investment of significant funds toward scaling its business, including its software, technology infrastructure, clinical care programs, overhead, and so on. Until the company (a) effectively and consistently manages Medicare and Medicare Advantage health care costs and (b) adds additional sources of revenues, the company will continue incurring deep losses. 

Revenue concentration. Although Clover has tens of thousands of members, it really only has one source of revenue: the government. Medicare funding depends on numerous factors, such as economic conditions and budgetary constraints. Obviously, these are very much outside of Clover’s control. Reductions in funding for Medicare programs would be bad news for Clover’s growth potential. 

Member concentration. At the end of FY20, 96% of Clover’s members were residents of New Jersey. Any changes to the health insurance landscape — whether that be from increased competition or regulatory changes — would significantly and adversely impact Clover’s operations.

Is Clover Health...Healthy?

It’s normal for growth-oriented companies to turn out net losses while they scale operations. The question is whether they can optimize costs and reach critical mass. For Clover, this means the company needs its membership to rapidly expand and, subsequently, management needs to leverage its data to profitably manage health care costs while maintaining sustainable levels of overhead. Entering the Medicare market as a DCE should help scale, but the questions surrounding cost management still stand. 

From a liquidity standpoint, the company has plenty of cash to sustain losses...for now. Burning through nearly $100 million per quarter won’t cut it, though. Could Clover raise additional capital if necessary? The company’s debt levels are low, so debt capital markets are a viable option. Like other meme stocks, Clover could also issue more shares while there’s fervent demand from retail investors — although this would dilute shareholder value. Additional support from existing stakeholders isn’t out of the question either. 

Only time will tell if Clover’s ailing from a temporary cold...or something untreatable.

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Sources

1. Clover Health 10-K

2. Clover Health 10-Q

3. Clover Health earnings release FY20

4. Clover Health earnings release 1Q21

5. Clover Health investor presentation