Description

July 11, 2019

Greensky, Inc. (NASDAQ: GSKY)                                                       Current Price: $11.42 ⎜Price Target: $40

  (250% Upside)

Introduction 

Greensky is a fin-tech company that facilitates loans at the point of sale through a platform that enables over 15,000 merchants to offer credit to their consumers in the home improvement (~85% of revenue) and elective health care (~15%) verticals.    

GSKY stock has performed terribly since its IPO in May 2018, but after taking a deep dive into the business, we have come away with a variant perception that is at odds with the market’s low assessment of GSKY’s future business prospects.  We believe that GSKY has a strong offering in the consumer finance space because it offers value to all participants on the platform, while at the same time it has a relatively low risk, capital-light business model that generates very strong cash flow profitability.  GSKY has significant room for growth in its existing verticals and has a long runway of potential new verticals to enter, giving it a uniquely strong, multi-year growth opportunity. The company continues to grow its merchant partner count, which is a strong leading indicator of future platform loan volume and should be poised to show better performance in the upcoming seasonally strong Q2 and Q3 reporting periods. 

The stock is priced as if GSKY is a broken growth story with significant credit risk.  Our view is that GSKY’s difficulties in its first several quarters as a public company are explainable by other factors and that the attractive stock price combined with high short interest has created an intriguing buying opportunity with the potential for a big percentage move higher in the stock.  

Business Overview

There are three key players in the Greensky ecosystem:

• the merchants, such as a home improvement business that will replace an old roof or HVAC

• the consumers, who are typically home-owners and have an average credit of 769

• GSKY’s bank partners that extend the loans to the consumers so that the merchant can be paid in full and receive funds the next day.

Greensky allows merchants to close high-dollar sales by providing credit to consumers in less than a minute via a paperless process completed via a mobile device. GSKY also allows merchants to offer homeowners a promotional financing option such as an interest-free loan if they are repaid within 12-24 months of the purchase.  For the consumer, this is typically preferable to using a high-interest credit card when faced with the prospect of a sudden, large-dollar non-discretionary purchase such as a roof or HVAC replacement. Even for a more discretionary purchase, such as for a home remodel, the “apply and buy” process in less than a minute at the point of need is often preferred to the time and effort required to get a home equity or home improvement loan from a bank.  

The advantages to the merchant in the GSKY platform are obvious: the consumer is more likely to make the purchase if an “easy” credit option is available to fund it, and there are opportunities for the merchant to make a bigger sale if the consumer has the option to pay off the purchase over time.  In addition, the ability to offer credit instantly to qualified purchasers elevates the merchant’s perceived value and professionalism to the consumer.   

GSKY’s bank partners also benefit from the platform by having a ready alternative to make loans to credit-worthy borrowers that offer higher effective yields than a comparable directly originated loan.  In addition, GSKY’s economics are designed so that GSKY has significant incentive to ensure that the loans perform through an incentive-driven formula, so to a certain extent the banks know that GSKY is aligned with the bank in ensuring that underwriting standards are maintained.  Finally, GSKY’s partner banks are able to build a geographically diverse portfolio of high-quality loans made almost entirely to consumers with high credit scores (average 750+) without the direct costs of marketing, originating, underwriting, or servicing the loans. GSKY bank partners also get the advantage of the protection of first loss offered by Greensky of ~500 bps. 

Greensky generally offers two categories of loans: an interest-deferred “promotional” loan, such as a 12-month interest-free rate, and a more “standard” unsecured consumer loan with a 10-12% APR that matures in 7-12 years.  Approximately 89% of the promotional loans are repaid by the consumer prior to the expiration of the promotional interest period. Loans that are not paid off under the promotional terms generally revert to much higher interest rates (~25% APR).  Roughly 62% of the loan book is comprised of the standard loans, while about 38% are promotional loans.  

A typical scenario is when a contractor on the Greensky platform closes the sale with the consumer by offering immediate financing, which as noted above can take the form of a standard unsecured loan or a promotional loan. GSKY’s platform allows the loan application to be submitted on a mobile device with an approval available within 60 seconds. Greensky’s algorithms then compares the loan with the specific requirements of each partner bank before assigning that loan to a specific bank.  The bank will send the funds to the merchant for the agreed loan amount. The merchant then pays Greensky a transaction fee at closing of ~7% of the loan value from the merchant at the time of the loan funding. The banks also pay Greensky a servicing fee on a monthly basis that is roughly 1% of the serviced portfolio value.

While the merchant fees average roughly 7% of the loan value, GSKY does vary the merchant fee percentage based upon the underlying loan type.  This allows GSKY to offer the merchants and end-customers a variety of loan options. Greensky’s system manages these offerings dynamically to match GSKY’s desired margin profile with the loan structure.  For instance, GSKY might realize an 8% transaction fee for a 12-month deferred interest loan, or a 7% transaction fee for a 10-year, 10% interest loan. The exact mix of loan types will impact GSKY’s GAAP income statement and will also impact reported cash flows. 

It is important to recognize that Greensky facilitates the loan but does not fund the loan with its own balance sheet.  The bank partners retain the underlying credit risk, while Greensky’s credit exposure is limited to a specified portion of its loan book that it places in escrow and which appears on GSKY’s balance sheet as “restricted cash”.  The escrowed cash for this purpose equals ~1.3% of the value of the serviced portfolio. The bank partners receive an attractive loan at an appropriate interest rate with a credit-worthy borrower, but without the origination costs or need to service the loan.  

The Value For GSKY’s Bank Partners 

Why would the banks want a partnership with Greensky?  There are five important reasons:

• The return with Greensky is around 50 bps higher than a standard bank loan— or up to ~50% higher yield with good credit metrics.

• The consumers are of good credit quality with an average 768 FICO score and home ownership. These are typically prime or super-prime customers with ability to pay and access to credit.  Each bank can also specify its credit requirements and GSKY will match the bank’s portfolio with loans that meet the criteria. The loans can also be geographically diverse from the bank’s own portfolio by loan type or region.

• Greensky has “skin in the game” and is incentivized to ensure good credit performance due to its fee structure on the loans, which allows GSKY to earn an incentive fee on the loans in excess of the bank’s required interest spread.  

• Greensky underwrites, documents, and services the loan and offers robust compliance reporting to ensure that the banks don’t have to commit significant operating expense or COGS to manage and service the loan book.  

• Because GSKY has skin in the game, all things equal, if there is a period of heightened delinquencies, the bank will do MUCH better with the loans under GSKY versus their own loans, due to the ~500 bps first loss that GSKY offers. (After the 500 bps, the bank is responsible for those losses.) 

The table below shows a comparison between the net interest income on a traditional bank loan versus on a book of GSKY-originated consumer loans. 

While it is not impossible for the bank to suffer credit losses that might reduce its interest spread below the specified required rate, it is unlikely. This is because before the bank can suffer losses sufficiently to impact its spread, GSKY has to burn through its incentive-related payment structure (which runs about 500 bps).  GSKY’s loan portfolios generate APRs in the range of roughly 10% (based on GSKY’s investor decks). Then there is the ~1.3% of escrowed cash. In other words, there is about 600bps of loss rate cushion before the banks get hurt.  

After reviewing this carefully, we have concluded that yes, it is “almost” impossible for the underlying credit performance to be that bad.  People with 750+ credit scores aren’t using GSKY’s platform because they need the credit, they are using it for convenience and budget management.  They have intent to pay, and most of them do. It is possible that in a severe recession credit performance could get that bad, but we don’t think that either GSKY or the banks suffer catastrophically even in a stress test scenario.  More importantly, the short thesis implies that such a scenario would represent an existential risk to GSKY. While GSKY’s profits would absolutely take a huge hit in a bad case scenario, it’s hard to come up with a realistic worse case where GSKY posts meaningful sustainable losses.   (i.e. there is one bad year --- maybe two, but then credit recovers). 

GSKY Economics

To explain how we come to the above conclusion, we think it is helpful to consider the GSKY business as having three sources of income. Please note, that the company only refers to two segments of revenue. Most investors we have talked to confuse and mix-up the transactional business and the incentive commission. In our pro-forma, each line has its own revenue item and cost of good item. 

The table below breaks this out:

In all loan types, GSKY will earn a transaction fee upon the completion of the loan which is recognized as revenue. However, in the event of a promotional loan, GSKY does have to pay the bank partner the minimum required rate specified by the bank, because the bank partners do not offer deferred interest loans themselves.  This is where the accounting gets a little complicated. Under US GAAP, when a deferred interest loan is made by the bank partner, GSKY creates an expense that also goes to a balance sheet liability called a Finance Charge Reversal (FCR). This means that on the promotional loans, GSKY generally funds the interest expense that it pays to the bank for the short promotional period from the revenue received from the merchant.  This payment shows up in GSKY’s income statement as an increase in COGS.  

Let’s now quickly review GSKY’s profitability metrics.  GSKY typically earns 700 bps of the value of the loan in the form of an up-front merchant fee at the time of the loan, which is recognized at the time of sale and is essentially all incremental profit. GSKY receives another 100 bps on servicing fees from the bank, for a total of 800 bps.  In addition, GSKY expects to earn about 150-250 bps annually in the form of incentive fees which are booked over time on the underlying performance of the loan portfolio. This incentive fee income will likely bounce around a lot from quarter to quarter, impacted by a combination of seasonal patterns, the percentage of loans originated that are promotional loans, and the timing of credit charge-offs and recoveries. However, and most importantly, the incentive payment from the banks to GSKY cannot go below zero.   

Our conclusions from this are as follows: GSKY can “increase” margins by electing to do more interest rate loans vs promotional, low interest loans. It can also increase gross margins by charging a higher APR, thus increasing the incentive fee, which lower the cost of goods sold.  We believe GSKY’s management looks to maintain a balance between generating high gross and EBITDA margins in the near term while also driving future growth and free cash flow generation over time. Operating expenses as a percentage of revenue in 2018 was ~24.5%. We believe that GSKY will continue to see operating leverage in its business model over time, but this may not be consistent year to year based on the composition of its loan book.

Understanding the Accounting 

Understanding the accounting, and most importantly, understanding the “Cost of Revenue” piece, is key to getting comfortable with Greensky. Greensky discloses all important metrics in its investor presentations.   

Here are the key concepts: 

• Cost of revenue = (Origination related expenses + Servicing related expenses + Fair value change in FCR liability)

• Fair value in FCR liability = (Receipts – Expense for Future Finance Charge Reversals)

• Receipts = (Incentive Payments + Proceeds from Charged-Off Receivables transfers + Recoveries on previously charged-off loans)  

The origination and servicing related expenses are straightforward. The Fair Value Change in FCR is composed of the receipts (which are the Incentive Payments as shown in the previous illustration) and the recoveries from charged-off loans, minus the new Future charge reversals.

As you can see, the fair value change in FCR liability is a large component of Cost of revenues.   

We believe that one of the reasons that GSKY’s stock declined in late 2018 was related a combination of reduced guidance, but also due to market interpretation of the reasons for that reduced guidance.  It is important to understand that the FCR liability can represent as much as 2/3 of cost of revenue for GSKY in a given quarter. For Q4 2018, GSKY was up against both seasonality effects (higher delinquency rates are common in Q4 and Q1) and a difficult compare to Q4 2017, when GSKY sold a large amount of previously charged off receivables.  There was also a rise in interest rates which created a higher FCR expense and reduced incentive fees due to a higher required bank return. It is our perception that the bear thesis on GSKY interprets this as early evidence of a secular profitability decline or business model flaw, but we think that these factors will revert back to GSKY’s favor in the upcoming quarters as seasonal impacts come into play and the interest rate environment has stabilized.  We will describe these factors a little more below.

Headwinds to Tailwinds

One of the modelling challenges with GSKY due to its short tenure as a public company is the impact of seasonality on the business, which we believe was not well anticipated by sell side analysts. There are a few different impacts of seasonality on GSKY’s business, depending on what metrics you are focused on. The home improvement segment will be seasonally stronger in the second and third quarter, which will increase loan originations and merchant fee revenue.  GSKY’s loan incentive payments related to the bank partner agreements are also seasonal and are lowest in Q4 and Q1. This is a result of seasonal patterns in consumer credit, which leads to higher delinquent payments and charge-offs during and immediately after the holiday season.  As a result of seasonally elevated charge-offs, GSKY recognizes lower incentive income in Q4 and Q1, and higher incentive fee income in Q2 and Q3.  As a result of these two factors, GSKY’s reported EBITDA margins are much higher in Q2 and Q3 than in Q1 and Q4. We believe that the market may not be fully baking in the seasonal strength in GSKY’s reported financials for the upcoming two quarters.   

Interest Rate Sensitivity

One factor that we believe is impactful to GSKY’s reported financials is the impact of rising rates over the course of 2018. While GSKY’s management publicly asserts that the company is relatively agnostic to changes in interest rates, our analysis leads us believe that both the company and sell side analysts under-estimated how quickly rising rates would impact the required bank yield built into GSKY’s existing loan book.  The immediate effect of the rising rates and bank yield was a sharp decline in incentive payments earned by GSKY. We believe that rising short rates were a factor in GSKY’s lowering guidance in November of last year.

We believe that GSKY does have the ability to adjust to a rising rate environment in accordance with management commentary, but we do think that there is a lag time involved and that GSKY’s Q4 and Q1 financial results were impacted by rising short rates. Greensky has reacted to the higher rate environment by increasing new loan APRs and by making other changes (such as merchant fee percentage).  After seeing incentive fee revenue decline in Q4 2018, Greensky has guided for the incentive payment to increase in 2019 by 20 basis points versus full year 2018.  Also on the positive side (and helpful to our long thesis) Greensky will suddenly be up against very weak comps starting in Q3’19, which will likely enable the company to dispel the notion that the business is not growing as strongly as expected. 

The company provided the following slide in its investor deck to illustrate how it can respond to interest rate changes by re-pricing new loans.  While the company points out the life-time cash flows on the new loans are the same as the loans made under lower interest rates, there is some variability in the quarter to quarter numbers as well as the timing of incentive fee recognition.

Solar Roof Sector Business Decline

One other factor that we believe analysts have missed regarding GSKY that will improve going into the back half of 2019 is that Greensky’s loan book did have a large weighting in solar roof panel-related loans, which offered much higher than average transaction fees for GSKY.  Beginning in 2018 GSKY began reducing its new loan activity in the solar area, and by Q4 2018 solar loans were down to 4% of GSKY’s transaction volume and roughly 7% of GSKY’s transaction fee income. The decline of these loans has reduced GSKYs’ growth and profitability, but most of the impact was felt in 2H 2018.  Going forward, with solar loans declining as a percentage of the loan book and with GSKY’s other verticals growing faster, this headwind will go away and comps will get easier starting in the back half of 2020. Finally, we view GSKY’s ability to react to the changing environment related to this line of business and move to focus its efforts on other areas demonstrates resilience and gives us more confidence that GSKY will respond appropriate to changes in landscape in its other business lines. 

The chart below shows the change in solar-related business by quarter though Q3 2018:

Why This Opportunity Exists

We also want to understand why we think the market might be giving us a good price when considering a long idea where we believe we have a variant perception.  Greensky completed its IPO back in May 2018 at $23 per share, and the stock has since fallen by almost 50% since the offering. We see three big factors that have combined to negatively impact the stock price: 

• The company went public with what appears now to have been overly optimistic management guidance and aggressive sell side estimates, and the business results in the quarters since the IPO have disappointed relative to those expectations.   We believe that GSKY’s business has faced interest rate headwinds since going public, and it may be that expectations were simply too high in any case. GSKY management was forced to reduce guidance back in November 2018, and the stock got hit hard, falling below $10 in late 2018.  

• The company has become heavily shorted based on a thesis that GSKY has embedded credit risk and is vulnerable to a significant decline in credit conditions or loan performance. The short thesis has “worked” in the sense that the company reported disappointing results relative to expectations and the stock price has dramatically declined from the IPO.  However, with over 40% of the float now short and with a short interest ratio of more than 20, we believe that it is likely that many short sellers have been drawn to the name (and have been rewarded to this point) without deeply understanding the business model. At the same time, the sell side has gotten increasingly negative. We believe that important elements of the short thesis are likely to be proven incorrect for those investors who are hinging their short positions on the belief that GSKY’s problems will continue and that GSKY’s business carries meaningful credit risk to the underlying loans that are originated through the platform.  From this price level, we will argue that GSKY stock is oversold and investor expectations are low. We see an opportunity for a big jump in the stock on any positive news. 

We believe that GSKY has some unusual elements to its business model that lead to GAAP accounting nuances that many investors likely aren’t willing to make a strong effort to deeply understand.  We believe that “fin-tech” or “growthy” investors likely are no longer interested in the business due to the loss of business momentum and the fact that GSKY stumbled out of the gate as a public company.  As a result, while GSKY has appealed to and rewarded the short seller community, it has not been able to draw any support from the buyside. We believe that in addition to short sellers eventually being compelled to cover, we see potential for a couple of quarters of better performance to help bring in a new group of buyers.  

Keys to Our Investment Thesis: 

Our core investment thesis on GSKY is that the market has become overly negative and the stock price does not reflect the quality of the business nor GSKY’s future growth prospects. 

For one thing, while the market price would imply a low or no growth business with no ability to scale and credit risk, a review of the business model and recent financial results show GSKY to be a strongly cash flow generative business with far less credit risk than the market appears to believe.  The technology platform is robust and offers a strong value proposition to both direct participants (i.e., the banks, the merchants) and the end consumer, who benefits from quick access to capital at reasonable rates compared to easily available alternatives. 

A quick review of the company’s disclosure shows that the platform usage is growing strongly: 

• Transaction volume has grown by 30% for each of the years 2016, 2017, and 2018, with the 2018 transaction volume reaching $5.03 billion, up 34% from 2017.

• The loan servicing portfolio (which is directly linked to GSKY’s service fee income) grew from $3.83B in 2016 to $5.39B in 2017 and $7.34B in 2018 (up 36% YOY).

• The number of active merchants has likewise doubled from 7,361 to 14,907 in three years.

• Cumulative customer accounts have grown from 1.077M to 2.24M in the last three years.

The growth in the key loan metrics above translate directly into GSKY’s financial performance:

• Revenue for 2016: $263.8M; 2017: $325.9M; 2018: $414.6M

• Pro forma net income: $76.3M in 2016, $87.1M in 2017, and $109.1M in 2018.

• Adjusted EBITDA: $130.7M in 2016; $159.4M in 2017; and $171.5M in 2018.

GSKY generates substantial excess cash flow from its business, with operating cash flow growing from $121.9M in 2016 to $160.4M in 2017, and $256.4M in 2018.  Capital expenditures are very modest relative to this immense OCF: Cap-ex was $6.6M in 2018, and less than $5M in both 2017 and 2016. GSKY defines its free cash flow as operating cash flow – cap-ex – changes in restricted cash).  For 2018, this resulted in FCF of $223M. 

Compared to the current market cap of $2.1B (and an EV of $2.2B), GSKY is valued by the market at a 2018 EV/EBITDA multiple of about 14X and forward multiple of 10X.  If one were to use GSKY’s definition of FCF, the 2019 EV/FCF multiple would be 10.5X. We would be quick to point out that we believe that GSKY’s operating cash flow has some “float” like qualities and therefore we do not consider it to be reflective of GSKY’s cash flow generation in no-growth or steady state mode.  Still, we think that making a very rough cut to the reported OCF to reflect our best guess of the impact of the favorable working capital characteristics of the business gets us to a number of maybe $235M in OCF for 2019, such that our interpretation of FCF would come in very much in line with the 2019 guidance of $220M or so EBITDA.  We therefore peg the stock as priced at something like 10X steady-state FCF at the current quote in the mid-$11 price range. 

GSKY also has significant room to grow in its current verticals and clearly has the potential to expand to other markets, which offers a long runway for future growth for the business. Greensky currently focuses on the home improvement (85% of transaction revenue) and elective healthcare (15% of transaction revenue) verticals.  GSKY’s investor deck asserts that these two markets alone represent at TAM in the U.S. of $600B, versus the company’s current annual transaction volume of $5B and current loan servicing book of $7B. There is a lot of room to take share in these two areas. They also have an opportunity to expand their TAM significantly to many other markets, which they have already begun to explore and which would be entirely incremental to our thesis. 

The keys to growth for GSKY are growth in merchants on the platform, along with growth in bank partner loan commitments. The graphic below shows GSKY’s merchant network growth in its two primary verticals.  The elective healthcare market is showing impressive growth, with the number of merchants on the GSKY network having more than doubled YOY through Q1 2019.  

The graphic below shows some of GSKY’s own internal metrics related to several important business metrics:

Examining the Short Thesis

In this section we’d like to quickly review several arguments made by short sellers and offer our views related to the veracity of each assertion:

Questions regarding management integrity/shareholder alignment

GSKY CEO David Zalik was previously a board member of a failed commercial lender called Rockbridge.  Rockbridge was sued by the FDIC in 2012, alleging that Rockbridge engaged in “aggressive high-risk lending” and “did not take appropriate actions to remedy regulator warnings regarding insufficient internal controls and underwriting between 2007 and 2009.”  The lawsuit was settled for $5M. While it is true that this lawsuit does not cast Rockbridge management in a favorable light, it is also true that a LOT of banks and commercial lenders took on too much risk during that period, and the Rockbridge lawsuit was the 13th FDIC liability lawsuit against Georgia banks during that time period.  We will also point out that at the time of the suit, Georgia had more bank failures than any U.S. state from 2008 through 2012.  Also, it is difficult to know how much influence David Zalik (who was listed only as a board member) had at the bank and how much this failure reflects on him personally. Our view is that Zalik has had an otherwise impressive career as an entrepreneur, and that the Rockbridge blemish is not enough to make an overall character assessment.   

We do agree that one could legitimately criticize GSKY management for having to reduce guidance in late 2018 six months after the IPO.  As noted above, we believe the management (and the sell side) did not fully anticipate how quickly rising short rates might impact its reported financial results.  Recent actions by management are consistent with what one might expect with a heavily insider-owned public company – GSKY has announced a significant repurchase authorization with the stock down 50% from the IPO price, and made meaningful purchases in Q4 2018 and Q1 2019 at what we view are attractive prices. 

Questions around Technology Value / Competitive Pressures

While GSKY does have (and will have in the future) competition in its verticals, we believe that GSKY has emerged as an important first mover with an early lead at capturing true point-of-sale, near-instant loan application, approval and contract generation. It is not trivial to achieve this with seamless integration with both the merchant and bank partner systems.  While several large payment and lending companies offer competing products, it seems to us that the most significant competition in these two verticals remain credit cards and home equity/home improvement loans. There seems to be a perception that because GSKY has not capitalized huge amounts of technology spending, that its technology platform can’t be extremely functional and therefore valuable.  We believe that the fact that the technology has enabled $5B in annual loan origination, services $7B in loans, and is attracting merchant count growth of ~40% per year is strong evidence of the technology’s value. We don’t argue that GSKY doesn’t and won’t have competition, but rather that they are taking share from the competition with what they have. 

Shorts assert that GSKY does effectively retain economic credit risk due to the structure of its guaranteed margin arrangement with the partner banks.

We have delved pretty deeply into this topic, and it is our belief that at no point is Greensky liable for credit expenses beyond the calculation of incentive payments and the escrowed money held as restricted cash.  COO Gerry Benjamin made this statement at the Credit Suisse conference in November 2018:

“Our performance fee can't be less than zero. If losses were to double and go from 2.5% to 5%, our performance fee would contract. The bank would still get their contracted margin. And it's that stability and resilience that the banks love in this high-quality asset. But again, we're not taking First Dollar Credit risk. We're not on the hook for a claw back. We're not guaranteeing the banks anything whatsoever.  We're truly asset-light. Unlike a Visa or a Mastercard where we get a transaction fee and a spend-centric model, we also have the potential, not the guarantee, but the potential to earn a performance fee associated with the excess profitability of that portfolio. I think it's a potent combination.”  

The bear thesis argues that due to some sort of timing mismatch between when the revenue is booked and when / if the bank suffers credit losses that will eventually eat into GSKY’s incentive income, and potentially may even burn through the 1% escrowed cash protection layer and cause a hit to GSKY’s equity.   We’ve already addressed the credit risk issue above but let us just say that we don’t believe that GSKY’s bank partners will encounter the kind of terrible credit performance that would cause GSKY to burn through its entire incentive income, much less the escrow line. However, it is important that investors understand that GSKY’s incentive income does occupy sort of a “second-line” credit position in that GSKY’s incentive income is on the hook in the event of unexpectedly poor loan performance.  However, we prefer to think of GSKY’s credit risk profile here as “credit opportunity” and not “credit risk”.   

As an illustration, we tried to calculate the impact to GSKY’s profitability for 2018 with the assumption that GSKY’s loan portfolio performance had been so awful that GSKY literally collects $0 of incentive-related receipts.  This would wipe out $139M of incentive payments that GSKY actually received. We calculate that EBITDA would have dropped from $170M to about $30M, assuming the incentive fee income decline falls nearly dollar for dollar to the EBITDA line (which in reality is much less – see slide below).  Obviously, that would be bad! But this is an extremely ugly theoretical scenario, and it doesn’t even cause GSKY to lose money.  

To present a balanced view, however, we completely agree that GSKY has indirect exposure to the credit performance of its originated loans.  If GSKY’s originated loan performance over time is poor and GSKY’s bank partners do not earn an all-in return commensurate with the risks they take, GSKY will lose its bank partners.  In addition, because GSKY doesn’t fund loans with its own balance sheet, GSKY is reliant upon the ability to attract bank partners to fund the loans and take the credit risk. It may be that GSKY has to improve the terms of its agreements to partner banks in the future in order to keep them or attract new ones.   

The banks, however, appear to view the proposition as positive: they make a loan with an attractive APR, and they can see that GSKY is heavily incentivized to ensure that overall portfolio performance is good enough to allow GSKY to earn the incentive fee (or at least some portion of it).  Given average APRs above 10% on the overall book, banks view GSKY as having 400-500bps of first-loss exposure (via the incentive fee) BEFORE the credit losses begin to hit the bank’s expected interest income spread.  

We therefore believe that most of GSKY’s bank partners will stay as long as their effective margin is reasonable relative to risk and other opportunities.  Shorts believe that in a situation of bad credit performance, banks will stop funding to GSKY. All else being equal, the opposite is true. In a period of credit underperformance banks will prefer to lend with GSKY, due to the ~500 bps first lost protection in the business model. We do think it is possible that any individual bank could pull back on its lending if they begin to experience unexpectedly bad credit performance (even if it is not in GSKY’s business) or reduce risk if they see the credit cycle turning down.  But we believe that is a risk that investors take in any lending-related business.  Our belief is that GSKY’s typical home improvement customer with a ~760 FICO score (traditionally considered prime/super-prime) is not the first place that banks will reduce if the credit cycle does turn down.

GSKY itself provides some stress-test disclosures in its investor materials, for what it’s worth.  Here is a slide taken from GSKY’s August 23, 2018 deck: 

Some Other Risk Factors to Consider

There are some additional elements to the GSKY thesis that we think investors should carefully consider.  One is that GSKY does have significant concentration risk in its bank partners. GSKY’s partners are big, super-regional U.S. banks with a lot of lending capacity, and roughly 85% of GSKY’s loans come from the five largest partners.  It is not clear to us how much risk this represents – we believe that if one partner pulled back or discontinued the relationship, GSKY could allocate more loans to the other bank partners. Also, GSKY will likely add more bank partners, but there is a ramp-up time before normal loan volumes are reached.  It’s a risk to consider.  

Also, while GSKY has ~15K merchants, there are groups of merchants that fall under the umbrella of larger organization, or “sponsor”.  While the merchant group appears fragmented, there is a possibility that GSKY could lose a group of merchants at one time if the sponsor entity is unhappy with the platform.  

GSKY’s share structure is also a little different: GSKY actually owns shares in an entity which owns 34% or so of the GSKY business, and there is a tax-benefit sharing agreement with the actual owners that some investors might wish to factor in to the enterprise value calculation or deduct from future earnings.  For those who are familiar with Interactive Brokers, it appears to be the same structure that IBKR used when they went public. Also, GSKY’s effective tax rate in 2018 was not a full tax rate, and so the move to GSKY’s estimated tax rate of ~20% in 2019 and beyond may add a new headwind to reported profits in the next several quarters.  

Lastly, we don’t disregard the garden-variety risks that come with being a business that rides the cycles of U.S. consumer credit in what certainly may be the late innings of a credit cycle.  We think that GSKY is better than the average business in the space, but our thesis won’t be as strong if consumer credit performance gets ugly.  

Catalyst

Shorts misunderstanding the business. With a short interest ratio of 23 days, there can be a substantial short squeeze. Lower bank payments going forward + Higher collected APR = higher incentive fees.