|Shares Out. (in M):||378||P/E||27.1||15.1|
|Market Cap (in $M):||2,460||P/FCF||NA||43.2|
|Net Debt (in $M):||-874||EBIT||19||79|
LendingClub (LC) was last written up by ValueGuy on VIC in December 2014 shortly after it completed an IPO on the NYSE. When the last pitch was written, the shares were trading near $24 and were priced to perfection. Since then, the stock has plummeted 73% to its current price of $6.51, currently only 2.7% above its all-time low of $6.34. While we recognize that LC is not a value investment by any means, we do believe that under $7, the risk reward of this investment is certainly attractive.
In fact, the ~50% decline in stock price performance since mid-December 2015 indicates that the market has already priced in an overly-bearish macro environment, predicting a significant increase in default rates with the potential increase of four additional rate hikes. However, most recent consumer metrics remain strong with increasing non-farm payroll numbers, high consumer confidence, and steady consumer debt obligations as a percentage of personal disposal income. Furthermore, the prospect of several additional rates hikes in 2016 is increasingly becoming less.
In addition, LC is largely past the technical risk and selling pressures of 2H15, during which the 180-day lockup expired on 303.4 mm shares owned by early stage investors.
Investment Thesis: Long
LendingClub (LC) is the dominant market leader in the peer-to-peer (P2P) lending space, with ~75% market share in the P2P consumer credit space. LC’s unique and asset light platform, combined with leading credit underwriting technology, have allowed it to enter as a disruptor into the consumer credit and small business (SMB) loan markets, which present a combined immediate TAM of ~$530 bn (of which LC has only penetrated ~3%).
LC has also entered the education and medical procedure financing markets via its acquisition of Springstone Financial which finance private education and elective medical procedures through a network of over 14,000 schools and healthcare providers.
Since going public in December 2014, the shares have traded steadily down, off of concerns regarding 1) the rise of interest rates and cyclicality of consumer credit, 2) increased competition from new entrants into the P2P space or retaliation from existing incumbents, and 3) potential increased regulatory oversight from agencies such as the Consumer Financial Protection Bureau (CFPB) and concerns regarding the Madden v. Midland Funding, LLC case.
Although these concerns have merit, LC’s value proposition to both lenders and investors, technology platform, and dominant market share should serve as considerable mitigants to the aforementioned risks. In fact, some of these concerns present opportunities for LC.
In a sector where there is virtually unlimited whitespace, players are sprinting to originate as many loans as possible, often at the cost of credit underwriting standards. LC has been able to become the market leader all while maintaining underwriting integrity. Its focus on transparency and risk management has helped it limit default rates and reinforce its value proposition with both lenders and investors.
This adherence to transparency, combined with a dominant foothold on the P2P space, will allow LC to continue to outpace other players in the space.
Recommendation: Long shares of LC, with a target price of $12.61 in the Base Case generating 93.7% upside.
Merits to the LC Business / Operating Model
LC has a clear and strong value proposition to lenders and borrowers on its platform. Lenders make more; Borrowers pay less.
LC reduces the enormous spread that traditional banks and credit unions make on taking in deposits and the interest rates they charge on credit cards.
The average interest rate of a borrower seeking to refinance credit card debt on LC’s platform is 21.8% and the national average interest rate yield from savings accounts is 0.06%.
On LC’s platform they shrink this spread offering borrowers on average interest rate of 14.8% and investors an average risk-adjusted 8.6% APY.
LC is able reduce the spread that traditional banks have and offer lower interest rates to borrowers and higher risk-adjusted returns to lenders, offering a compelling value proposition.
LC is able to do so in that they have a lower operating expense ratio (~2%) than what a traditional bank would have (~5% to ~7%)
LC is able to achieve this cost reduction because they manage no physical branches and take in no deposits. As a result, they are not classified as a bank and can avoid the cumbersome costs of guaranteeing deposits including capital reserve requirements, FDIC insurance, and ABS insurance.
Note: LC’s current operating expense ratio is slightly higher due to their focus on increasing originations and the associated marketing and customer acquisition costs that come with their rapid expansion
Large, immediately-addressable, TAM of ~$530 bn across the consumer credit and SMB credit markets
Much of LC’s consumer credit loans are to individuals that seek to refinance their credit card balances
The total revolving consumer credit balance in the US is ~$880 bn. Paring this amount down for balances that don’t carry from month to month, that aren’t large enough to warrant a refinance, and have debtors who also qualify LC’s requirement of a 660 FICO score, the consumer credit market is estimated to be ~$300 bn (Source: Morgan Stanley)
For the SMB loan market, there is approximately ~$300 bn of loans. Of this amount, about ~$130 bn are loans under $100,000 in size (which is approximately the size of LC’s SMB product). There is also ~$100 bn of unmet demand as traditional banks and lenders have shifted to more profitable activities. In aggregate, the SMB credit opportunity for P2P lending platforms is estimated to be ~$230 bn (Source: Morgan Stanley).
Furthermore, LC’s TAM is increasing as it makes acquisitions (Springstone Financial) and strategically branches into the patient and education financing markets
The student loan market is estimated to be ~$1.1 trillion within the US (Source: Federal Reserve Bank of New York).
LC also has an underappreciated technology in underwriting credit risk which has strong network effects and serve as a moat around its business
Marketplace models demonstrate network effects and LC is no different.
LC’s long history, large amount of data, and better track record has given it the ability to price risk and underwrite loans to achieve a better risk-adjusted return for investors. LC has been able to deliver net returns better than or in line with investor’s expectations continuously over the past 8 years.
Its track record and success means that investors are willing to require a lower risk premium
This leads to lower rates for borrowers
Lower rates for borrowers as well as lowering the acquisition costs of new borrowers
This leads to better credit performance and more borrowers
Better credit performance and more borrowers leads to more data and an even stronger track record
In a marketplace model which shows a “winner-take-most” dynamic, LC’s strong network effects will allow it to remain entrenched in its market leading position for its core consumer credit market and allow it to take market share from adjacent product markets
LC is also entering into partnerships with top technology firms, financial institutions, and regional banks make LC’s position as market leader more entrenched and offer the opportunity to scale even quicker into adjacent markets
Some recent partnerships include:
Partnership with Google to offer SMB loans up to $600,000 in size
Partnership with Alibaba to offer SMB loans at very low acquisition costs
Exclusive non-SBA term loan provider for Sam’s Club’s millions of small business members
Partnership with Citi to provide affordable credit to moderate and low-income families
Partnership with BancAlliance and its 200+ regional community banks to offer co-branded loans
LC has an asset light operating model as opposed to traditional banks as it does not need to invest in physical assets. LC also has a fixed cost component to its scalable model. Therefore, the incremental revenue from an additional lender/borrower borrower drops significantly down to the bottom line.
Discussion of Risk 1): Rise of Interest Rates and Cyclicality of Consumer Credit
LC has grown at explosive rates primarily due to the “near perfect” credit conditions seen today:
Low interest rates on savings/checking accounts and on the 3-Year CD (~1.5%)
High interest rate on credit cards
Low defaults and net charge offs (NCO)
These factors give LC the ability to squeeze the spread traditional banks have giving them a compelling value proposition for lenders and borrowers to join their platform
However, conventional wisdom states that with increasing interest rates, consumer credit performs worse. The bear thesis on LC revolves around the concept that with rising interest rates, fewer investors will join the LC platform and NCOs will erode the spread that LC is available to offer.
How consumer credit cycle and continued rises in interest rates would affect LC
To assess this concern, one must understand how a rise in interest rates would affect the supply (lenders) and demand (borrower) of loans on LC’s platform
A rise in interest rates would initially decrease the supply of borrowers as relative risk/reward for P2P loans look less attractive when compared to other venues to invest capital (e.g. a savings/checking account)
In fact, we have not seen interest rates on savings/checking accounts increase after the 25bp rate hike in December 2015.
Demand for loans from borrowers increases as the floating APR rates on credit cards flex up and interest rates charged on existing balances increases
LC’s spread can shift up and has the ability to offer higher net returns to lenders making their offerings attractive
However, what is paramount in being able to offer an attractive net return hinges heavily on LC’s ability to price the risk. LC’s should be able to manage this as it has the most robust credit models given its long operating history and the sheer aggregate amount of data it has collected from its originations.
LC’s unparalleled credit models and ability to price risk can be seen in how it navigated the recession
LC was able to offer 2% to 5% net returns during the recession (Source: CEO Renaud Laplance)
In fact, during the financial crisis, the asset class of credit card receivable backed ABS greatly outperformed other asset classes such as the S&P, high yield credit, and investment grade credit.
This leads us to believe that LC (whose P2P consumer credit loans are high composed of credit card receivables) could offer diversification benefits in future downturns.
Prosper, LC’s closest competitor, which started operating a year before LC, had credit losses which greatly exceeded investors’ expectations. This inability to accurately price risk led to investors pulling money from the Prosper marketplace.
Therefore the need will be to focus on lenders to ensure a supply of funds. Retail investors have historically been the most fickle but LC has been diversifying its investor base to more institutional investors (less elastic) and even potential BDC partnerships (permanent capital sources).
Furthermore, it is mainly consumer credit that is cyclical. LC should be able to stabilize across its patient financing and education loan products.
Discussion of Risk 2): Increased competition from new entrants into the P2P space or retaliation from existing incumbents
The P2P lending space is seen as having very few barriers to entry and is viewed as a commodity service
We fundamentally disagree with this notion as LC’s strong network effects, track record and trust from investors, and existing market share all serve as barriers to entry.
LC also benefits from high organic traffic and search rankings (Source: Alexa).
It’s undeniable that institutional capital is easily attained right now which several upstarts entering the P2P lending space.
However, within LC’s core space of consumer credit, it operates in a duopoly with Prosper where LC has ~75% of the market and prosper has ~23% of the market. The remaining ~2% is held by other P2P lenders.
Absent of significant fee reductions, or much lower interest rates, it is hard to believe that a marginal investor or borrower would willingly choose an alternative platform with inferior technology.
Furthermore, many new entrants into the P2P lending space aren’t competing in the core P2P markets (consumer credit, SMB credit, student loans)
New entrants have focused on niche sectors like wedding loans or funeral loans in an attempt to acquire enough scale to be acquired by bank or a P2P leader like LC or Prosper.
Today one can see excess capital being turned away by leading platforms and cascading into emerging alternatives, as emerging entrants offer lower rates at the expense of credit underwriting standards.
However, in the down cycle, emerging platforms are expected to be impacted first as capital begins to dry. Leading platforms are likely to be insulated.
As the result the coming credit cycle may even serve as a benefit as it will thin out the heard, further entrenching existing leaders.
Another concern is competition dynamic between the incumbents and LC in the consumer credit/ SMB space.
The relationship is complex.
Smaller regional banks are much more amenable to partnerships to cross-brand and cross-sell loan products. Many smaller banks choose not to issue SMB loans due to their relative lack of profitability.
Larger banks are mixed, some are starting their own ventures (Goldman Sachs) while others are willing to partner (e.g. Citi and LC)
In June 2015, Goldman Sachs hired Tarit Talwar, a former top executive from Discover, to help build out its online consumer loans platform.
Although Goldman has access to capital, risk management, and access to key executives, we remain skeptical in Goldman’s ability to build a successful mainstream consumer brand, especially given its “reputational taint” amongst consumers.
Currently, both “build” and “buy” appear to be unattractive options for banks as a response to P2P lending as building platforms would carry significant risk as the sector evolves and M&A carries significant risk as current valuations are very high.
We believe that the most realistic path forward is the concept of “lending-as-a-service” where banks partner with platforms as investors or use them as an origination arm (e.g. partnership between J.P. Morgan and On Deck Capital).
This allows big banks to combine their access to a broad customer base with the cheaper operating model and proven underwriting algorithms of LC, creating the most overall value.
Discussion of Risk 3): Potential increased regulatory oversight from agencies such as the Consumer Financial Protection Bureau (CFPB) and Discussion concerning the Madden v. Midland Funding, LLC case
Additional oversight from the Consumer Financial Protection Bureau (CFPB)
Regulation is always a wildcard and additional oversight from various federal government agencies could present challenges in the form of increased regulatory costs (decreasing margins) or in worse cases, business interruptions.
Prosper shut down its operations for 9 months in 2008 to complete its registration process with the SEC
LC preemptively shut down its platform for 6 months, but due to its shorter downtime, it was able to outpace Prosper in the P2P consumer credit space
Nevertheless, regulatory burdens have historically served as a barrier to entry
The main concern right now is the regulation of P2P lenders by the CFPB increasing regulatory costs and eroding margins.
However, the incremental regulatory cost may not be as burdensome as one would expect.
P2P lenders are currently regulated by the SEC as their loans are classified as securities.
Originally, when the SEC issued the first cease-and-desist order to Prosper in 2008 to stop all operations and register under the SEC, P2P lenders formed a trade association, Coalition for New Credit Model, in hopes of easing regulations and influencing legislations.
Specifically, the trade association’s main goal was to have the government reclassify P2P lending as a consumer banking service rather than a securities offering. As a consumer banking service, loans can be sold to other parties, but as securities, P2P loans are subject to significant and costly regulation.
In 2011, the US Government Account Office (GAO) issued a report on what they saw as the two potential future approaches to the regulation of the P2P lending industry on the federal level:
1) An SEC-centered approach
2) A CFPB-centered approach
The SEC centered approach is the current state under which the P2P lending industry is regulated. A transition to the CFPB centered approach would translate most likely to a lower cost of regulation but may potentially lower the barriers to entry in the industry.
It is important to note that it is currently unclear if there is a possibility of dual oversight and regulation by both the SEC and CFPB.
Discussion of the Madden v. Midland Funding, LLC case
Facts of the case: In the case of Madden v. Midland Funding, LLC, Madden (plaintiff) alleged that the Midland Funding (defendant) had violated the Fair Debt Collection Practices Act (FDCPA) and New York’s usury laws by attempting to collect an interest rate of 27% when the limit is 25% in New York.
In May 2015, an appeals court reversed an earlier U.S. District Court decision on the grounds that non-national bank entities are not entitled to protection under the National Bank Act.
On Aug. 12, the Court of Appeals denied a rehearing of the case. The case could make its way to back to the lower District Court or end up at the Supreme Court.
LC currently uses an issuing bank (Utah-based Web Bank) framework, which involves loan issuance by a bank that is governed both by federal preemption and choice-of-state-law. If the recent Madden ruling would were applied nationwide, and the choice-of-state-law nullified, LC would be subject to each states’ individual interest rate limit and would have to implement a series of state licenses.
Management estimates that only ~12.5% of LC’s national originations would be exposed to this ruling, and has suggested that it could reprice the majority so that it could still offer those loans.
Should LC have to obtain a series of state licenses, we believe this would be less of a burden than expected. In fact, SoFi, a lender in the student loan market, originates loans on its platform under its own name, and in doing so, maintains consumer loan licenses in various states in order to keep compliant with various state usury laws.
LC’s Current Valuation:
LC is currently valued at 2.2x 2016E Consensus Sales of $714.82 mm and 12.2x 2016E Consensus EBITDA of $126.9 mm.
However, given LC’s commanding market share in the consumer credit space, a massive immediately-addressable TAM of ~$530 bn, of which LC has only penetrated ~3%, and the projected 35% YoY CAGR growth in loan originations, we believe the investment presents a very favorable risk/reward profile.
Operating Cases Discussion:
Given the vast whitespace in the consumer credit and SMB loan markets, we believe LC’s valuation will be determined by two factors: 1) how fast can it grow its top line by originating loan volumes and 2) how quickly LC can achieve steady state EBITDA margins. Given this, the operating drivers in the model mainly revolved around loan originations growth (and hence, growth of the top-line) and operating expense margins (EBITDA margin).
Management’s long term estimate of EBITDA margins is 40%+, an estimate we significantly pared down in our operating cases.
Our analysis is mainly centered on the Bear Case, where we assumed that (1) acquisition efficiency deteriorates due to competitive pressures, driving sales and marketing expense margin higher each year, (2) LC fails to extend beyond consumer credit and SMB lending, limiting its TAM, and (3) LC never achieves an EBITDA margin anywhere close to Management’s estimate of 40%+ and instead has an EBITDA margin of ~17%, mirroring that of other commoditized consumer product companies that mainly compete on marketing spend and lower prices.
Specifically, in this bearish scenario, loan origination growth only grows at a CAGR of 23.2% through 2020E and long-run EBITDA margins only reach ~17%. Furthermore, this case assumes P2P lending becomes a commoditized product and that companies in the space can only compete on marketing. As a result, LC is unable to benefit from any real economies of scale in regards to its marketing spend and sales and marketing expense margin actually increases as a percent of total net revenue.
Reflecting these assumptions, we arrive at an implied share price of $5.51 or 15.3% downside.
We know that the assumption regarding the sales and marketing expense margin is sufficiently bearish. LC has already been able to leverage economies of scale and reduce customer acquisition costs through greater marketing efficiency and higher conversion in the direct channels as its brand awareness continues to improve.
LC was able to reduce sales and marketing expense as a percentage of originations by 9bps in 3Q15.
In our Base and Bull cases, we assumed conservative reductions in expense margins (as would be expected of a platform marketplace company which can leverage economies of scale).
The Base Case assumes that loan origination grows at a CAGR of 36.2% over the next 5 years. The EBITDA margin is assumed to grow steadily and reach a long-term EBITDA margin of ~29%.
The Bull Case assumes that loan origination grows at a CAGR of 45.2% over the next 5 years. The EBITDA margin is assumed to grow quicker than expected due to higher loan volumes and reach a long term EBITDA margin of ~35%.
Current Share Price: $6.51
Base Case: Target Share Price of $12.61
Total Return: 93.7%
Bull Case: Target Share Price of $18.58
Total Return: 185.4%
Bear Case: Target Share Price of $5.51
Total Return: (15.3%)
Continuous better-than-expected revisions in regards to loan volumes originated
New announced partnerships with companies with balance sheets or BDCs could accelerate origination growth and provide a more permanent investor base
Continued successful results from LC’s entry into its patient financing and student loan spaces
Successful launch into new markets such as mortgages
Positive news from the ongoing Madden v. Midland Funding, LLC case reducing overhanging regulatory concerns
Successful results of managing defaults and NCOs in a volatile and rising interest rate environment, further validating the resiliency of LC’s model
Aforementioned macro, competition, and regulatory risks
Additional favorable information from Goldman Sachs and other established lenders in regards to their internally built online consumer credit platforms, hence validating the “build” option
Loosening of underwriting practices leading to less net returns to investors leading the business to become more cyclical
Diminishing marginal returns from entering new markets with incumbent lenders of size (e.g. On Deck Capital in the SMB space and SoFi in the student loan space)