Description

Lending Club just went public; over seven years the business spent $100mm+ to create the world’s largest and most successful peer to peer lending operation. The company is based in San Francisco and has 742 employees. From inception to date they have facilitated approximately $6.2bn of consumer loans. Here is a link to the IPO prospectus:

S-1/A: http://www.sec.gov/Archives/edgar/data/1409970/000119312514435442/d766811ds1a.htm

The Business

A person with $1,000 can visit the Lending Club web site, lend ten other persons $100 each, and then receive interest and principal in one central account. Last year the company turned a profit, and sales in the third quarter of 2014 more than doubled when compared to the prior year period ($56.1mm 3Q14A v $27.4mm 3Q13A). Lending Club realizes a gross profit margin of about 5% of each loan originated. They have a third party bank originate loans that have been pre-sold to the site’s membership. The bank receives a fee in return and the company bears neither credit risk nor interest rate risk. To realize $56.1mm of sales in 3Q14A they actually originated $1,165mm of loans (vs $567mm originated in 1Q13A). For a sense of scale, US consumers have roughly $870bn of revolving credit card balances today and $1.1 trillion of student loans. The addition of mortgage and home finance would expand the domestic market to $13 trillion. The company just launched a foray into the small business market which is roughly $300bn in size. The main idea is that the company has a lot of runway for growth.

At this point, I would gently suggest that the reader visit lendingclub.com and then come back after a few minutes of perusing the site.

Ok, welcome back.

Lending Club enjoys a lower operating costs than a bank because the company automatically underwrites and services loans, and does not maintain a branch network. So, the interest rates offered to borrowers through their platform are generally better, on average, than the rates those borrowers would pay on a credit card or other unsecured installment loan. The average loan is roughly $14,000 and carries a 14% interest rate. Rates range from 6%-23% depending on the borrower’s credit. Loans are capped at $35,000 and borrowers must have a 660 FICO score, three years of credit history and a debt/income ratio below 35% (excluding mortgage). In practice, the average borrower has a 7 year credit history, $72k of income, and a 700 FICO score. Once qualified, a prospective borrower explains in writing their intended use of funds (fix truck, new boiler, credit card refinance), and that explanation appears along with job title, geography and other anonymized detail for perusal by other members. 80% of loan applicants undergo an income verification process. According to the company, nine out of ten Lending Club loan applicants are actually declined. The company’s rapid volume growth, combined with underwriting discipline, makes their profitable expansion all the more impressive.

John Mack, former head of Morgan Stanley (and Credit Suisse) joined the board. We spoke with him as part of our diligence and he shared the following insights: a person who seeks a small loan typically prefers to avoid the potential embarrassment of being declined by a bank officer and instead feels better about an otherwise anonymous online application. In addition, a bank spends the same amount to originate a small personal loan as it would spend on a $1mm personal loan. So, banks do not want to originate small loans (they prefer to issue credit cards). No surprise that many borrowers on Lending Club are indeed refinancing credit cards. (Larry Summers is on the board too).

Credit Quality

See p.50-63 of the latest 10-Q for a graph of historical charge off rates broken out by vintage and loan grade.

10-Q: http://www.sec.gov/Archives/edgar/data/1409970/000119312514397209/d794350d10q.htm

Lending Club originates each loan with a rank (A-G) and the lower the rank the higher the interest rate. Loans are either three years or five years in term. The charts speak to the predictability of the credit pools and the quality of their credit decision algorithms. A longer track record means investors/lending members require less premium – and that in turn attracts more high quality borrowers over time. The data go back to 2008, so thankfully we can get some sense of default rates through a major recession.

Lending Club contacts past due borrowers in the case of late payment – but does not take the in-house activity too far. After 90 days delinquent a troubled loan is referred to a collection agency and then any proceeds (less the third party collection agent’s fee) are paid directly to the lenders.

Margins

The company describes two long run performance targets in terms of Contribution Margin and EBITDA Margin, respectively.

1. Contribution Margin

Contribution margin has historically ranged from 37%-47% with a seasonal bottom in 1Q and a peak in 4Q.

Contribution Margin expense consists of Sales & Marketing and Origination & Servicing. Sales & Marketing consists of ad spending, channel testing and new product launches. The company says that this overall expense has trended down as a % of sales over the past two years, and that ad spending in general is managed with the seasonality of the business in mind.

Contribution margin in 3Q14A was 48% and the long term target provided by management is 50%. The fact that management has given guidance at the Contribution Margin level, and that we are relatively close to the long term target, illustrates that they are taking a disciplined approach to profitable growth and the related ad spend. Variability in the overall Contribution Margin is generally driven by Sales & Marketing spend.

The second part of Contribution Margin is Origination & Servicing. Origination and Servicing consists of bank fees, credit agency fees and direct staff payroll. Origination & Servicing has been relatively flat as a % of sales over the past two years because declining costs in mature areas have been offset by higher costs in new areas.

2. EBITDA Margin

EBITDA margin for the 9ME3Q14A was 9.3% and the long range target provided by the company is 40%, so that’s thirty percentage points of margin expansion opportunity if they are right. Note that the factors included in Contribution Margin are also included in EBITDA margin.

Engineering and Product Development accounts for 11-12% of sales and include salaries, non-capitalized software and depreciation of capitalized technology assets.

Other G&A accounts for 18-23% of sales and includes legal, finance, accounting/audit and HR. They have been overinvesting in these areas to take the operational risk out of their steep growth rate.

So, if we put the 50% long term Contribution Margin target together with the long term 40% EBITDA target, that tells us that while Engineering and Product Development + Other G&A account for 29%-35% of sales today, as the business scales they will combine to account for no more than 10% of sales in the long run. Check the P&L, there are only a few line items (scroll to top to see link to S-1/A).

Conclusion

I’m bullish on Lending Club and believe that over time the company has the opportunity to dominate the peer to peer lending space (via M&A of emerging players as well as organic growth). It’s difficult if not impossible to get my value investing brain around the idea that a big multiple of TEV/sales makes sense. So, I’m not going to bother (and neither should you). Maybe one day animal spirits will be suppressed and you’ll get it on the cheap – I’ll be there buying too (we invested while the company was private). But, in the meantime, this is the story and this is how the business works - period. If you are not willing to pay up, then join the Lending Club site as a member and go make some loans at 15%! Either way you will leave this write up with an immediately actionable idea, depending on the kind of risk you prefer.

Catalyst

The company just went public so we're likely to see a flurry of sell side initiations in 1Q15