The online lending industry has been red hot this bull market in terms of origination growth. Companies started coming public in 2015. The big names are Lending Club (LC) and OnDeck (ONDK). However, the post-IPO performance has been train wreck for a number of one-off reasons, pushing the valuations for these two online lending pioneers to mind-boggling lows. Now is the time for savy value investors to come in and swoop up these “next-gen” business models that will be paving the way forward in the industry for decades to come. We expect shares of ONDK to double to $10+ equal to a reasonable 3x current book value. LC’s revenue is set to double to over $1 billion by 2020, which we expect to also cause the share price to double to $12+ equal to only 2.5x revenue.
Online Lending Industry Overview
Lending Club and OnDeck Capital debuted their IPOs in 2015 presenting growth investors with an attractive opportunity in online lending. One company is a pioneering marketplace lender serving consumers, while the other is a balance sheet lender transforming into a licensing technology serving small businesses. These two companies (and others) got their start during “perfect storm” conditions for entrepreneurs targeting financial services. Now, public and private market investors increasingly have their choice of lending businesses that are rapidly disrupting the vast credit landscape. Combine these ingredients – a favorable backdrop and a large addressable market – and you get a long runway of opportunity ahead as users increasingly turn to alternative channels in both consumer and commercial lending. The lending market is undergoing one of the most significant transformations in its history.
Here are eight key themes to focus on:
• The consumer lending landscape continues to expand, with more product offerings and broader participation from prime and near-prime consumers.
• It is not just about the consumer segment anymore, as online small business lending takes its place on center stage. • Social signals and other unstructured data sets are transforming conventional credit analytics for both balance sheet lenders and marketplace platforms.
• Institutional investors are now the dominant source of lending capital, replacing the “peer” in marketplace models and de-risking on-balance sheet models.
• The fluid and evolving regulatory environment remains an ever-present backdrop for investing in the lending sector.
• Three dominant business models are emerging – marketplace and balance sheet lending; both are viable and compelling, but there is also the opportunity to license technology.
• Public market investors now have a choice to make in terms of allocating their capital to “next-gen” online lenders versus “old guard” incumbents.
• Capital flows in the private markets have been brisk, with pre-IPO lenders garnering the attention of well-heeled, cross-over investors.
We see the ingredients of a “perfect storm”. The financial crisis and the Great Recession prompted contractions in both consumer and business credit, leaving scores of individuals and small businesses with no place to turn for loans. At the same time, the ensuing and prolonged low interest rate environment has fixed income investors clamoring for new opportunities to generate returns. In tandem with these structural changes, the rise of social signals and advances in technology have led to incremental, non-traditional signals that the next generation of financial services companies can use to better evaluate lending decisions.
Is $12 trillion large enough? The credit markets are substantial, and the current crop of next-generation online lenders is just beginning to scratch the surface. We believe there is significant opportunity for multiple lenders across several verticals to deliver continued strong growth for the foreseeable future.
Consumer lending has gone mainstream. Online-based lending has moved well beyond the subprime consumer segment and high APR, short-duration loans. New players, such as Lending Club, are addressing prime and near-prime customers with more reasonably priced, longer-dated installment loans.
Small business lending takes its place on center stage. The SBA is a resource for small companies seeking credit, but not for the owners of “mom and pop”, asset-light businesses. OnDeck estimates there are ~28 million businesses in the U.S. that do not qualify for an SBA loan and have been abandoned by community banks and credit unions (e.g., the local pizza shop or dry cleaner).
Lending Club – 2Q 2017 Earnings Recap
After what can best and only be described as a rough run for the last year or so for the team at Lending Club, things appear to have picked up some as of the marketplace lender’s latest quarterly earnings report. The firm logged the second-highest quarterly revenue in its history, a situation that had the firm’s long-concerned investors sending the stock up 8% in after hours trading. Lending Club reported a net loss of $25.5 million, or -$0.06 per share, compared with a loss of $81.4 million, or -$0.21 per share, a year earlier.
By the numbers, the performance was also in line with what investors wanted to see — revenue was up 35% to $139.6 million during Q2, a solid beat on the analysts’ consensus estimate of $136.4 million. Originations returned to growth in the second quarter, up 10% to $2.15 billion. Meanwhile, operating expenses fell by 12.5% to $165.1 million in the quarter. Revenue for the year — on the strength of that big performance — got an upward revision to the range of $585 million to $600 million, a reasonable pick-up on the previous forecast of $575 million to $595 million.
Chief Executive Scott Sanborn said on the conference call that the company was “back on its front foot.” Lending Club has spent much of the time since May 2016 on its back foot following an internal investigation that revealed a series of concerning issues about how loans were handled and packaged for investors. The firm was forced to acknowledge it had altered documentation when selling $22 million in loans to investment bank Jefferies Group to make the quality of the loans within the package seem higher than they were. The loans were later repurchased by Lending Club. The loan malpractices led to the ouster of then-Chief Executive and founder Renaud Laplanche. It also led to mass desertions of investors from the platform — which, in turn, caused originations to crater. Under Sanborn’s leadership since June of last year, Lending Club has been working double time to win back the trust of investors, bank lenders and other partners who had taken a step back from doing business with the company. We are now seeing great progress in the right direction!
OnDeck Capital – 2Q 2017 Earnings Recap
OnDeck reported 2Q Adjusted EPS of $0.02, which excluded a $3.2 million severance charge and represented the first positive figure since its IPO. Nice! Huge!!
The company made significant strides toward achieving the aggressive cost reduction plan first outlined on the 4Q16 call and raised further on the 1Q17 call. Credit displayed signs of stabilization as late-stage delinquencies rolled into charge-offs, and reserves on newer originations reflected tighter underwriting. The company anticipates accelerating volumes off the 2Q trough and is still guiding to a reduction in quarterly operating expenses to ~$40 million in 2H’17, leading to modest year-end GAAP profitability. Great!
The implementation of cost rationalization appears on track. Consistent with management’s stated objective to reduce operating expenses to a $40 million per quarter run rate by the end of the year, total operating expense of $44.6 million in the quarter marked a 6.3% Y/Y decrease, lowering the total efficiency ratio to 51.4% vs. 55% in 2Q16. Excluding the related $3.2 million severance charge incurred during the quarter, the Y/Y reduction of 13% brings the company within striking distance of the targeted $40 million quarter run rate. We note, however, that while sales & marketing expenses have remained muted in recent quarters given the pullback in growth initiatives, incremental expenses could conceivably trend upward again if the origination growth trajectory picks up in early 2018 as expected.
Credit appears to be stabilizing, which is fantastic. While the 18.5% headline NCO% translates to the sixth sequential quarterly increase, we note that the downward pressure exerted by a shrinking portfolio has been pronounced, particularly when considering the ~40-45% (excl. rollovers) historical quarterly paydown rate. Further, the strategic pullback in longer-maturity (15 months), higher balance (up to $500K) term loans by management since 3Q16 has more than likely compounded the reverse denominator effect, which, in our view, will run its course in the next 2-3 quarters, consistent with the downward trending weighted average term of new originations since the pullback.
Growth in originations is expected to return to double-digit Y/Y growth in 2018. Commentary regarding origination and UPB growth amounted to the most meaningful incremental outlook, in our view. Specifically, instead of an expected lower UPB balance at the end of this year, management has now guided to a sequential increase in the UPB balance for Q4, which we believe is yet another sign (assuming the absence of a material increase in origination volumes) that the implementation of more stringent underwriting since 2H16 and recent vintage performance is providing support to portfolio attrition in the form of lower charge-offs.
Lending Club Consensus Estimates
OnDeck Consensus Estimates
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