LendingClub, the current leader in marketplace lending, has yet to face its toughest competition.
byTimothy Puls
Equity Analyst
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Analyst Note 06/17/2015
Investment Thesis 06/03/2015
The company’s future goals are to provide more traditional types of loans--from small business to mortgages, putting LendingClub in more direct competition with traditional banks. But the company cannot replicate the funding-cost advantage that banks possess--low-cost deposit funding to keep borrowing rates competitive. The company does tout more efficient operations relative to banks, but it must compete for investors to fund the loans it wishes to underwrite, which presents a material challenge, in our view. This hasn’t been a problem so far in the company’s history given the "quest for yield" among income investors, as returns on investment have averaged between 5% and 7% on LendingClub’s platform. While good for now, investors may soon be lured away when interest rates rise, preferring more modest returns in safer types of investments (LendingClub’s credit losses average 5%-8%). As this occurs, LendingClub will face pressures to provide higher yields to investors by raising borrowing rates, or by reducing servicing margins charged to private investors. Even with an efficient distribution model, the company will face competitive pressures on both sides of the lending equation, which could stall LendingClub’s pursuit to disrupt the lending industry.
Economic Moat 06/03/2015
Proponents of peer-to-peer and marketplace lenders argue that the companies possess a cost advantage versus banks in originating loans, which may be true, but LendingClub faces high customer acquisition costs that offset that benefit. Over the past three years, the company’s largest costs have been sales and marketing, which have eaten up 2% of the total value of originations in the past two years. Although these costs would naturally recede as consumers become more aware of the brand, a swath of competitors already participating in online lending and more to come will force the company continue to spend to attract borrowers. Further, since LendingClub provides only one product to borrowers, it doesn’t benefit from customer switching costs like banks that service clients in several ways. And we don’t think the company has developed a network effect that inherently attracts borrowers. For these reasons, LendingClub may be forced to continue spending heavily to attract and retain borrowers.
At this time, the uniqueness of LendingClub’s platform is primarily attributable to the branchless distribution model, which we believe is replicable, and the market environment surrounding unsecured consumer credit. The only proprietary aspect of LendingClub’s model is its underwriting algorithm, which is different from other underwriters only in the specific data points used. In addition, the company’s recent growth is largely a function of banks pulling away from unsecured consumer loans since the financial crisis, which left many consumers able to access credit only via high-yielding credit cards. LendingClub found a way to provide cheaper credit to these consumers; however, the company’s rates are still quite high, averaging 14% on newly originated loans in 2014. When this is coupled with an average origination fee of 4.5%, consumers with even decent credit may be able to find cheaper options elsewhere. Further, with improved balance sheets and recently mediocre returns, we believe that banks have the incentive to become more active in unsecured credit again, adding another element that could force LendingClub to reduce interest rates. Lower rates will limit interest in the platform from the perspective of loan investors, potentially leading to fewer originations, where LendingClub derives a majority of its revenues. As a result, we think LendingClub’s future is far from secure, as we think it will face stiff competition in attracting borrowers.
Valuation 06/03/2015
Risk 06/03/2015
Management 06/03/2015
Overview
Reports surfaced that Goldman Sachs will enter the online consumer lending business, adding a powerful bank to LendingClub's growing list of competitors. We expect several large banks to follow in the footsteps of Goldman, which will make life very difficult for LendingClub as it attempts to make the transition into loan categories beyond unsecured consumer credit. As a result, we're skeptical that LendingClub will be able to achieve the growth necessary to warrant the company's current valuation. At this time, we plan to maintain our no moat rating on the company and $12 fair value estimate. With that said, we consider a range of possible outcomes for LendingClub, and a bullish scenario could provide the stock with enough support to maintain its recent levels, in our view. With this in mind, we think investors should simply steer clear of the stock.
Goldman's entrance into the market offers some validation that online lending may have a place in financial intermediation; however, it supports our belief that banks will attempt to replicate the marketplace model in some form. We view the direct competition from banks as a major roadblock for LendingClub's ability to achieve the growth expected by the market. We consider LendingClub's business to be a no-moat business in part because it is replicable. Banks only need only develop an underwriting algorithm to assess credit, an infrastructure to service loans, and a process to attract customers. Most banks already have the tools to compete, in our view, as adapting years of underwriting expertise with the vast customer data that banks possess into an underwriting algorithm is no giant leap. While LendingClub may have a lower cost structure than traditional banks because of its lack of physical branches and smaller head count, we think this comparison is overly simplistic as banks offer far more services beyond loan origination, which increases customer switching costs.
Investment Thesis 06/03/2015
LendingClub employs a simple business model. The company underwrites loans but originates only loans that private investors have already agreed to purchase. As it doesn’t maintain ownership of the loans, the company derives nearly all of its revenues from origination and servicing fees. This implies that the company will succeed or fail based on the volume of loans that it can originate on its platform. Lending is a transactional business driven by low cost, and customer loyalty is minimal. For LendingClub, and any lender, low cost is represented by the interest rate offered to borrowers. LendingClub’s low interest rates offered for unsecured consumer loans relative to the likes of credit card companies partially explains the company’s rapid growth thus far, while limited supply for these types of loans has contributed as well. In our view, LendingClub is likely to face much stiffer competition going forward.
The company’s future goals are to provide more traditional types of loans--from small business to mortgages, putting LendingClub in more direct competition with traditional banks. But the company cannot replicate the funding-cost advantage that banks possess--low-cost deposit funding to keep borrowing rates competitive. The company does tout more efficient operations relative to banks, but it must compete for investors to fund the loans it wishes to underwrite, which presents a material challenge, in our view. This hasn’t been a problem so far in the company’s history given the "quest for yield" among income investors, as returns on investment have averaged between 5% and 7% on LendingClub’s platform. While good for now, investors may soon be lured away when interest rates rise, preferring more modest returns in safer types of investments (LendingClub’s credit losses average 5%-8%). As this occurs, LendingClub will face pressures to provide higher yields to investors by raising borrowing rates, or by reducing servicing margins charged to private investors. Even with an efficient distribution model, the company will face competitive pressures on both sides of the lending equation, which could stall LendingClub’s pursuit to disrupt the lending industry.
Economic Moat 06/03/2015
In our view, LendingClub does not possess an economic moat. Peer-to-peer and marketplace lending has been touted as a disruptive force to traditional bank lending; however, the industry is in its infancy and currently measures as a blip on the radar in providing financing to consumers and small businesses. Further, banks and credit card companies have yet to implement much of a competitive response to this new distribution model. Whatever the response, we would expect LendingClub’s business to be pressured by the incumbents of the financial world.
Proponents of peer-to-peer and marketplace lenders argue that the companies possess a cost advantage versus banks in originating loans, which may be true, but LendingClub faces high customer acquisition costs that offset that benefit. Over the past three years, the company’s largest costs have been sales and marketing, which have eaten up 2% of the total value of originations in the past two years. Although these costs would naturally recede as consumers become more aware of the brand, a swath of competitors already participating in online lending and more to come will force the company continue to spend to attract borrowers. Further, since LendingClub provides only one product to borrowers, it doesn’t benefit from customer switching costs like banks that service clients in several ways. And we don’t think the company has developed a network effect that inherently attracts borrowers. For these reasons, LendingClub may be forced to continue spending heavily to attract and retain borrowers.
At this time, the uniqueness of LendingClub’s platform is primarily attributable to the branchless distribution model, which we believe is replicable, and the market environment surrounding unsecured consumer credit. The only proprietary aspect of LendingClub’s model is its underwriting algorithm, which is different from other underwriters only in the specific data points used. In addition, the company’s recent growth is largely a function of banks pulling away from unsecured consumer loans since the financial crisis, which left many consumers able to access credit only via high-yielding credit cards. LendingClub found a way to provide cheaper credit to these consumers; however, the company’s rates are still quite high, averaging 14% on newly originated loans in 2014. When this is coupled with an average origination fee of 4.5%, consumers with even decent credit may be able to find cheaper options elsewhere. Further, with improved balance sheets and recently mediocre returns, we believe that banks have the incentive to become more active in unsecured credit again, adding another element that could force LendingClub to reduce interest rates. Lower rates will limit interest in the platform from the perspective of loan investors, potentially leading to fewer originations, where LendingClub derives a majority of its revenues. As a result, we think LendingClub’s future is far from secure, as we think it will face stiff competition in attracting borrowers.
Valuation 06/03/2015
As we initiate coverage on LendingClub, we are setting our fair value estimate for shares of the company at $12. The most important factors to our valuation of LendingClub involve the growth of loan originations, the average origination margin that the company receives on those loans, the servicing margin on its loan portfolio, and customer acquisition costs. We think the company will be able to originate over $7 billion of loans in 2015 and over $12 billion in 2016, which represents 75% and 60% origination growth for the two periods, respectively. Over a long-term view, we think origination volume growth will slow to a more sustainable level of 9%. We forecast the company’s margins on originations to begin to decline in 2015, falling gradually from 4.5% in 2014 to below 4.0% in 2016 and settling closer to 2.0% over a long-term view. The company’s servicing margin should actually increase, in our view, as the company extracts larger servicing fees on small business loans, which we expect to make up a larger portion of the overall loan portfolio in the future. As such, we model servicing margin to increase from 0.4% of average loans in 2014 to a long-run average near 0.6%. Like many young companies, LendingClub’s expenses have been greater than its revenues, representing an average of 110% of revenues over the past three years. Increased scale will drive significant operational leverage in the business, but we continue to believe that the company will have to spend significant capital to acquire customers in the near term. Our forecasts imply that expenses will continue to consume over 90% of revenue in the next two years and over 70% over a lengthened time of five years. In the long run, we think expenses will run at roughly half of revenues. Our estimates imply that the company will be generating roughly $1.5 billion of revenue by 2024 with profits of $570 million. Based on our discounted cash-flow approach, this scenario yields a $12 fair value estimate.
Risk 06/03/2015
The biggest risk to LendingClub’s business is increased competition. There are several established marketplace lenders, and likely more will enter the market. In addition, banks pose a competitive threat to the company’s ambitions of expanding into other loan types. LendingClub will be challenged to transition its business from the current niche of financing unsecured consumer credit loans into a more mainstream lending operation that can finance small business loans and collateralized loans, such as mortgages. This challenge may become more difficult should interest rates rise, making LendingClub’s loan-investor returns less attractive relative to other investments. This would force more aggressive competition for investor funds, pressuring LendingClub’s margins to lower levels.
Management 06/03/2015
We consider LendingClub’s management to be a Standard steward of capital. LendingClub is still in its very early stages as a company, and we would not expect every capital-allocation decision to be a profitable one as the business evolves and is refined. With that said, the company’s team of experienced industry professionals--John Mack, former boss of Morgan Stanley, and Larry Summers, former Treasury Secretary, are both on the board of directors--should keep the company on the right track. The only major acquisition made by the company, for Springstone Financial, is a good fit from a strategic standpoint to broaden the company’s loan offerings into educational and medical procedure financing, and the cost of the company was not excessive, in our view.
Overview
Profile:
Lending club operates the world’s largest online credit marketplace that facilitates loans to consumers and businesses, giving investors a direct opportunity to finance consumer and business loans. The company derives fees from loan originations (90% of revenues) and loan servicing (less than 10% of revenues, but growing). LendingClub has originated over $9 billion of loans in its history dating back to 2007, primarily unsecured consumer loans, and is beginning to offer small business loans through partnership distribution channels.
