Lending Club: Can It Live Up To Its Potential?

| About: LendingClub Corporation (LC)

Summary

Lending Club performs a great service for both its borrowers and its lenders. That deserves to survive and flourish.

Valuation and growth necessitated by the cost and revenue structure are problematic.

By my simple computations, the stock is still over-valued, but i have hopes that, with time, management will be able to justify something close to the current market cap.

Lending Club (NYSE:LC) is a very good company that performs a valuable service in the marketplace. Despite the bad publicity caused by the firing of chief executive Renaud Laplanche for misleading the board of directors and fudging investor requirements, Lending Club is one of the best lenders to come along-ever. Indeed, one can argue that the firing of Laplanche should bring kudos to the company rather than opprobrium. The board of directors took fairly prompt action to rid the company of those responsible for violating its business principles.

As I see Lending Club, it is an exemplary lender and investment platform because it offers simple and consistent products, collecting agency fees that are far lower than the costs of brick and mortar banks. Lending Club thereby enables ordinary people to reduce their borrowing costs and maybe even get out of debt. The cost structure also allows individual investors to earn risk-adjusted returns that are greater than the marketplace offers almost anywhere else. Indeed, the cost structure allows small banks to earn a cost-adjusted spread that is greater than they can make on their own. All those things are benefits to the economy as whole.

Here is a snapshot of Lending Club loans, taken from the Lending Club website:

Click to enlarge

As an investor in notes, I can readily understand the terms of the notes and the basic facts about the borrowers. Many times I would wish for more detail about the borrowers, but I gather that there are regulatory issues that get in the way.

Nevertheless, a number of institutions have suspended buying notes and I would not be surprised if many individual investors will do the same until the hubbub dies down. For those of us who are still in the market to buy notes, I see this as an opportunity because the relative dearth of buyers likely will cause the rates on the notes to go up a bit.

In my article on Lending Club published on May 10, I was critical of its fast growth and fast run-up of expenses. The fast growth now is, of course, coming to an end, at least temporarily. Whether new management will seek to adhere to a fast growth policy, I do not know. But I think they are likely to emphasize the company's real strong suits: Simple products, adherence to good business principles, and an efficient idea that permits intermediation between borrowers and lenders that is more cost-effective than traditional banking mechanisms are for the similar borrowers and lenders.

Becoming a public company probably was a mistake. Every online company wants to be a unicorn, but not every business idea is unicorn-sized. An idea can be a very good one and a very profitable one but one that is more suited to gradual success. The back end for investors may be farther away, but that is just the nature of some things. The founders get less rich, but consistent profitability can pay regular dividends, if anybody cares about that.

At some price, Lending Club stock will be in that category. From what I read among the analysts, the value of Lending Club may be around $1 billion. That used to be money. But I wonder if that is not a high valuation if we look at the current business. (At a market price of about $3.60 today, the market cap is about $1.4 billion.)

What income level would justify a billion dollar valuation and how far from that income level is Lending Club?

I assume that if you are in slowish growth but reliable business, then you need to make 10% on your market cap at a minimum, which on a billion dollars would be $100 million per year, after tax. Lending Club was not anywhere near that in Q1 2016. It earned $4 million (or $16 million annualized).

The business model is heavily dependent on origination fee revenues. With $8 billion of loans outstanding (see chart above), the approximately 1% servicing fees bring in only about $80 million a year ($20 million a quarter-it was $16 million in Q1 2016). Revenue from origination fees in Q1 2016 was $125 million on originations of $2,750 million, per the May 9, 2016 8-K (or about 4.5%), but even so, expenses (about $150 million in Q1, therefore about $600 million annualized) ate up most of the revenue. Data come from the May 9, 2016 8-K, which is excerpted below. Here is an excerpt from the most recent 10-K that describes Lending Club's revenue streams:

"Generally, the transaction fees we receive from issuing banks in connection with our marketplace's role in facilitating loan originations range from 1% to 7% of the initial principal amount of the loan as of December 31, 2015. In addition, for education and patient finance loans, transaction fees may exceed 7% as they include fees earned from issuing banks and service providers. Servicing fees paid to us vary based on investment channel. Note investors generally pay us a servicing fee equal to 1% of payment amounts received from the borrower; whole loan purchasers pay a monthly servicing fee up to 1.3% per annum on the month-end principal balance of loans serviced and certificate holders generally pay a monthly management fee up to 1.5% per annum of the month-end balance of assets under management."

Given the revenue sources and current expenses, in order to make the hypothetically required 10% (say 13% pre-tax), originations have to increase to about $3,500 million per quarter from the current $2,750 million and be consistent or on an upslope, without incurring additional expenses. Not incurring additional expenses may not be realistic-and it may not be realistic to expect that a 10% after tax return would be acceptable-but this sort of back-of-the-envelope computation suggests that Lending Club may not be very far away from being able to justify a $1 billion valuation-if it can recover its funding customers. But there are a lot of "ifs". Therefore I still see the current market valuation as quite a bit higher than I would want in order to invest.

For more complete income statement details, see the following excerpt from the Lending Club May 9, 2016 8-K.

Click to enlarge

I really like this company a lot. I hope management can figure out how to reduce expenses so that they do not have to rely so heavily on constantly needing originate such a large volume of loans.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.