LendingClub's Potential Is Massive

| About: LendingClub Corporation (LC)


LendingClub is the leading platform in an absolutely massive addressable market where size may bring advantages.

No balance sheet risk and healthy cash levels limit the downside,book value is likley just under $3.

The company has over-corrected for a serious but small offense, and this may be a big opportunity.

In keeping with my theme of "broken disruptors," (I recently covered Chipotle), another rare opportunity seems to have emerged in LendingClub Corporation (NYSE:LC).

LendingClub is the leading platform for peer-to-peer lending, which enables consumers to get unsecured consumer loans through the LendingClub website. Borrowers enter data into the platform, and based on LendingClub's proprietary algorithm, loans are offered, usually within 1-5 days. Similarly, consumers can invest in others' loans, and can select a diversified portfolio of securitized loans. Loans on LendingClub are graded like school grades are, A through G, and not only use traditional metrics like FICO scores but other data such as employment, salary, and current indebtedness, and claims that its algorithms are actually more accurate than traditional bank lending criteria, which LendingClub and other marketplace bulls claim are subject to human biases.

Moreover, LC's cost of originations is much lower than those of traditional banks, which need to invest in physical branches and employees to originate the loans. While still in the early innings, LendingClub's cost of originations is roughly 2%, while that of traditional banks are 5-7% (Macquarie Research Report, May 2016). Because of the low costs, LendingClub is able to offer high-quality borrowers (FICO 600-720+) rates on unsecured loans at are seven hundred basis points lower than credit card companies, and likely much lower than banks would offer as well. A majority of LendingClub's current borrower base (~69%) uses the loans for refinancing, mostly credit cards, while the other 30% of customers loans for other purposes, such as Home Improvement, Major Purchases, Medical (1%), Business loans (2%), and other purposes. The education and patient loans are a very small part of the current mix, and was enabled through the 2014 purchase of Springstone. In March 2014, LendingClub also began to finance unsecured small business ad offer lines of credit. The education, patient, and small business loans are only offered to private accredited investors and not available to other retail investors on the platform. Management has also indicated it would eventually go into other lending verticals such as mortgages.

Consumers with excess savings can invest in the loans of others through the platform in the form of notes available through the LendingClub platform. You and I can go on, select the criteria for loans in which we want to invest, and the LendingClub algorithm will match your investment to loans available on the platform. Notes are securitized versions of loans. You can invest in LC loans in increments as small as $25.

In addition to the Notes, accredited investors can invest in Certificates or Partnership Units of LendingClub-managed accounts. In this instance, LendingClub acts essentially as a fund manager for accredited investors, who often invest larger dollar amounts and in a more "hands-off" way than others on the platform.

Finally, the platform offers to sell entirely Whole Loans to institutions such as banks, who have the low cost of capital in the form of checking and savings accounts, and can benefit by using LendingClub to invest in loans outside their geographical footprint, and to earn interest on pools of consumer loans that may be too small on an individual basis for big banks to typically bother.

The value proposition is that borrowers can get lower rates than credit cards, and access to credit for which they might not have qualified while investors can achieve mid-high single digit returns, which is greater than the near-zero one gets from savings accounts and treasuries.


LendingClub was founded by Renaud Laplanche in 2006, and actually began as an app of Facebook, and stressed the social networking aspect of lending to others over the internet. The company received several rounds of venture funding since, and has become more its own platform, and now emphasizes the automation/algorithm/ big data aspects of the business. The current board includes high profile names such as John Mack, former CEO of Morgan Stanley, Larry Summers, Harvard Professor and Economist, who advised the Obama administration and many others at high levels of government, Mary Meeker, of Kleiner Perkins Caulfield &Byers, and other venture capital executives from LC's venture funders such as Daniel Ciporin, Jeff Crow, and Rebecca Lynn. John Mack invested a personal stake in the company, and Google invested in the platform as well.

LendingClub is the largest and most sophisticated of all of the P2PLending Platforms out there. In 2015, there were roughly 16 billion in loans that were originated and invested in through online platforms. LendingClub originated 8.4 billion in 2015, which was a ~100% increase over the prior year. That means LendingClub has well over 50% market share in this high-growth area. As the platform has grown, the company's investor base has become increasingly populated by banks and financial institutions (roughly 33%); however, individual retail investors are still the majority of investors.

LendingClub went public in late 2014 at a price of 15$/ share, though the stock quickly shot up to an all-time high of $27.90/share, on the promise of the disruptive prospects for the company and large total addressable market to reshape the 3.3 trillion dollar U.S. Consumer loan market; however, concerns about the business model, regulatory risk, uncertainty about performance through cycles, and uncertainty about maintaining a high growth rate in the face of a slowing U.S. economy in early 2016 caused the stock to fall to 8$/ share this past winter. LendingClub has raised its interest rates on its lower quality borrowers (graded C and D), as that segment had faced increased defaults in early 2016, but only on its lower grade loans, and a relatively small increase.

Adding to the downturn was the shocking scandal in May of this year which led to the resignation of the CEO: "In April 2016, a LendingClub employee reported to Laplanche that the dates on approximately $US 3 million in the firm's loans appeared to have been altered. LendingClub's internal auditor engaged an outside firm to investigate the report. This investigation found additional problems with loans, including that $US 22 million in loans which had been sold to the Jefferies investment bank did not in fact meet the bank's investment criteria. LendingClub bought these loans back from the bank and resold them." (Wikipedia, NY Times)

Adding to this was the fact that Laplanche did not disclose that he was invested in an investment fund that bought LendingClub loans, which LendingClub itself was considering purchasing (WSJ).

This led to the board declaring they no longer had confidence in Laplanche, and Laplanche resigned on May 6, 2016. The stock, plunged from $8 to under $4. Three other managers relating to the Jefferies loans were also fired. Some institutions paused their loan-buying program. LendingClub made it clear that it would have to step in and use its balance sheet to buy loans in the meantime, although the company expects to resell these loans once the institutional buyers start up again.

Separating the Good from the Bad

It is my thesis that LendingClub's current problems are relatively minor and fixable, and that the share price has overshot to the downside. Should LendingClub reinstate loan buyer confidence in the coming months and continue its leadership and transparency as the leading P2P platform, the upside is massive, and the downside I believe to be limited thanks to a healthy balance sheet. Because LendingClub has no debt and *typically* does not bear the credit risk of its borrowers, the company is thus asset-light, very well capitalized (the company has ~900M in cash and marketable securities and no debt, on a current 1.8B valuation), there is no near-term risk of insolvency. The company's book value, which is mostly excess cash is roughly 1B. If the entire P2P concept were outlawed tomorrow or people lost confidence in funding loans, I therefore below the downside is roughly book value, so maybe 40% downside from here ($3). On the other hand, the upside is incredible.

I will first delve in to the potential earnings power of the platform, then look at current and potential problems, and explain why I believe the problems are fixable, or not as dire as the stock price reflects.

Peer to Peer Lending Potential

Estimates for the peer-to-peer lending market by 2025 vary widely, yet all seems to point to significant growth. Foundation Capital, which is LendingClub's venture investor, believes the peer-to-peer market will be $1 trillion by 2025. A recent PWC paper on the included a "conservative estimate" (their words) at $150 billion by 2025, which would account for 10% of the $800 billion revolving consumer credit market (credit cards, etc.) and 5% of the $1.4 trillion non-revolving consumer credit market (home equity, car loans, small business loans). The International Securities Commission estimates that the market will be $70 billion in the U.S. by 2020. The US Consumer Debt Refinancing opportunity alone (or the "Core" business for LendingClub) is a $465 billion-dollar opportunity.

I also was able to track down an institutional buyer of LendingClub Loans. His quotations will be referred to throughout the rest of this writeup. When I asked about the total addressable market for these P2P platforms, the response was:

"I'm not sure $1 trillion is the number by 2025, but it will certainly be hundreds of billions of dollars, possibly half a trillion within the next 10 years. It is without a doubt the wave of the future. People want to be able to apply for a loan in their homes on their own time, they want an answer in seconds of days and I don't want to have to go into a branch to sign the loan documentation. online platforms allow all of the that."

While this is somewhat of a small sample, with all of these informed sources painting a bullish picture, combined with the current growth rates and innovation, I would say it very likely that this market will be huge.

LendingClub Competitive Advantages/Leading Position

LendingClub is currently the largest and most established platform, with over 50% market share of all peer-to-peer lending platforms. It is bigger than the next four platforms combined. The question is, does LendingClub, through its first-mover status and scale, generate any sort of competitive advantage through network effects, and if so, are those advantages still intact after the current troubles?

LendingClub believes that it does in fact have these advantages. The company proclaims that investors want to go where the most borrowers are so that they can diversify, and not be a disproportionate amount of any one marketplace's notes… Perhaps some institutions may like that kind of negotiating leverage, but it is perhaps more comfortable for big banks to go where everyone else is, so that all competitors share the same risks.

The real interesting advantage is the scale that can feed more data into the LendingClub algorithm. The more loans that are made, scored, and tracked, the better the algorithm will become. If this is true, and I believe there is some truth to it, LendingClub may very well become a dominant share of the market, perhaps even larger than it is now; however, there are a lot of unknowns, and while new competitors have sprung up, most are small and not yet public.

My aforementioned primary source, an advisor to an institutional buyer of LendingClub loans, seemed to indicated that LendingClub does in fact have these advantages, and that the scrutiny of being a public company is actually likely what aided in identifying the current controversy, and that this kind of transparency and SEC regulation is actually a benefit. The advisor said:

In regards to your question as to whether another online platform could replace LendingClub currently due to its recent issues, I am not sure about that. Currently we are not considering any alternative platforms to LendingClub. LendingClub is by far the most sophisticated and the largest platform of its kind on the market. Most importantly, they are one of the very few that Have gone public, and are therefore regulated by the SEC. As a regulated bank ourselves, we would not want to do business with a non-public private company in this market. There would be too much risk with that. We like the transparency that LendingClub affords due to it being public and it is my personal view that the recent issues are a result of that transparency and because they are public they will be forced to fix these internal control problems, which I believe to be modest, and will emerge stronger and with better controls once these issues are resolved, which is exactly what we would want to see happen.

In this regard, it is possible that LendingClub may become even more of a trusted destination due to having had gone through these growing pains. This is the same type of scenario that happened with Netflix in 2012, and what I believe is may happen with Chipotle.

Parsing the Controversy

After all, the loans that they were "doctored" have since been bought by LendingClub and since re-sold. It was only 22 million worth of loans, while the company originated 2.75 Billion in loans in Q1 alone! That is virtually nothing. An internal audit has verified that all of the other loans are kosher.

My guess is that with the stock price coming down and with the company being relatively newly public, there was great pressure to execute and show growth to justify the price. This led to some "skimming" around the edges of a borrowers' stated criteria, which management probably felt was so immaterial that it wouldn't matter. Instead, the problem was detected and disaster ensued. Still, a 50% drop in the stock on top of the 60% drop the stock had prior to the controversy seems to me overdone based on my valuation estimates below. IT was a stupid decision, but this kind of things happen when management sees a growth opportunity, and aggressiveness overwhelms prudence. One needs a healthy dose of both to be a successful entrepreneur, but, especially with a finance-related company, trust and integrity are even that more important. This is why institutional buyers of the loans have "paused" in the wake of the crisis, such as Jefferies and Goldman Sachs.

With some institutions pulling back, LendingClub is looking to reassure investors and to lure others back in to buy loans. While Jefferies and GS have pulled back, the company is currently in discussions with Citigroup, as well as hedge funds, to resume lending. In the near-term, LendingClub has begun funding and holding some loans. This should be temporary, and LendingClub has roughly 900 million in cash and marketable securities with which to do this, which should be more than enough to fund loans for a prolonged period.

The institutional advisor I talked to also had paused its buying program, but did indicated that he believes the program will start again by the end of this month.

This tells me that the problem was small, these managers were pretty stupid, but that the value proposition is still there for institutional buyers.

Loans Have Performed Well

Institutional buyers are likely to be there because the portfolios have historically performed well. My source indicates that their portfolios of highly-graded borrower loans have returned between 6 and 8 percent, including charge-offs. My source indicates that these returns are "better than our models anticipated."

LendingClub has very high customer satisfaction, and that fact that it has been able to grow its retail base of investors over 7 years seems to prove that the model works. It certainly works for borrowers, who consistently rate LendingClub with a Net Promoter Score in the high 70's, much higher than substitutes of Credit Unions, Community Banks, Regional Banks, Credit Cards, and National Banks.

But How Well Will It Perform in a Downturn?

One of the criticisms of LendingClub, especially after having to raise its rates on lower-end borrowers this year, was how these loans would perform in a downturn. LendingClub's 2008 vintage has returned on average 2.5%, which is not bad considering that vintage was originated right before the biggest downturn in this country since the 1930's. Vintages since on average have returned between 6-8%.

Moreover, my source has claimed that "We have modeled down credit cycles, noodling building in default rates similar to what occurred in the unsecured installment loan market during the 2008-2010 recession, and the portfolio still performs satisfactorily."

Again, this is a small sample, but think about this: The credit card has been around for a long time and has weathered downturns… Just because the industry has not gone through a full cycle while at this scale doesn't mean that it will suddenly implode when one happens.

Recent Bad News and Press

The credit markets tightened a lot in Q1 2016 after the fed raised rates, and there was a minor 22-basis point uptick in defaults. These defaults were concentrated in the lower-grade loans, according to LendingClub, and LendingClub has raised its rates for that tranche of borrowers.

In light of the current controversy, LendingClub has also raised rates slightly, an average of 55 basis points, across its loan pool, partly in an effort to get all of these consumer loans funded in the wake of the crisis.

While not terrific news, this is hardly an earth-shaking development, but rather seems to be a tweak to the existing model, which is an ongoing and organic process. No one can reasonably think that the LC algorithm will be exactly the same next year or five years from now, but various news reports seem to emphasize this as some kind of disaster.

In the wake of Laplanche's resignation, as well as that of 3 senior executives, Scott Sanborn, the Chief Marketing Executive, was promoted to CEO. On June 7th, the company abruptly canceled the annual meeting of shareholders and postponed it until June 28th. While certainly not confidence-inducing, it seems plausible that since the founder and CEO resigned only on May 6th and several large investors paused their purchasing of loans recently, that the company may need some extra time to pull things together and give a clearer picture of the state of the business to investors. The annual stockholders' meeting is to be held on June 28th. While not necessarily a catalyst, any positive surprise could lead to a big move up in the stock, while any lackluster announcement or lack of things "getting back to normal" may have the opposite effect.


With a growth stock like this with many uncertainties, valuation is somewhat difficult but not impossible. I always strive to get to an intrinsic valuations, as the relatively new industry and unique company positioning in it make comps difficult. Sell-siders usually value the company based on future projections of EBITDA, as the company is near breakeven.

I put various inputs into a 10 year 3-stage growth DCF. Since many market studies seem to put numbers out to 2025, this fits in quite well.

In my DCF, I put in a 30% revenue growth rate for 5 years, decelerating to a 1.75% terminal growth in 2025 (the 10-year T-note, roughly). At this rate, LendingClub would be making about 3.4 Billion in revenue in 2025. This equates to roughly $ 60 Billion in loan originations. When compared to the "conservative" PWC estimate of 150 Billion, this is roughly 40% market share, which, since LendingClub is over 50% of the market now, may also be conservative, but I think reasonable.

I once again capitalized R&D and operating leases, and amortized the R&D asset over 5 years. On that basis, LendingClub would be profitable (LendingClub made about 70 million in operating cash flow in 2015). I have margins expanding to about 40% in 2025 (while capitalizing R&D and leases). On a GAAP basis this would lead to operating margins in the mid-30's, which is high but around where enterprise software with dominant, sticky products, such as Oracle, reside. I used a sales to capital ratio of 1.1, which is around what the company currently achieves when you take out most of the cash from the balance sheet. Typical internet companies have around a 1.3 sales to capital ratio, so this may prove conservative.

I used a fairly high discount rate of roughly 10.5% (1.5 beta on a 6% risk premium to the 10-year, slightly reduced by capitalized leases), which, when you have a risk-free rate and a debt free, cash-rich balance sheet, seems pretty conservative, but this is a new industry with many unknowns.

I also modeled in a 10% chance of the firm failing, and shareholders getting 75% of the current book value (which is mostly cash) in that scenario.

These assumptions spits out roughly a $10.30/ share stock price, or more than double from current levels.

Bear Case: At the current price levels, the assumptions for revenue would have to go down to 20% for the last five years (remember the company has grown ~90% y/y in the most recent quarter) and for margins to expand to only 25%, while the Sales-to-Capital ratio would drop to 1. These are pretty low estimates and points to the fact that the market is pricing in the current problems or model really struggling to achieve its potential, (1.9 billion in 10 years) and having margins be far lower than other platform/ software companies, and that achieving this will take more capital investment intensity than even current levels.

As for the bull case, really, the sky is the limit. A 50% growth rate CAGR for the next five years, decelerating to maturity in year ten, would leave 2025 revenues at just under $10 billion dollars, which equates to 200 billion of loans originated. While a big number, this equates to roughly 20% of the trillion-dollar estimate thrown out there by Foundation Capital.

With 40% operating margins and a sales to capital of 1.3 (roughly what other internet companies do), the value is $26.94.

Thus, the market seems to be pricing in the risk of the entire model just going away, or only being able to achieve a fraction of its potential.

If you believe that this is a possibility, then stay on the sidelines.

If, however, one believes that this is a hiccup, and that LendingClub's issues are temporary, there is substantial upside.

And, what is the downside? The book value of the company is about 1 billion, and most of it is in cash. If things fall apart, what is the downside? 3$/share? $2.50? The risk-reward seems asymmetric.


LendingClub has the possibility of coming out of this crisis a better company, and it has the early lead in a massive potential market where size may be a competitive advantage through powerful network effects. Given that the book value of the company, which is mostly cash and marketable securities is more than 50% of the current value, while the upside is multiples of the current price, I would advocate taking a position at these historically low levels.


  • More headline risk regarding clerical snafus at the company could undermine confidence.
  • Investor Pullback: This could happen for a prolonged period, and could cause the further erosion of confidence in growth. Still I believe the value proposition for investors is there, the value proposition for borrowers is definitely there, can the company has the balance sheet to buy up loans for the foreseeable futures. However, if months go by without institutions stepping back in to some degree, I would pause.
  • Down credit cycle: This doesn't even necessarily mean that the portfolios will perform badly or worse than alternatives such as high-yield or stocks, but is more about uncertainty.
  • Competition Taking Share - This is possible, but LendingClub has such a big lead, and my primary research with the institutional investor gives me confidence in LendingClub's competitive position, despite the headlines.

Disclosure: I am/we are long LC.

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