Disclosure: I work at LendingRobot, a RIA specializing in the peer-to-peer lending industry.
Lending Club's Shareholder Meeting
- Q2 2016 originations are expected to be approximately $1.4 billion - a third lower than Q1 2016
- The company will be taking one-time write-offs of between $45-70 million
- 179 staff positions have been eliminated
- Revenue growth is expected to continue in 2017
Reading between the lines, the company is expecting to plunge into the red in Q2 2016 in the ballpark of $90-$120 million due to the reduction in revenue combined with several large one-time expenses. In addition, revenue growth is not expected to rebound to previous levels for the rest of 2016.
Does this report spell the death-knell for the company? Probably not. When evaluating a business's long term potential, it is easy to get caught up in the latest crisis and forget that a valuation of the business should include an examination of the core business model.
A look at Lending Club's Core Business
Lending Club was founded on the premise that banks are not optimal vehicles for issuing personal loans, and that the process of underwriting can be more efficient. Lending Club uses efficiency gains as a business advantage, and passes on the lower expense ratio in the form of lower rates for borrowers and higher returns for lenders.
With the business advantage of lower costs, it is important that the company find the appropriate risk premium to maintain an equilibrium between the supply of borrowers and supply of investors. If Lending Club charges too much, there will be no demand for loans and if too little is charged then investors will find investment opportunities elsewhere.
These two aspects represent the fundamental core of Lending Club's business, and ultimately form the base for how Lending Club should be valued as a company.
Lending Club's Cost Advantage
(source: compiled Lending Club 10Q Data)
Through the past 13 quarters, Lending Club has maintained its cost advantage and has even steadily widened its contribution margin. Although Lending Club still spends most of its revenue on sales and marketing expenses, so far they have avoided committing to heavy fixed costs. Theoretically having lower fixed costs provides Lending Club the flexibility to adapt to natural swings in loan availability. Q2 and Q3 2016's earnings report will therefore be quite interesting, as the company is anticipating the first decline in quarterly loan origination and revenue growth since the company's founding. This decline will prove to be a test of Lending Club's ability to adjust on-going expenses in response to a decline in revenue.
The second critical aspect of Lending Club's core business is the ability to maintain an equilibrium between the supply of borrowers and investors. Lending Club has often stated that they do not want to take on credit risk; the company would prefer to function as an intermediary between investors and borrowers.
Supply / Demand Management
It has been pointed out that Lending Club has been required to fund a larger percentage of loans originated on the platform in the past month. Lending Club reported in their shareholder meeting that they have purchased approximately $40 million of loans (representing approximately 2% of total originations) in May and June 2016. The company is hoping to sell these notes at a later date, and has also taken great steps in extricating themselves from credit risk, going so far as to offer $9 million in recent investor incentives.
A look at borrower/investor equilibrium shows how well Lending Club has managed to avoid funding loans themselves over time.
(source: compiled Lending Club Loan Data)
This chart shows the quantity of loans funded by investors as a percentage of all loans originating on the platform. In the early days of the company's history, Lending Club took on more credit risk as the company struggled to spark investor interest in borrower notes. Between January 2013 and April 2016, between 99.91% and 99.99% of all loans that have originated on the platform have been funded by investors.
This is quite a remarkable balancing act, especially considering loan origination volume grew nearly 9-fold in the same period. To accomplish this, Lending Club actively managed borrower marketing campaigns (consistently allocating approximately 39% of revenue on marketing) and borrower interest rates (adjusting rates over 50 times since the company was founded).
A Potential Conflict of Interest
It is not enough to just look at the borrower/investor equilibrium over time to see how well they are managing supply and demand. Entering into this equation is a potential conflict of interest, as Lending Club earns the majority of revenue from loan origination fees. Especially since Lending Club's IPO in 2014, this means that the company has a short term incentive to lower the threshold required to obtain a loan so that more loans are issued and revenue is increased. While this temptation exists, lowering this threshold would be detrimental in the long run, as a lower quality of underwriting would result in increased defaults and increase the risk premium demanded, which would upset the supply equilibrium.
Although critical to the long term success of the marketplace, detrimental changes to the underwriting may not be readily apparent to the outside observer since risky borrowers typically take a few months before they default. In addition, Lending Club has been growing at an exponential pace since inception in 2007. Since cumulative defaults increase as loans get older, this means analyzing charge-offs is not trivial.
However, drastic negative changes in underwriting can be detected by graphing the total number of defaulting loans against the volume of new loans issued and observing the difference in slopes.
(source: compiled Lending Club Loan Data)
The graph shows the slope of the normalized log issued and default loan counts. Holding the increase in default loan counts constant, we can see that growth of new loan counts is greater than the growth in default counts (with a slope of 0.0459). This suggests that the platform's underwriting policy has remained resilient to short term growth pressure.
It is important to note that Lending Club has popularized an asset class previously reserved for institutions and the rich. This asset class has provided returns for investors that are much more stable than equities and bonds, as seen on the historical performance chart at LendingRobot.com.
Despite the recent setbacks, Lending Club's core business of efficient underwriting has not changed. Lending Club has maintained consistent underwriting policies, used a variety of tools to actively manage borrower/investor equilibrium, and has had a history of lowering their expense ratio. Lending Club remains a viable company with a bright future.
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.
Additional disclosure: I work as an Investment Advisor Representative for LendingRobot, a technology-based niche RIA specializing in the peer-to-peer lending space.