OnDeck Capital's Hidden Margin Of Safety

| About: OnDeck Capital (ONDK)

Summary

This article explores how GAAP accounting is obscuring the earnings power of ONDK.

ONDK is optically profit-less, but has the potential to ramp up earnings substantially if it slows down its expansion.

While this is not what the company will or should do, it's a helpful illustration of another source of margin of safety in the stock.

This is ignoring the substantial opportunity ahead of the company and the value creation over the longer-term.

OnDeck Capital (NYSE: ONDK) is an interesting case study of how GAAP accounting does not properly present the true economics of a fast-growing company. A significant change for the company's accounting treatment in 2016 entails the company's plan to sell less loans through its Marketplace (its origination business) and instead hold more their own balance sheet. As credit market conditions deteriorated earlier in the year, ONDK made the decision to hold more loans on its own books. Its disciplined risk-management model did not allow for accepting reduced pricing in the capital markets. Of course, this means the company will book lower revenue for the year, as it recognizes the gain on sale through its origination model immediately whereas it recognizes interest income over the life of its loan. Because ONDK is growing rapidly, this distorts the picture, as all of its expenses are booked upfront. Moreover, the company is also making substantial technology and sales and marketing investments to grow its core and OnDeck as a Service offerings. GAAP does not allow you to capitalize this spending, as it is not considered typical 'CapEx.' This is definitely true from an accounting standpoint, but economically, these expenditures are closer to growth CapEx than they are to OpEx. Economically, they should be seen in a different light, and makes the company look more profitable under a 'normalized' situation. In this article, I will explore the normalized earnings power of the company, and show that it can easily become profitable if it chooses to reduce growth. While I don't believe this is in the right long-term interests of the company, I believe it is a source of margin of safety for the stock and an additional reason why it may be mispriced.

Normalized Economics

To present the normalized economics of the company, this article will present a model in which the company opts to hold its entire loans under management portfolio on its own books and earn interest income. In effect, it will become almost like a bank, which will mean it can substantially reduce its technology, marketing, and processing (which go towards the origination channel) spend. Remember, this is a low-to-no-growth scenario, so it simply assumes the company operates like a bank, cuts its massive growth-related expenditures, and maintains its relatively small (certainly in proportion to the overall TAM) book of business.

The revenue in the model is derived from an assumption that it maintains an Effective Interest Yield of 34%. For reference, its Q1 Effective Interest Yield stands at 34.5%. Its TTM Loans Under Management (LUM) is assumed to remain static at $982M. This results in the following gross revenue:

LUM

$982M

EIY

34%

Gross Revenue

$333.88M

Click to enlarge

This 'explosion' in Gross Revenue (relative to what the company did in 2015) comes from the fact that the company is using its own balance sheet to fund the loans. Under this model, it will be very difficult to grow at high rates, but it allows ONDK to capture most of the economics of its loans (compared to the gain-on-sale from its Origination model, in which the loan buyer gets to share in the returns). The gain-on-sale is recorded immediately, so in the short-term, it makes earnings look better. Over the longer-term, actually holding the loans is what allows ONDK to gain the full benefit of the loans. The company showed this in their Q1 2016 investor presentation. Seen below, in a hypothetical $100 loan with a 6% gain on sale, the company books $6 of revenue immediately and takes no provision expense (as it does not actually hold the loan).

Click to enlarge

Source: Q1 2016 Presentation

Compare that to a $100 loan with a 15% NIM. In such a loan, the company would make $15 over the course of the loan, but expense $6 immediately (see below). Because ONDK is growing so fast, this clouds the economic reality. By the time the company is ready to make $15 from the original loan, it will have originated new loans, incurred additional provision expenses, as well as engaged in other operational spending and technology investments. This is precisely why the company does not appear to be profitable currently. If it reduced these expenses and focused on simply maintaining its LUM, the picture would look substantially different.

Click to enlarge

Source: Q1 2016 Presentation

So, it's the point of this analysis to show what the company would like if it retained all of its loans on its own balance sheet, curtailed some of its spending, and managed itself for intermediate term profitability. Unlike the origination model, however, this will reduce the company's balance sheet flexibility. Also, the Origination model has the potential to scale more easily over the longer-term, and will ultimately be the higher margin revenue-stream (once it does reach scale). Again, this is just to show what the company could achieve in a normalized setting. It's meant to illustrate what a transition to a stable funding model would look like, and how the company could adopt this structure to become profitable very quickly.

Operating Build-Up

From Gross to Net Revenue, the model assumes a 7% charge-off rate. This is higher than the Q1 2016 rate of 5.8%. The company has commented that they would be able to cut OpEx by 30% if they were to sacrifice growth. In order to be conservative, let's assume they can cut G&A and Technology & Analytics spending by 10% of their 2015 figures. Processing spend is left unchanged from 2015. Sales and Marketing spend is decreased by $2M, which reflects non-cash charges. This is likely conservative given that the company could easily focus on repeat borrowers (many of whom are underserved by traditional lenders and reliant on ONDK) and reduce its salesforce significantly. This leads to $114M in Operating Income.

Gross Revenue

$ 333.88

Charge-Off

7.0%

Net Revenue

$ 265.14

Less:

Sales & Marketing

58.92

Processing

13.1

G&A

40.77

Tech & Analytics

38.34

Operating Income

$ 114.01

Click to enlarge

Assuming the company finances its loans 75% debt, 25% equity, and a blended funding cost of 6% implies roughly $44M in interest. Just to note, the company closed its latest securitization at 4.8%. At a 35% tax rate and 70.4M shares outstanding, this implies $0.64 in EPS on a $5.22 stock.

Operating Income

$ 114.01

Interest Expense

44.190

Net Income (35% tax rate)

$ 45.38

EPS

$ 0.64

Click to enlarge

For those worried about the company's ability to fund itself through difficult times see below. While securitization does slow down during moments of panic, it doesn't go away. ONDK's high-yielding paper and relatively small size in relation to the overall market should realistically remain well-funded throughout downturns. The company's ability to weather 2008-9 shows this. With that said, the stock remains only slightly above book value, with a massive runway for growth, and the potential to scale back and becoming profitable as needed. It's a growth stock with a value price, and I recommend buying at prices below book.

Click to enlarge

Disclosure: I am/we are long ONDK.

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.