Lending Club: Invest In The Notes, Not The Company

| About: LendingClub Corporation (LC)


Lending Club has a great model passing off the balance sheet risk of their loans to investors.

The model allows them to generate revenue on all loans originated.

However, revenue does not translate into profits and competition is fierce in the consumer lending market.

Let me start by saying that I truly admire the Lending Club (NYSE:LC) model. They changed how the game is played in the space of consumer lending by originating loans and then selling them as securities to investors. This provides for a win/win/win scenario between the company, investors and borrowers. What this does for LC is it transfers the balance sheet risk from themselves onto the investor who purchases the loans so they essentially get risk-free revenue. What it does for the investor is that it allows them to obtain a return that is most likely higher than their risk-adjusted returns in many other asset classes. With loans charging APRs in the 6% to 30% range, LC can charge an origination fee to the borrower and a servicing fee for managing the loan and the investor can still obtain a 5%-8% return on their investment after charge-offs which is a potentially higher return one can obtain from alternative investment assets. Also winning in this scenario is the borrower who is most likely getting a lower interest rate than they could get from traditional lenders like banks.

I believe LC is very similar to Visa (NYSE:V) and MasterCard (NYSE:MC) in the respect that they essentially charge a toll. V & MC charge a small fee each time one of their credit cards is used, but they do not take any risk that the credit card is not paid just like LC charges an origination fee and servicing fee, but they transfer the risk of the loan going bad onto the investor. This drastically limits the downside risk to their balance sheet. But the problem with LC is that they have yet to prove that their model produces any real net income in relation to their valuation. Over the trailing 12 months (ended June 30, 2016) LC has brought in net revenues of $509 million, but the problem is that they had negative $74 million of operating income during that period and a net loss of $72 million. Much of the net loss was due to potentially one-time items in the 2nd quarter such as Goodwill of $35.4 million, an increase in professional service fees of $14.9 million due to items previously disclosed by the board, approximately $14 million in incentives paid to investors and an increase in compensation related costs of $6.5 million associated with severance costs and a retention program. But even if you back out the $70.8 million, LC still lost about a million dollars over the last 12 months. So, the best case is that LC is essentially a break-even company with a market cap of around $2.34 billion (380 million shares at ~$6.15). They do also have ~$832 in cash as of 6/30/16 so their enterprise value is ~$1.5 billion.

So why would one buy stock in a company with a ~$1.5 billion enterprise value that doesn't make money when they could just buy a portfolio of properly diversified portfolio of Lending Club notes and earn around 5%-8%? It must be the future earning power of the corporation, correct? Investors must believe that LC will continue to take market share, originate more loans, earn more in origination fees and servicing fees and generally be more profitable in the future. There are a few problems I see with buying stock rather than buying the notes.

1. Competition - The business of making personal loans is extremely saturated. LC is not only competing with other peer to peer lenders like Prosper, but they are also competing with banks and other financial institutions. Many of these companies have also been in the space forever like Wells Fargo (NYSE:WFC), Discover (NYSE:DFS), Citibank (NYSE:C), Bank of America (NYSE:BAC), etc. While LC claims they have the "secret sauce" when it comes to originations, one could arguably ask what differentiates their originations from the traditional lenders since they all use the same traditional scoring metrics when originating loans.

2. Economic Downturn - What happens to LC notes if/when an economic downturn happens? Most likely charge-offs would increase and investor returns would be affected. Investors may stop using LC to invest and drastically slow the amount of originations.

3. Profits - This is the big one to me. LC has been around since 2006 and has yet to really be profitable. Their best year was 2013 where they earned $7.3 million. In 2014 they lost $33 million and in 2015 they lost $5 million. While 2016 is not over, given the poor 2nd quarter they had this year, 2016 will most likely be another money losing year (they are currently sitting at ~$80 million in losses for 2016).

My advice would be for investors to purchase notes off the Lending Club platform rather than stock of the company, at least until the company proves they can actually make money. I believe better returns can be achieved by buying a diversified set of their notes and potentially achieving their historical returns of 5% to 8% per annum versus the stock which is overvalued.

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.