Introduction: The Product
LendingClub (NYSE:LC) has successfully built a strong narrative as a "Fintech" company that matches everyday borrowers to investors, peer-to-peer, circumventing the traditional credit institutions and offering a cheaper product through the magic of technology. Lending Club's core product, the investment notes they sell to investors on behalf of borrows, has a few key flaws. The first issue worth mentioning is that all of the loans facilitated by LendingClub are unsecured loans, not backed by any collateral. This is traditionally the type of loan with the highest default rate and lowest recovery rate. Because these notes are backed by no collateral, the borrower is not as incentivized to pay and the lender's losses are not mitigated in the event of default. To believe that LendingClub has cracked the code with their algorithm making these types of loans less risky is extremely naive.
Another disadvantage is that LendingClub's notes are almost entirely illiquid:
"The Notes are generally not transferable except through the Note Trading Platform operated by FOLIOfn, an unaffiliated registered broker-dealer."
These three main risks (high risk of default, low recovery rate, and illiquidity), are all masked by the current low interest rate environment. Not only do sub 3% ten-year Treasury yields give these type of loans historically low charge-off rates, they also boost demand for risky products, like LendingClub's Notes, which offer far higher yields and income than a retail investor can get investing in a bond fund or CD. As the economy fluctuates over time it will expose the risks of LendingClub's product and weaken their proposition relative to other investment options.
Low Interest Rates Drive down Credit Card Defaults
Part 2: The Business Model
The investment thesis surrounding LendingClub is that it is an innovative new business model, which has a cost advantage and is the logical alternative to traditional credit and bank loans. Peer-to-peer sounds new age, however, the business model is not drastically different than what many companies in the financial services industry are already doing. For example, many payday lenders use the exact same "peer-to-peer" system. They supply unsecured loans and match them up with third party investors taking a fee for being an intermediary (they also lend online). Here is how EzPawn, one of the biggest payday lenders in the US, describes their business in Texas:
"We do not offer loan products, but rather offer credit services to help customers obtain loans from independent third-party lenders."
This is LendingClub's business model in a nutshell -- an intermediary for high rate unsecured loans. The major difference being they seek out borrowers in a range of credit classes and allow a larger pool of lenders to be their "third-party." These similarities show Lending Club is not the transformative and disruptive business to the banking industry as some paint it to be.
In other ways, LendingClub resembles a securitization operation run by shadow banking intermediaries and could potentially move even further in this direction as they grow. LendingClub's premium "portfolio tool" is securitization on a small scale. The portfolio tool takes a number of different loans ("notes" as LendingClub calls them) with similar characteristics and yields and groups them together to hedge against defaults and pre-payment risk. This sounds a lot like CDOs and MBSs: chopping a number of loans into a portfolio and selling it as a singular product. If we can accept that LendingClub's model is not disruptive and more like that of a market maker (selling loans or packages of loans to small dollar investors), than the business can be more reasonably valued. As an intermediary, fee-based, market maker LendingClub's key to success will be in scaling the business significantly and levering up the low marginal cost of providing an online market place for investors and originating loans.
Part 3: The Future
Using the financial intermediary industry as our compass, let's take a look at the numbers and what LendingClub has to achieve in order to deserve their $9+ billion valuation. LendingClub has increased their loan origination volume from a mere $51 million in 2009 to $2 billion in 2013, a nearly 40 fold increase. Lending Club converted this $2 billion in transactions into $97.98 million in revenues, a 4.75% "revenue yield." Valuing LendingClub like a trading operation and assuming they can scale quickly and effortlessly (which is a big assumption), their net margin on these revenues should be around 10-15% (their current net margin is 7.45%).
Reverse engineering LendingClub's $9 billion dollar (and climbing), valuation we can see just how far they have to go. Some simple calculations show that LendingClub needs to facilitate $88 billion in loan originations to become a $4.2 billion revenue company and earn $630 million in profit. Not coincidentally, CIT Group, the largest US bank with a market cap lower than LendingClub, (22nd most valuable bank), earned $676 million last fiscal year. Investors in LendingClub, at the $9 billion dollar valuation, are essentially saying LendingClub, with under $100 million in revenue and $2 billion in loan volume can become as big and as profitable as the twenty most valuable banks in the US who command hundreds of billions in revenue and hold trillions in tangible assets.
Reverse Engineering $9 Billion Valuation
There are a number of problems with LendingClub making it to $88 billion in origination volume. Although LendingClub originates loans for all types of purposes, mortgage originations give some context to how large a figure $88 billion in originations is. $88 billion in originations would be more volume than what all but the two largest US Banks originate in mortgages over a calendar year. Two of the largest credit card companies, American Express (NYSE:AXP) and Discover (NYSE:DFS), whose loans hold similar characteristics to the kind Lending Club, had $66 billion and $64 billion in credit loans outstanding last year, respectively.
Part 4: Concluding Thoughts
LendingClub's products are niche from a demand perspective. The products LendingClub competes with, especially on an institutional level, such as credit securitizations, asset backed securities, or other fixed income products are far more liquid, can be obtained in bulk, and are easier to compare against each other. The battle to scale for LendingClub will be uphill without the institutional market and their current product is just not built to appease this type of customer. While Lending Club lacks any competitors in their direct space, this can largely be attributed to, again, the relative niche nature of their product. There are really no significant barriers to entry to market in peer-to-peer online lending. Their low cost alternative to traditional credit is also easier and cheaper to replicate than traditional credit institutions.
Low barriers to entry mean LendingClub can be a victim of their own success in two ways. If they are successful as investors hope, than the incentive of huge profits while taking virtually no balance sheet risk will bring many competitors into the market, eroding the profitability of LendingClub by raising customer acquisition costs. This happens in similar industries to peer-to-peer lending, such as online gambling, payday lenders, and brokerages. In these industries competition raises the selling and advertising cost to win customers even though providing the actual service remains cheap and often gets driven down (i.e. the platform and processing). This is the likely outcome if LendingClub's model is a success.
The second way in which their success could hurt them is in the area of regulation. Currently LendingClub is lightly regulated (another way in which there are low barriers to entry in their current form). If LendingClub or the peer-to-peer lending industry grows, than regulation will follow without a doubt. Regulation could cap interest rates they could offer or fees they could charge, as has happened with other unsecured loan industries, or at the very least raise regulatory compliance costs. Lack of regulation has added to LendingClub's cost advantage over other credit institutions and eventual regulation would lessen the relative attractiveness of their services. LendingClub is a highly speculative investment with business fundamentals and industry structure that do not support the common narrative that has driven the stock to insane heights. For both users of LendingClub products and investors in the company, there appear to be many more risks than potential upside.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.