On Deck Capital, Inc. (NYSE:ONDK) based in New York City is a subprime commercial lender which had its IPO on December 17, 2014. In the IPO, the company issued 11,500,000 shares at $20 per share, raising gross proceeds of $230 million. On Deck specializes in commercial loans of $5,000 to $250,000. It has no branch offices, loans are primarily applied for over the internet. On Deck claims to have a proprietary loan underwriting model that helps it reduce charge-offs. The company is currently in hyper growth mode. Revenues in 2013 were $65.2 million, up 154% from 2012. Revenues in the first nine months of 2014 were $107.6 million, up 156% from the same period one year earlier. The company earned a small profit of $654,000 (before a $300,000 warrant downward adjustment) in the third quarter of 2014, its first profitable quarter.
The first strength, as previously mentioned, is the rapid growth. Part of the growth is due to ease of use and quick access to cash. According to the S-1:
Small businesses can apply for a term loan or line of credit on our website in minutes and, using our proprietary OnDeck Score, we can make a funding decision immediately and transfer funds as fast as the same day.
After the recent IPO, leverage is very low. Proforma net worth per the S-1 is $254 million. However, the S-1 assumed 10 million shares at $17 per share. Actual proceeds were 11.5 million shares at $20 per share, $60 million higher. This brings proforma net worth as of September 30, 2014 to $314 million. Total proforma assets September 30, 2014 was $680 million which includes $60 million for the extra IPO proceeds. This brings the debt to equity ratio to 1.17, low for a lender. Considering proforma cash is $237 million of total assets, actual leverage much lower. However, leverage will increase rapidly due to hyper growth with little profits.
On Deck gets an obscenely high interest rate on its loans. For the first nine months of 2014, the average interest rate was 41.2% and the average APR was 53.2%. Most subprime lenders get 10-25%. Part of the reason for the high rate is the short term of the loans. Loans are 3 to 24 months in term and the average loan term is under six months.
The company has a low expense model. There are no branches or deposits. Underwriting is done almost entirely automatically through the internet using a credit scoring model. This advantage however, is more than offset by high marketing expenses. Marketing expenses were 6.7% of average loans for the first nine months of 2014, way above the under 1% most banks pay.
The average interest rate of 41.2% reveals how risky this business is. In fact I am not aware of any lender who charges a rate higher, or anywhere near what On Deck gets. Loan losses are running 11.3% of principal. Loan loss reserves totaled 43.7% of revenues in the first nine months of 2014, similar to prior periods. This same ratio is currently under 10% for most banks, under 5% for the better performing ones.
On Deck almost completely relies on a credit scoring model to determine who gets approved. There is very little manual over-rides. Many banks, especially larger banks, use a credit scoring model. Almost all manually review the loan application and over-ride the model if deemed necessary. Most also meet with the applicant to determine management capacity. They do this because they know that no model can pick up all the moving parts of a business credit profile. Unlike loans to consumers which underwritten using a few key ratios, businesses have hundreds of moving parts. Every industry has a different profile, and within each industry every company is different. The recent recession was in part caused by over-reliance by the credit agencies on models. Economists have had a particularly hard time predicting the economy with their models. Models just can't be very effective for analyzing something as complex as a business. For one thing, a model cannot assess management effectiveness which is arguably the most important factor in the success of a business. On Deck's very high rate of loan losses indicates the model is not working very well.
This business has not been proven through a business cycle. On Deck started in 2006, and was very small in relation to its current size during the recent recession. Many subprime lenders went under during the last recession and most of those that survived suffered losses. What concerns me most is how little the profit margin is. In its first profitable quarter, the company had a profit margin of 1.5%. When loan losses are running 43.7% of revenues this leaves little cushion for rising charge-offs in a weak economy. Those loss reserves would only have to increase by 3.4% to wipe out profits. Keep in mind we just had GDP growth of 5.0% last quarter, so the company is currently operating in good economic times.
The price to book value is well above most other lenders. Based on the closing price of $22.44 on December 29, 2014, market cap is currently $1.52 billion. As mentioned above, proforma book value is $314 million. This brings the price to book ratio to 4.83. This is above almost every other lender bank or non-bank out there.
Management is a question. All of the executive officers are under 40. Neither the CEO or the COO have lending experience. Amazingly, neither does the SVP of Analytics, the guy in charge of the credit scoring model.
On Deck does not have deposits. As a result its cost of funds are much higher than banks, even after factoring in deposit gathering expenses needed to have a branch network.
Finally, paying an APR of 53.2% is not a good deal for borrowers. This rate is only going to be paid by those with the weakest credit. Even high cost credit cards are less than half that rate. Those borrowers who do pay on time will eventually leave when their credit allows them to borrow from a bank or credit card.
This stock may perform relatively well in the short and intermediate term due to its hyper growth which many investors pay a premium for. However, it will be hit hard by the next recession or even an economic cooling. Investors should sell when it becomes apparent the economy is slowing.
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. The author has no business relationship with any company whose stock is mentioned in this article.