LendingClub Is Quietly Expanding Its Institutional Clients Base

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About: LendingClub Corporation (LC)
by: LEL Investment LLC
Summary

LendingClub evolved from P2P lending in 2009 to an institutional lender-driven platform in 2018.

Revenue slowdown is not a concern as quality of loans continue to improve and institutional investors like it.

LendingClub provides efficiency to the existing credit system through cost saving compared to traditional brick and mortar bank model by grabbing shares from traditional banks rather creating new credit.

LendingClub enjoys a higher variable margin and thus employs a cost leadership moat to defend themselves from the competition from advertising-based credit product platforms and traditional bank models.

LendingClub will leverage its fixed costs and improve profitability at scale. We believe that once LendingClub becomes profitable, the valuation multiple should expand.

LendingClub Corporation(LC) is the largest U.S. online marketplace platforms that connects borrowers and lenders, facilitating loan origination at a lower cost of debt for borrowers and superior risk-adjusted returns for investors than traditional banks. The marketplace facilitated approximately $40.0 billion in loans from 2007 to 2018. LendingClub charges issuing bank transaction and collecting investor fees as the loan servicer.

EXECUTIVE SUMMARY

We summarized the risk factors of the company below and will discuss each factor in the following paragraph.

Key takeaway from the Q42018 earnings release:

On February 19, 2019, LendingClub released its fourth quarter 2018 report and FY2019 outlook. The stock was down 15% on that day and 24% since the earnings release. We believe the sell-off can be attributed to the company’s weak and decelerated 2019 revenue growth outlook, citing 7%-13% growth in first quarter of 2019 and 10%-14% in FY2019.

LendingClub is shifting focus from P2P lending to institutional lender-driven platform

We believe the panic is overdone and investors should understand where the company is heading long term, as it is shifting focus from P2P lending in 2009 to an institutional lender-driven platform. Lending Club has demonstrated improved operating metrics and is beginning to show the benefit of economic of scale. We believe the sell-off makes it a buying opportunity for investors.

Leveraging fixed costs to improve margin

From chart below, we continued to see LendingClub demonstrate its benefits from economic of scale, as the company leveraged its fixed costs such as origination, research and general expense.

Source: Company’s 10K, 10Q

Revenue slowdown is not a concern as quality of loans continue to improve and institutional investors like it

From the revenue mix analysis, we clearly see that the revenue slowdown has been driven by its managed accounts and self-directed customers because of the wind-down actions of LendingClub’s investment advisor and its shift of focus to institutional investors.

Per investors’ request, LendingClub decided to tighten its underwritten standard. We see the annualized loan charge-off rate has improved since it peaked in 2017. As the result, we see the investor demand rebounded nicely. Banks(41% of revenue) grew nicely at 34% accelerated from third quarter 2018. Overall, institutional investors as aggregate(78% of revenue) grew at 44% accelerated from third quarter 2018. LendingClub proved that it can effectively control the quality of loan.

Source: Company’s 10K, 10Q

LendingClub functions as lender-friendly borrower acquisition platform for lenders. It provides efficiency to the existing credit system through cost savings compared to the traditional brick and mortar bank model. It works on the basis of grabbing shares from traditional banks rather than creating new credit, which highly depends on the macro environment.

Who are LendingClub’s customers?

LendingClub has continuously evolved its investor base from 90%, comprised of the retail investor group in 2009 to financial institution driven in 2018.

Source: Company’s presentation

It currently serves these two major types of institutions:

Community banks:

Community banks typically have a higher efficiency ratio and expense ratio compared to traditionally large banks because they provide fewer varieties of products and less convenience due to fewer branch/ATM locations. As a result, community banks are at a disadvantage in attracting retail customers compared to larger banks.

Source: FDIC

For community banks, the cost of building or buying their own online origination platform is prohibitive. In collaborating with LendingClub, banks can achieve more with less risk: they can get improved services for a significantly lower capital expenditure; a reduced cost of doing business; and, more importantly, access to market segments that would otherwise not meet their credit criteria.

Asset managers:

Assets managers look for assets with (i) return and quality, and (ii) diversification.

(i) Return and Quality:

Compared to bank partners, asset managers have a high-risk tolerance and return requirement. LendingClub structures Club Certificate program, typically 3-to-5 year tenure and customized for different asset managers. It uses transaction data, behavior data and other risk tools along with its 10-year credit database to evaluate loan risk to provide asset transparency for asset managers. LendingClub also provides post-lending loan servicing and takes over the loan application process for asset managers, which reduces their operating costs and improves return.

(ii) Diversification:

LendingClub provides assets manager with a new asset class which traditionally is profitable while being close to the bank industry. With an average short duration and higher yields, a Club Certificate program could be added to the portfolio as a balance for corporate and sovereign credit.

Source: Bloomberg

LendingClub has sold over $1 billion Club Certificates in less than one year since the program launch. As both banking and asset management markets are huge, and currently undeserved, We believe LendingClub’s business model is disruptive to the traditional banking model. Hence, the company could still grow through taking shares from the existing market regardless of the uncertainty of the macro environment. Source: Company’s presentation

LendingClub has shown consistency in grabbing shares from traditional banks. It now accounts for 10% of total U.S. personal loan balances outstanding.

Source: TransUnion Industry Insights Report 2017

Auto loans are another great market recently trending

Another area of focus is auto loans, according to New York Fed consumer credit panel and Equifax(EFX). As of the fourth quarter of 2018, the U.S. auto loan outstanding balance is 1.2 trillion. In our recent article, we pointed out that the emergence of the online used car platform, Carvana(CVNA), can be attributed to its low variable cost lending model. LendingClub is currently quietly growing its refinance auto loan revenues. An excerpt from their earning transcript:

Auto originations since launch are three times higher than personal loans at the same point in their life cycle. So, we remain encouraged about auto as a long-term driver of our growth. Having developed the user experience and credit model in 2018, we will be focusing on building out our investor base in auto in 2019.

Carvana originated loans through its low-cost lending platform at the rate of 136% in 2017 and 138%, in the amount of $1.2 billion, in 2018. Clearly, there is strong demand in auto loans. We believe LendingClub should partner with other brick and mortar car dealers to bring down the consumer’s financing cost.

LendingClub enjoys a higher variable margin and thus employs a cost leadership moat to defend against the competition from the advertising-based credit product platform traditional model. It will leverage fixed costs and improve profitability at scale.

LendingClub has currently incurred a GAAP loss compared to profitable advertising-based lending platforms such as Lending Tree(TREE), which attracts users by providing a variety of credit-related product information on its platform. LendingClub heavily invests in fixed costs such as acquiring talent and building its own proprietary algorithm system. However, LendingClub is continuously improving its borrower conversion rate by investing in its machine learning credit system. LendingClub’s high variable margin shows that it has better customer acquisition efficiency than Lending Tree. We believe LendingClub’s business model is more competitive long term.

Source: Companies' earnings report

As borrowers are shifting to digital channels, traditional large banks such as J.P. Morgan Chase are also building their own digital platforms, although traditional banks enjoy a lower cost of funding compared to community banks. However, due to higher brick and mortar fixed costs at J.P. Morgan Chase(JPM), LendingClub is more competitive than JP Morgan Chase in customer acquisition cost; hence, overall the company could offer lower interest rate loans along with its community banks partners.

Track record in margin expansion

LendingClub has consistently shown an improving variable (contribution margin) and fixed cost structure (EBT margin) that strengthen its cost advantage against peers. Its contribution margin and EBT margin have improved over the past 3 years.

Source: Companies' earnings report

Competitive advantage of a low variable cost model

Compared to lending platforms like OnDeck Capital(ONDK), which take most of the credit risk of the loans it originates and relies on its own credit solvency to access capital, LendingClub obtains capital from diverse sources. LendingClub provides products to banks, insurance companies, asset managers and other financial institution investors through a standard and customized program.

Furthermore, Lending Club sources funding from banks, other institutional and lending club-funded inventory (mainly for the Club Certificate program and to keep a small piece of the loan in inventory to satisfy regulatory requirements). Banks typically target high credit profile customers while institutional investors look at yield and liquidity. The mix of the investor base provides diversification of access to capital for the lending club.

Source: Company' earnings report

Valuation is cheap compared to fintech peers

Compared to its fintech peers: Source: Yahoo finance, Bloomberg

LendingClub's current depressed multiple compared to other fintech peers because it is not profitable yet. However, with $645 million cash on hand, we are not worried about its liquidity. Also, we believe LendingClub will be profitable by leveraging its fixed costs. The valuation multiple should expand once the company becomes profitable.

Disclosure: I am/we are long LC. 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.