Two public companies dominate by revenue the non-bank small business financing space for the last six years. They are Square, Inc. (NYSE: NYSE:SQ) and On Deck Capital, Inc. (NYSE: ONDK). Their core business is called Merchant Cash Advance (MCA). There are a plethora of private MCA companies but we are not discussing them in this article except to point out the competition for SQ and ONDK.
It is disconcerting that SQ and ONDK are rapidly growing revenues but neither generates exciting profits from their core business operations. Retail investors get no respectable ROI. So, I am reluctant to recommend retail investors put money into either of the two companies, but I believe there is more share price growth potential from ONDK in the long run because management is grappling to strengthen its core business.
MCA is a largely unregulated industry growing out of and continuing to prosper from the turmoil of the 2007 economic meltdown. MCA growth is stimulated by the banking industry’s froideur to lending to small businesses. MCA companies, on the other hand, specialize in reaching out to undercapitalized businesses, owners with just fair credit ratings, and assets already pledged or doubtfully secure.
A Merchant Cash Advance is not a loan as courts have ruled. Therefore, federal and state governments’ rules and regulations for loans and what is considered usurious lending rates do not apply. Additional fees, commissions to brokers, and penalties merchants may be liable for are also largely unregulated. An MCA is a purchase of future assets with the merchant buying back those assets using future credit and debit cards deposits coming from future sales. I see little standing in the way of the MCA industry continuing its rapid expansion (est. 20% annually).
In exchange for a quick turnaround and little paperwork an advance lump sum payment, fewer fees, and commissions are made to the merchant from an MCA capitalbacker. The company withdraws money out of merchant deposit accounts from credit and debit cards sales on a daily or weekly schedule for a specific length of time. Here is one scenario from Georgia McIntyre, February 2019:
Say you run a coffee shop, and you need an infusion of about $20,000 of capital. You don’t have time to wait around for approval from a bank or longer-term lender, and plus, you probably can’t qualify for one anyway. Your credit history, time in business, and annual revenue just aren’t there. So, you turn to a merchant cash advance provider for that $20,000. You’re approved for a $20,000 merchant cash advance, with a factor rate of 1.35. All in, you’ll need to pay $7,000 for a total of $27,000. However, when you consider how quickly you need to repay your merchant cash advance, you’ll realize how expensive they can be. Say that the merchant cash advance provider plans to take 15% of your daily credit card sales and that you usually bring in about $10,000 a month in credit card sales. This means that you’ll make 216 daily payments of about $125 each day. All in, that’s an effective APR of 106.66%—making the merchant cash advance look more expensive than it originally seemed.
First, privately owned MCA companies are opening every day and targeting the same merchants.
Second, there are some creeping changes in bank lending. For instance, in July, JPMorgan Chase (NYSE: JPM) pulled out of its working relationship originating new JPM small business loans with ONDK. Shares dived 22% on the news. JPM made no definitive statement why it abandoned the relationship but told American Banker in 2016, JPM entered into it to speed-up decision making and funding of JPM’s small business loans using ONDK technology. Third, exacerbating stress to share prices are reports that small business loan approvals at big banks are hitting record highs. Competition from banks approving more small business loan applications is worrisome, but continue merchant application processing delays and setting high credit standards. MCAs get money merchants in 48-72 hours.
Fourth, and this might have spurred JPM to break off with On Deck, came a slew of bad publicity and publication of consumer complaints about MCA companies. It made headlines at Bloomberg and in newspapers. The collection tactics of some MCA capitalbackers on defaults of buybacks by merchants are reportedly much more aggressive than collecting on traditional loan defaults resulting in a lot of bad press. Nevertheless, small business merchants are not anything if not hopeful and confident. Small business merchants “know” their businesses will generate enough receipts to buy back their assets in a short time frame. The extra dollars they pay mean little over the long term. The lure of an upfront lump sum infusion of cash is enticing to get them through a tough time.
Another caveat for investors is the significantly higher rate of default on assets buybacks from merchants than traditional loan makers. MCA capitalbackers with top-shelf due diligence analytics and collection agencies still experience defaults that chip away at profits. The Small Business Administration estimates its default rate is two percent. MCA buyback defaults are believed to be significantly higher but there are no figures.
SQ is steadily expanding financial services it offers users but that investment is doing little to improve the financial quality of SQ. It's market cap today is nearly $27.5B. The company claimed a $31.9B market capitalization at the beginning of 2019. The 52-week high share price was $101.15 but share price dipped to $50.37 at the beginning of 2019, as the company remains unprofitable. Too many observers are impressed that the Q2 ’19 revenue of $563M is an increase of 46.2% Y/Y. EBITDA grew 54% suggesting profitability may not be far off but not in Q3 ’19 according to the company guidance.
Generating excitement about the stock is not prospects for its core business but the new business plan offering other financial services. SQ introduced the free debit Cash Card, a Cash App bitcoin exchange to which the CEO is pledging to make a seminal investment, and the Cash Boost program of discounts at retailers and restaurants when users pay with their Cash Card. People extrapolate from anecdotal information that these programs are generating substantial profits but there are no breakout impact data to value their impact on a company that lost about $63M in y’17 and $38.5M in Y’18. Square posted a loss again in Q2 ’19 of $7M compared to Q2 ‘18’s loss of $6M only losing money in five of its last six quarters despite higher revenues. Observers are impressed overall revenue reportedly jumped one billion dollars in 2018 over the previous year but at this rate, the greater the revenues the faster SQ is heading to the cliff of disaster.
SQ offers a stylish black card for its Cash App service that boasts 7M active users. Cash App is a mobile phone app payment service proprietary to Square allowing users to transfer money to one another or email. Users are able to transfer money to another and to a cash account via its Cash App or email. They are able to withdraw money using its debit Visa card, called Cash Card, in ATMs or transfer it to a local bank account. Users sign their name on the mobile app and the signature is printed into the card and sent to the user. Cash App also supports ACH direct deposits. July 2019 was the biggest month ever for Cash App downloads. Cash App generated $135M in Q2 for Square.
It appears that the 32 analysts set a price target for SQ topping $84 and recommending a hold or buy are overly impressed by revenue generation and the companies new products, rather than considering how badly the SQ core business is floundering. Institutions hold an increasing number of shares, yet insiders have been selling shares in large blocks throughout 2019.
I like ONDK as a better investment than SQ at this time. There is significantly more room for share price growth by the end of 2019 strengthening the company’s organization, focus and intrinsic value. Also, management is paying serious attention to the with low-interest rates and merchants searching for alternative financing. 33% of small business owners know that “lack of capital/cash flow is their number one problem and only a small percentage are versed in financing businesses. That bodes well for ONDK with MCA as its core business.
Being number two in the public sphere of MCA companies gets ONDK little respect or attention. Holistically, the company’s financial position appears healthy despite suffering setbacks. But it is grappling with its problems
On Deck offers alternative financing programs in addition to its bulk business of MCAs. It offers lines of credit and term loans. It sells technology to banks and others wanting to make fast decisions about delivering capital to merchants.
Moreover, there is not much to say for a takeover should another company be interested with origination volume down, yield declining and loan losses are a looming threat. My concern is mostly for the ineluctable level of debt (~253%) compared to net worth; management is struggling to reduce the debt and it will help if operating cash flow continues to exceed total debt. But that is going to require strict operating procedures and smart decision making on every new MCA. Meanwhile, insiders are buying more shares than selling this year.
If management is confident in the quality of its technology, which does not appear to be the reason JPM walked away, management might want to consider building the platform and marketing it to community banks, private MCA companies, start-ups in the business, etc. Technology services coupled with new financial services instruments (including some banking services) ONDK is beginning to offer could prove to be sources of significant income enhancing the core business profit center.
The MCA industry is continuing its strong growth trend despite bad press and other negatives. MCA capitalbackers can strengthen their positions hiring outside firms to undertake due diligence examinations and others specializing in collections in the MCA arena. It appears too for the near term the cost of money for MCA companies will remain cheap and the stand-off position of federal and governments from regulating the MCA industry make for a gold rush time.
The MCA business is growing in popularity worldwide. There is a new British MCA Association dedicated to promoting the industry to merchants. MCAs are being used in Australia and Canada (OTCPK: OTCPK:IOUFF). Small Business Trends reports having surveyed more than 2,000 small business owners. Merchants rank “money management skills” next to last among the Top Characteristics for Running a Successful Business. This leads me to believe the MCA has a whole new target market among small business owners who will be turning to capitalbackers when banks turn them away.
MCAs might feel like a gold rush with promises of amazing returns to capitalbackers. Just remember what Mark Twain warned prospectors, "During the gold rush its a good time to be in the pick and shovel business."
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