LendingClub (NYSE:LC) operating performance in the last 12 months has significantly exceeded my expectations on all metrics. This includes profitability, and growth as well as strengthening its strategic position whilst widening its moat.
The share price, however, went deep south despite its seemingly strong fundamental performance. The market sentiments are just awful when it comes to fintechs currently (and technology shares in general).
The fundamental performance, however, has been exceptionally strong, and more importantly, the business model appears sustainable throughout the economic cycle. LC is well-positioned to benefit from the current operating environment as well as weather a potential recession given its bank charter, access to low-cost deposits, and high capital ratios.
(All charts in this article are from LC’s Investor Relations website)
LC’s Growing Profitability
The below chart clearly demonstrates LC’s profitability in the last 12 months. It is up and to the right.
Important to note, though, that this is not an adjusted EBITDA figure. Rather it is GAAP Net Income that incorporates depreciation as well as stock-based compensation. It also includes the lifetime estimate cost of credit booked on day 1 as required by the accounting rules for loan loss provisions otherwise known as CECL.
LC has progressed from a net loss of $47 million to a net income of ~$40 million in 12 months. If you exclude the day 1 CECL provision (economically, this should be amortized over the life of the loan or recognized when incurred), then LC adjusted income for Q1’2022 is ~98 million.
The driver for the increased profitability is the acquisition of Radius bank, which allows it to retain high-returning consumer loans on its balance sheet. This gives rise to a growing and stable interest income stream. LC is also benefiting from lower costs as it doesn’t need to pay away issuing bank fees as well as benefiting from a low-cost and stable deposit base.
Based on my back-of-the-envelope calculations, LC generates as much as ~40%-50% RoE for unsecured loans retained on the balance sheet. These are exceptional returns for a bank and not unexpectedly, LC has been growing these assets at a very fast clip as can be seen below.
Reasonable Near-Term Projections
During Q1’2022 which is a seasonally slow quarter, the LC platform’s unsecured loans have grown by a net $554 million. This growth includes new loans retained during the quarter less payments (including prepayments). End-of-period for Q1’2022 (“EOP”) unsecured loans stand at 2.36 billion. If you assume that for the next 3 quarters, LC unsecured loans would grow at a similar clip, then LC will exit 2022 with a $4 billion outstanding unsecured loans balance (for which the CECL day 1 provision has already been booked) deriving net interest income of ~12.5%. Or approximately $500m of unsecured lending net interest income for 2023 (assuming no further growth in the unsecured portfolio).
Now, let’s take a look at the cost base for LC. The quarterly run rate (based on Q1’2022) is $191 million whereas the marketplace revenue for Q1’2022 is $189 million which by itself almost covers its entire cost base. Additionally, LC is generating net interest income from its other assets including commercial loans, mortgages, and secured lending.
So, putting this all together, it is clear that LC’s profitability is going to grow strongly. In fact, during 2021 and 2022, LC is priming the pump by aggressively growing, in absolute terms, the unsecured loans portfolio and associated income stream. The benefits will become much more pronounced in the GAAP numbers in 2023 and onwards.
Understanding The Strategy
LC is completely focused on growing the high-returning unsecured lending assets. It is a no-brainer, given the exceptional returns it generates on loans it holds on its balance sheet.
There are of course a number of constraints. The first one is capital; LC needs to keep a prudent buffer above its capital ratios (the binding constraint for LC is the leverage ratio) which limits the quantum of loans it can retain in a particular quarter. Fortunately, the business is generating a lot of organic capital through earnings which in turn feeds that virtuous cycle that allows it to grow the balance sheet quickly.
Another constraint is the need to keep a vibrant marketplace. If LC retains the majority of loans on its books, then investors (who are key to LC’s business model) would not have sufficient assets to bid on.
The third constraint is the demand for unsecured loans (i.e. level of originations) and the competitive landscape. During the pandemic, outstanding credit cards loans decreased substantially due to fiscal handouts and thus origination levels were somewhat subdued (roughly reaching 2019 levels in 2021). Credit card debt refinancing is LC’s main use case for its unsecured lending products. In recent quarters, though, it appears that credit cards spend and balances are growing quickly, and this should be a tailwind for LC’s business model.
So, the playbook for LC is becoming clear. The key motivation is to retain as many loans as possible on its balance sheet whilst retaining a healthy buffer above its capital ratios and selling enough assets on the marketplace to satisfy investors’ appetite.
But what happens if demand for unsecured loans ultimately dries up?
LC will likely allocate capital to cross-selling other products such as secured lending (auto loans, mortgages). The ROEs are not going to be as great as the LC platform’s unsecured lending assets but still going to generate good returns and increase overall profitability. After all, there is no point in having idle capital sitting on the balance sheet.
In any case, given the current economic conditions of high inflation, lower real incomes, and rising rates – I can also envision the demand for such products to only increase substantially in the medium term as more and more people are living paycheck to paycheck.
In other words, there is a long runaway in front of LC and I am not seeing it reach maturity or plateauing any time soon.
Clearly, given the operating leverage in LC’s business, if it can continue to grow the balance sheet (say to $6, $8 or $10 billion), most of the incremental interest income generated will fall to the bottom line.
The Recession Risk
This is of course the biggest risk with the thesis. The risks may manifest in outsized credit losses (in case of a nasty recession) and investors fleeing the platform (at least temporarily).
Having said that, there are several mitigants now factored in LC’s business model:
- Loans are high FICO scores (averaging 727)
- LC has a stable deposit base
- Based on the pandemic performance, LC’s credit outcomes are 30% to 50% better than the industry and borrowers appear to prioritize repaying personal loans over credit card debts
- High capital ratios to cushion any outsized credit losses.
The underlying performance and numbers in the last 12 months speak for themselves. The profitability trajectory in 2023 and beyond is even better. Management is perennially conservative in providing guidance, they beat every time and with a wide margin. LC is likely (in my view) trading on around ~8-9x PER for 2022 and significantly lower for 2023.
Mr. Market is currently in a risk-off mood especially when it comes to no-profit tech companies. LC on the other hand is very profitable and growing on a GAAP basis.
I am solely focused on the fundamentals, business trajectory, and strategic position as opposed to short-term volatility in the public market price of the security.
I remain very bullish and LC is my top pick in the fintech/banking space.