Despite the recent market sell-off, FANG (Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Google (NASDAQ:GOOG) (NASDAQ:GOOGL)) is still positive YTD. FB is up 16%, AMZN 67%, NFLX 103% and GOOG at 16%. They are currently evaluated using DCF models, which do not take into account the ability of technology companies to enjoy explosive growth through the introduction of new products.
These companies are platforms, and when they introduce a new product, it is immediately adopted by most users who are already embedded into their ecosystem. This allows FB to push video ads, AMZN to easily grow and bundle more services into AWS, NFLX to add original programming and GOOG to introduce deep linking to Android. FANG should not be evaluated based off their current products but their value as platforms that can easily create new products.
Platforms are the inevitable end product of the scalability of technology and a winner takes all market. The company which solves user problems the fastest, attracts users, which attracts more users and results in a platform. The platform then has a captive audience, which can be channeled into new products. So when evaluating a tech company, instead of doing a DCF model, investors should be asking Is this company going to become a platform that will take over the entire marketplace?
To reach an answer to the question, we have to first answer three questions:
- How large is the total addressable market?
- How does the product help buyers?
- How does the product help sellers?
If the company makes its own product and is the seller, it needs to allow people to build on top of their product so that it can be customized to fit any purpose without the use of additional resources from the manufacturer.
Now lets attempt to examine if LendingClub (NYSE:LC) is a company that can take over the entire marketplace. From a fundamental perspective, its a great product because it merely connects borrowers with investors; it bears no credit risk. From the 10-K:
We sell securities or whole loans to investors and the securities are matched in terms of rate and duration with the underlying loans. LendingClub does not assume credit risk or interest rate risk which are borne by investors. Therefore, there is no capital requirement or DSE insurance.
How large is LCs total addressable market TAM?
LendingClubs TAM is the $3.42 Trillion of outstanding consumer debt.
Until 2014, LendingClub only handled P2P loans up to $35,000 for the purpose of consolidating debt, paying off credit cards and home improvement. In 2014, it acquired Springstone Financial LLC for $140 million and entered the market for financing private education and elective medical procedures. In the same year, it started offering small business loans up to $300,000 for expanding businesses, buying inventory, working capital, purchasing equipment and refinancing debt. In a 2015 interview with Forbes, LendingClubs CEO mentioned that there are plans to expand into car loans and mortgages, exposing LC to the entire consumer credit market in the US.
How does LendingClub help borrowers?
LendingClub can attract borrowers by providing:
- Easy access to credit
- Cheaper access to credit
Traditional access to credit through a bank loan:
- Go to your local bank and meet with a person who tells you what documents are necessary
- Collect the documents and make time to travel to the bank again with the documents
- The banker inputs all the information into the banks system and provides a quote.
- If you find the terms of the loan acceptable, you sign documents and receive the money 2-4 weeks later.
Traditional access to credit through a credit card:
- Locate all of the statements you receive from the credit card company.
- Locate the maximum borrowable amount on the statement and dig through the fine print for interest rates.
- Plan how you will split the amount across multiple credit cards.
- Withdraw the money and then juggle different repayment schedules.
Accessing credit through LendingClub:
- Fill out an online form in 3 minutes to receive a quote.
- Upload documents in 30 minutes to verify the information provided earlier.
- Wait 3-5 days for loan approval.
- Wait 2-3 days for the money to be deposited in your account.
Of the 3 options, LendingClub is easily the most convenient choice.
Price of credit
As of 6/30/15, 70.45% of LendingClub borrowers report using their loans to refinance existing loans or pay off their credit cards. Based off this information, we can easily infer that customers have already attempted borrowing from traditional lenders and are not attracted to LendingClub for its convenience, but for its cost of credit. If LendingClub were not a cheaper alternative, borrowers would never refinance debt at a higher rate.
So how is LendingClub providing cheaper access to credit? Are they merely mispricing it because they are a startup with no experience at credit analysis? The most apparent answer to the question is that LendingClub has fewer costs than the traditional bank or credit card company.
The established players have to manage a large retail footprint, creating rent and employee costs which creates more opportunities for cross selling but also is a consistent cost base which cannot be scaled easily. The incumbents are also running their operations on outdated technology infrastructure, which they dont attempt to improve unless it breaks.
In contrast, LendingClub has no physical locations, has a technology platform, which can easily accommodate more users with the addition of some client support staff. LC also does not have to deal with sending statements or processing transactions made at the borrowers direction; all communications occur over email and LC is automatically paid out of the clients bank account.
Despite the lack of much human contact in the LendingClub process, the company is still able to build relationships with borrowers with roughly 27% of borrowers coming back to LendingClub and obtaining a second loan within four years of obtaining their first loan.
For a borrower, there are few reasons to not be on LendingClub. It provides convenient and cheap access to credit, especially for borrowers with high credit ratings who can borrow for as low as 5% on LC.
How does LendingClub help investors?
Investors in P2P loans are only concerned about the returns they receive on their investment. Despite the interest LC has received from institutional investors, retail investors accounted for 70% of loans in Q2 2015. Institutional investors only accounted for 9% of loans last quarter. Retail investors are attracted to LendingClub because it offers 11% interest annually compared to the 1% they currently receive on CDs. There are more than 100,000 active retail accounts with an average account size of well over $15,000.
Investors will continue to fund loans on the platform as long as they are sufficiently rewarded for their risk. It is difficult to determine what an acceptable rate of return would be for investors in the nascent P2P market but we can absolutely determine that investors are receiving less than double-digit returns on their LC investments. For data on actual investor returns, LendingClub is very helpful with this nifty chart:
(click to enlarge)
As you can see, the median return on a 2-year LendingClub portfolio is 7.3%, which is close to the 8% rate advertised in this video. The returns start as high as 13% when the portfolio is 3-6 months old. Then, the defaults start kicking in and drag down the overall ROI for the portfolio.
The default rates are absurdly high at 6.5% annualized per portfolio which suggests the low cost of credit is being provided by the retail investor who is uneducated about default risk and its implications on his/her portfolio.
NSR Invest has collected data on over $9 billion of LendingClub loans out of the $11 billion issued to date.
(click to enlarge)
The data they have collected points to an alarming trend. Even though consumer balance sheets started improving in 2010, LC default rates climbed from 5.85% in 2010 to 7.46% in 2012. While recorded default rates are lower in 2013 and 2014, it takes 9 months for 89% of a loan in default to be written off so investors can expect the default rate to rise substantially before all the loans come due. APR paid on loans has also declined from 14.8% in 2013 to 13.1% in 2015 even though the creditworthiness of borrowers has remained constant.
The returns on P2P loans are dependent on the credit cycle. Returns will be higher in good times when people are employed and can easily pay off debt or refinance it. Returns will be poor when borrowers lose their jobs and lose access to credit. LendingClub technically has performance data on a period where credit dries up as it issued loans back in 2008 and 2009. However, the data is not very helpful because it only covers loans totaling $70 million, which were probably all issued to early adopters in Silicon Valley, a population not representative of the entire US.
Overall, LendingClub is marginally better for loan investors, but is not the best choice for investors looking to invest in consumer credit. The APR and default rates will change as LC adds new type of loans, but LendingClubs default rate remains too high. If they can bring down defaults from 6.5% to 5% and provide 7.5% return on a pool of 12.5% loans, it will have addressed investor demands for high returns. As of now, LendingClub provides enough returns to keep investors interested – not enough to lock them into the platform forever.
Will LendingClub become THE online lending platform for consumer credit?
It is possible but I cannot crown them the winner yet. LendingClub is tackling a massive market with a large opportunity for disruption and it provides easy and cheap access to credit for borrowers. However, it does not offer returns high enough to keep investors from looking elsewhere. Until LendingClub resolves this problem, any of the other startups in the lending space could leapfrog them by evaluating credit from a different perspective, which leads to lower defaults and higher returns.
I recommend Holding LC due to its growth potential but would not consider buying the stock unless it lowered the default rates on loans.