LendingClub Stock: Highly Profitable FinTech Bank (NYSE:LC)

2022 has been a dismal year for FinTech stocks, to say the least. The bubble has truly deflated.

LendingClub (NYSE:LC) (in green) outperformed on a relative basis in the earlier part of the year but gave away that outperformance in the fourth quarter as rapidly rising rates and a looming recession disproportionately impacted its business model. Investors are shunning away from consumer lending stocks currently and understandably so.

Specifically, marketplace revenues are impacted by higher costs of funds for investors, compressed NIMs due to rates impact, and fears of loan losses in a recessionary environment.

My thesis is premised on fundamentals

My thesis for LC has always been premised on fundamental performance, sensible bank-like valuation, and not optimistic or “bubblish” valuations.

I see LC as a super-efficient bank with a business model that delivers a very high ROE. In a normal macro environment, it should compound book value rapidly.

For 2022, it is currently valued at a low single-digit PE. The fact of the matter is that LC is predominantly an unsecured personal lender and thus in the riskier spectrum of banks. Whilst it is conservatively reserved and manages risk well, in this part of the economic cycle, investors are shunning away from such investments in spite of the obvious value. It is really the macroeconomic uncertainties that are driving the price action currently.

In other words, this is a cyclical headwind and not a structural problem with the business model. Once the macro environment improves, this stock will likely melt up.

In this article, I will explain in detail the strategy, and capital allocation, review the numbers, and look ahead to 2023 and beyond.

Capital allocation strategy and Balance Sheet Composition

Understanding the capital allocation strategy is key to evaluating banks. As an investor in banks, if you do not fully understand this concept, then in my view, you are flying blind.

The two most important capital ratios for banks are the Common Equity Tier 1 (“CET1”) and Tier 1 Leverage Ratio. For LC, the minimum requirement for both ratios is effectively 11%. Tier 1 Leverage Ratio is the binding constraint (i.e. the ratio that is a limiting one for LC). The simplest way to think about this is that for every $1 billion of assets on its balance sheet (e.g. loans, cash, etc), LC must retain at least $110 million of capital. If LC grows its loan assets too quickly, then it runs the risk of breaching these capital ratios. This is precisely the reason why LC indicated that it will retain only ~20% to 25% of loans on the balance sheet as it expected that its organic capital generation would be able to support this level of asset retention.

Now given that loans retained are three times more profitable than ones sold, LC opportunistically sought to maximize the former by redeploying excess capital. In reality, in recent quarters, it was able to retain more than it guided for due to over earning and accounting recognition of a tax asset. The below chart is showing the trend over the last five quarters:

As you can see from above, in recent quarters, LC has retained a higher percentage of loans than it originally guided for. The capital to support this has been generated from earnings, a sell-off of non-core assets (yacht portfolio inherited from Radius bank), as well as the recognition of tax assets in Q2’2022.

LC’s capital ratio progression in the last five quarters is also shown below:

As you can see, despite the additional loans retained in recent quarters, LC was able to keep its Tier 1 Leverage Ratio well above the 11% minimum.

Also, note that the jump in tangible book value from $7.75 in Q1’2022 to $9.50 in Q2’2022 is mostly due to the recognition of the tax asset noted above.

So in short, the demand for unsecured loans is very strong. For LC, the main constraint is the capital ratios (specifically the Tier 1 Leverage Ratio) but it strives to retain as many loans as possible, given the exceptionally high profitability. So excess capital generated through organic earnings is recycled and deployed to increase the loans on the balance sheet. I estimate the marginal ROE on such loans to be in the range of ~50% or higher which is exceptional for a bank. My estimate is post-expected losses but a pre-tax number.

It is important to understand the economics of placing loans on the balance sheet. The CECL methodology (expected lifetime losses provisions) is very capital-intensive. LC recognizes lifetime losses of the loans upfront (e.g. 6%-7% of the loan amount), and then the economics come later in the form of an interest income stream. For Q3, LC booked a provision (loss) of $83 million mostly related to the upfront CECL charge of the loans retained on the balance sheet in that quarter alone.

How does that manifest in the asset composition of the bank?

The loan assets composition of the bank is extracted from the Q3 earnings presentation:

So not surprisingly, the mix in the last five quarters has heavily shifted towards unsecured personal lending originated through the LC platform.

Secured personal lending comprises residential mortgages and auto-loan refinancing which is a recently introduced product. LC is not pressing the pedal on auto-loan refinancing as the returns on capital are not as high as personal lending. Hence, the preference at this juncture is to prioritize the highest returning assets class which is unsecured personal lending. As noted previously, in Q1’2022, LC sold its yacht loans portfolio (hence the drop in secured lending balances), this was done to free up capital for more unsecured personal lending assets.

LC also holds a commercial loan portfolio which it prefers to grow leisurely. There are two primary reasons for keeping this portfolio. Firstly, it is providing some assets’ diversification from consumer lending. Secondly (and probably more importantly) the client base is a stable source of low-cost operational deposits. I will discuss the deposit strategy later on in this article.

Why is the gross yield on personal loans decreasing?

It is intuitive to think that as interest rates rise, the gross yield on the unsecured loan portfolio should increase in tandem. This is not the case as illustrated in the table above where gross yields have decreased from ~16% to ~13.5%, but why is that?

There are a number of reasons:

1. The LC management team made a decision to derisk the portfolio as early as late-2021 as they expected the economic environment to deteriorate. As such, LC remixed the loan portfolio to a higher average FICO score (~730) by targeting more super-prime customers. This naturally results in a lower average yield on the portfolio but clearly has proven to be the right decision given the consensus forecasts for a recession in 2023.
2. There is a time lag between the Fed raising rates and being able to charge higher loan yields. Given the rapid rise in rates, this had a more profound impact on this rate cycle.
3. Borrowers have materially slowed down their prepayments as such fewer fees are recognized in the yield line item (an accounting phenomenon).

The deposits, however, were repriced higher instantaneously and the combination of lower gross yield and higher cost of funds resulted in compressed NIMs. The good news is this is likely a temporary development that will last another quarter or two assuming that the Fed pauses (or materially slows) the rate hiking cycle.

The deposits

LC’s deposits comprise predominantly checking accounts, high-yield savings, CDs as well as commercial client deposits. The current mix and cost of funds for Q3’2022 are shown below (note that it would be materially higher now given how rates have moved in Q4):

At the moment, LC’s biggest source of deposits is from checking and money market accounts. LC’s checking account is an award-winning account that offers 1% rebate on most purchases and full rebates for ATM withdrawal fees.

LC also has $268 million of non-interest-bearing deposits. For the new FinTech banks, sustainably generating deposits at a competitive cost is key to their success and a massive competitive advantage. LC is very focused on diversifying its source of funds including raising deposits from its commercial clients. So far, LC has been more successful in its deposit strategy compared to other FinTechs such as SoFi Technologies (SOFI) but the latter seems to be catching up recently.

Loan losses And Risk Management

The below extract provides a summary of the loss coverage ratios:

The consumer loans (held for investment) are comprised mostly of unsecured personal loans as well as small amounts of auto loans and mortgages. The loan allowance ratio currently sits at 7.2% and has been increasing steadily over the last 12 months, as LC continues to build reserves due to the deteriorating macro environment.

This is how expected losses operate under CECL, as economic forecasts darken, banks increase their CECL provisions in expectation of tougher economic times. Currently, the actual loan losses are still below pre-pandemic levels but normalizing as per the below chart:

So in summary, LC has been preparing for a recession since Q3’2021, it is conservatively reserved (in line with or better than the large bank’s cards portfolios) and the management team is very cognizant of the potential risks ahead.

In a recent interview with the Wall Street Journal, the CFO reiterated this focus on risk management:

We’ve been proactively taking actions to make sure [that] if there is a recession in 2023 and consumers are heavily impacted by that recession, we’ve done the right things on credit to be prepared for that to happen. That continues to be our focus. I think just across any industry, whether it’s personal loans, auto, credit cards, everyone is watching delinquencies. Everyone is watching charge-offs very closely to see if something is going to crack.

LC, in the last 15 years has originated $80 billion of loans and has extensive experience in managing the credit cycle. In the recent pandemic, LC achieved credit loss outcomes that were at least 30% better than the industry as a whole. LC’s management team recognizes the importance of managing credit risk effectively and preserving underwriting credibility and investor confidence in its marketplace.

Industry-leading cost efficiency

LC is the undisputed leader in marketing cost efficiency. It also has the ability to flex its cost base during downturns as it demonstrated in Q3’2022:

The marketplace also delivers a number of benefits including real-time intelligence on investors’ demand which allows LC to dynamically adjust its origination funnel based on investor demand. Importantly, selling loans through the marketplace is delivering far better economics than securitization used by peers such as SoFi, as highlighted by the CFO in the WSJ article:

WSJ: What are you seeing in terms of investor demand—either through the securitization market or whole loan sales?

Mr. LaBenne: We haven’t issued a securitization [since 2019]. We use the marketplace, which is essentially whole loan sales to buyers, or we use the balance sheet. And both of those are much more economically attractive than a securitization.

WSJ: Is it more economically attractive at the moment or just generally?

Mr. LaBenne: Generally, but at this moment even more so. So we’ll see how things play out in Q4. It’s obviously been very volatile. Now, if the market recovers, and we think there’s a really attractive economic opportunity to do a securitization, then maybe we’ll go down that path again. But it’s not something that we have to tap into.

So What Does It All Mean For 2023 and Beyond?

One way of thinking about LC’s profitability is to separate the marketplace revenue (ranging from $170-$210m in recent quarters) and the growing NII predominantly driven by unsecured consumer lending.

On a back-of-the-envelope calculation, the marketplace revenue covers the full cost base of the company. So the interest income could be extrapolated as a proxy for the pre-tax income. Note that LC is exiting 2022 with ~$5 billion of personal lending plus other assets, and all of these assets have been provided for under CECL (recollect the economics of recognizing expected loan losses on day 1). Assuming an NIM of 10%, that equates to an income stream of $500 million alone (excluding income from all other loan assets) whereas the current market cap of LC is only ~900 million.

Obviously, that’s a simplistic analysis as some loans are repaid and new ones originated, but it does give the reader a flavor of the profit trajectory and returns. Now extrapolate the portfolio to $8 billion or $10 billion and the operating leverage is simply astounding.

Obviously, the main risk for 2023 is a deep recession and outsized loan losses. Even in that scenario, I expect LC to remain solidly profitable as it is conservatively reserved and has a significant buffer on the top line to absorb outsized credit losses. The management team also has strong credentials in managing through a downturn.

My base case on the economy is somewhat bearish. It seems to me that the Fed is not going to pivot until the employment market cracks. I think this is the only way to eradicate inflation for good or at least this is what the Fed believes.

So I am comforted by the focus on LC’s management on proactively fronting these risks. I prefer a management team that is focused on risks rather than reaching for growth given the macro environment. LC’s CEO indicated that it is now slowing down coming into the turn (i.e. potential downturn) but accelerating as they come out.

Final thoughts

LendingClub is a highly profitable (on a full GAAP basis) FinTech with industry-leading cost efficiency. In a normalized macro environment, I expect it to deliver outstanding returns on capital (>30% ROE). This should enable it to compound its tangible book value and share price rapidly.

2023 is going to be a challenging year as I expect a moderate recession. LC’s management has been laser-focused on risk management in the last 18 months and it is conservatively reserved. I expect LC to pass the recession test with flying colors.

There are other headwinds including waning investor appetite for unsecured lending and compressed NIMs due to rapidly rising rates. These are temporary in nature. Once recession fears peak, I expect the stock to rise rapidly and trade at a healthy multiple to book value.

I am currently taking advantage of the distressed share price. I remain very bullish.