One of the harder things in investing is assessing a turnaround. Still, those that bet correctly can reap huge rewards. For about a year now, Lending Club (NYSE:LC) has been trying to dig itself out of the mess it made for itself in May 2016. With new leadership, several new executive hires, and more disciplined underwriting practice, the company is seeking to reestablish trust in the institutional investing world, so that deep-pocketed banks and asset managers would continue to use its platform.
As I said prior to the latest earnings report , the first quarter was likely to shed light on a few data key points, but was unlikely to yield a definitive answer on the turnaround. That turned out to be the case.
Revenue and Originations
Revenue came in at $124.5 million, which beat analysts expectations for the quarter by $1.7 million. This came from $2 billion in loan originations. While revenue beat expectations, the figure was down 18% year over year, and 5% from the last quarter. Originations were down 1% from the fourth quarter. This may seem odd, given that Lending Club is purported to be a disruptive growth company.
However, investors need to know that the company tightened its lending standards in January, eliminating the riskiest 6% from its risk pool. That is because the percentage of charge-offs, or the amount of loans that are not paid back, had been creeping up on a particular set of borrowers. Eliminating that set of borrowers set back growth, but was the correct thing to do in order to keep loan investors on the platform.
While negative growth may make some investors lose faith, the company also raised the low end of its guidance for the full year, from $565 million to $575 million, while keeping the high end of its range at $595 million. That means the company is confident growth will return later this year as it ramps up marketing initiatives, as the guidance implies 15-20% growth over 2016.
A big positive in the report was the return of banks to the platform. Out of the $2 billion in originations, banks accounted for $787 million, or 40% of total originations. That is the highest percentage going to banks since the fallout from last May, and almost back to the level of total dollars banks invested in the first quarter of 2016, before the scandal hit.
This is very important for Lending Club. As famous bank robber Willie Sutton once said when asked about why he robbed banks, "because that's where the money is." Banks are much more routine in their investing than asset managers or individual investors, so this segment is the most dependable long-term recurring revenue for Lending Club. Since banks have a low cost of capital with their deposit base, they make very favorable partners for Lending Club's high-grade loans, and visa-versa, if, of course, banks trust Lending Club's underwriting. That is why banks fled the platform after last year's scandal, and why it's so important that they are returning.
Costs remain elevated
While revenues were slightly down, however, certain costs crept up. Sales and marketing, combined with originations and servicing costs, crept up from $69.8 million to $71.3 million. Contribution margin contracted to 42.7%, below the company's long-term target of 45-50%.
General and administrative expenses actually fell $10.4 million, but this included $9.6 million in an insurance recovery for D&O insurance. Moreover, CEO Scott Sanborn noted higher than expected legal expenses next quarter, still due to the board remediation from the last year's fallout, and adjusted up his estimates for non-recurring costs from $20 million to $25-30 million.
The company also noted increasing technology costs as it rolls out new products such as auto loans, and that stock-based compensation remained elevated, but should come down as a percentage of revenues as the year goes on.
Outlook unclear, patience required
Lending Club beat estimates, but those looking for a definitive turnaround will have to wait a bit longer. Progress was made on improving the loan quality and getting banks to return to the platform. Still, margins contracted, the company is investing for growth, and is paying retention bonuses to key executives. Investors need to have faith that the company will be able to grow without sacrificing loan quality going forward, which ultimately requires faith in the company's technology and algorithms.
The potential of the peer-to-peer lending market is massive , with some predicting the P2P market reaching a trillion dollars by 2025, so investors that believe in Lending Club's potential must have patience. Hyper-growth got the company in trouble last year. It can't afford to screw up loan quality again.