Elevate Credit, Inc. (NYSE:ELVT) the newly public subprime fintech lender, delivered its first quarterly earnings report as a public company on May 8, and the results were impressive. Loan originations grew almost 40%, while revenue grew by a smaller 20%, due to the lowering of interest rates on Elevate's high-rate loan products. Elevate's IPO was unusual -- most tech IPOs sport high growth rates but negative earnings. In the first quarter, Elevate actually delivered a net profit of $1.7 million. Adjusted EBITDA margin expanded to 16%, above the 10% margin posted in 2016 and the 4% in 2015.
However, while these numbers were impressive, one number is likely giving investors pause, which may explain the drop in the stock price since the earnings date.
The big blemish on the quarter was a high net charge-off rate as a percentage of revenues. Net charge-offs measure the amount of principal and interest more than 60 days past due, minus recoveries from prior periods. That number shot up to 59% in the quarter, above the company's target range of 45-55%, and up 600 basis points year over year. While the company was still profitable, the $1.7 million in net earnings was down from $6 million in the year-ago quarter.
The charge-off number is likely to worry investors who might be wary of a company that deals in subprime lending, which has a less-dependable customer. An uptick in charge-offs could potentially point to a deterioration in customer quality, putting Elevate's advanced underwriting technology under the spotlight.
However, after hearing the company's explanation, I think the concern is overblown. In fact, that problem number might be downright deceiving.
Principal or interest?
Management explained that the rise in loan loss provisions was partially related to a new credit score the company tested on lots of new customers at the end of 2016. As is the case with many financial companies, when new customers increase, there is often an initial uptick in defaults or loss ratios. Even Berkshire Hathaway's GEICO insurance unit suffered higher losses and contracting margins in 2016 as it accelerated sales and customer acquisition efforts.
Elevate had also reserved for some of these losses in the prior quarter, as many problem loans were past due (though less than 60 days) on December 31, 2016. Adjusting for these prior reserves, the first quarter loss provision was only 53%, within the company's target range.
And while the 53% loss provision is still at the high end of the aforementioned 45-55% target, Elevate deliberately lowered rates on all of its products this quarter. As the company makes revenues from the interest it charges, lower interest rates (and therefore, lower revenues) per loan means loss ratios will increase as a percentage of revenues.
However, the company lowered rates for good reasons: One, the company's goal is to continue to lower rates as earnings turn positive in order to retain and attract new customers, and two, repeat customers with successful payment histories can attain lower rates. That means average APRs should decrease as the company gains more repeat (and therefore, higher-quality) customers. .
And this higher-quality customer base is revealed when one looks at principal-based loss ratios. For instance, this quarter's loss ratio as a percentage of principal plus interest due was only 16%, exactly in line with last year's number.
And when one looks at principal-only measures, the picture gets even brighter. In fact, 2016 is on track to be the company's best-performing vintage (fancy word for "year") on losses compared to total loan originations, and 2017 (the dark black line) is off to an even better start, though there are only a few months of 2017 data:
Elevate reported a concerning net charge-off rate as a percentage of revenues in the first quarter, but a deeper look at the numbers shows this is not something to worry about. In fact, principal-based loss ratios show the company is actually improving its underwriting, not falling behind.
Moreover, lower interest rates should pay off long-term, even with a short-term hit to margins. Lower rates will allow the company to out-compete smaller, privately held competitors , and lower APRs should help the company gain more acceptance from regulators (who are often concerned about high-interest loan products), thereby increasing the company's total addressable market.
As long-term oriented investors, we like it when a company stays focused on building long-term competitive advantages at the expense of quarterly results. With an otherwise strong showing, Elevate Credit, Inc. is a name to watch.
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