The digital marketplace bank and online personal loan company LendingClub (LC 0.56%) recently reported third-quarter earnings results that beat expectations. Despite the solid performance, the stock sold off anyway as the company reported lower guidance for the fourth quarter.
When LendingClub completed its acquisition of Radius Bank early in 2021, effectively becoming a bank, the company developed a hybrid model through which it sells a large chunk of its loans to institutional investors. It then puts a smaller but noteworthy portion on its balance sheet to collect recurring interest income payments. The move drastically changed the company's financial profile.
While it has been frustrating to watch shares sell-off so heavily this year, LendingClub is in a much different place from where it was pre-pandemic, yet trades at a similar share price. That's why I would advise shareholders to keep their faith and hold their shares right now.
LendingClub finds it's hard to fight the Fed
LendingClub's main business is consolidating credit card debt, mainly for prime borrowers. So if someone is paying 20% interest on their credit card debt, LendingClub will offer them 16%, providing customers a lot of savings and the company with a high-yielding loan that can generate attractive returns.
Before buying Radius, LendingClub sold all its loans to institutional investors. But with Radius, LendingClub now sells about three-quarters (give or take) of its loans to outside investors and puts about a quarter of its originations on its balance sheet, which it originates with deposits from the bank.
The bank also allows LendingClub to save on loan origination costs because it doesn't have to pay a third-party bank to originate loans. Loans that LendingClub places on its balance sheet are three times more profitable over their life than loans sold to investors, although LendingClub then becomes responsible for any loan losses.
Investors who buy LendingClub loans essentially fund these loans with their own capital sources, which are more sensitive to the Federal Reserve's overnight benchmark lending rate, the federal funds rate. With the Fed aggressively raising interest rates, these institutional investors now have a higher cost of capital to fund loans they purchase from LendingClub. In turn, this leads them to demand higher yields on the loans so they can maintain attractive returns.
When the Fed raises interest rates, LendingClub can also raise the yields on its loans. But it can take some time because first, the credit card companies need to raise yields so the company can maintain its arbitrage business, which also takes time.
That means many investors who normally purchase LendingClub loans face higher funding costs but the same yields right now, which compresses their returns and explains why some investors headed to the sidelines. This decreased LendingClub's marketplace revenue in Q3, a trend that could continue next quarter as well. LendingClub also saw its deposit costs go up pretty significantly.
More conservative underwriting
While credit quality is still relatively benign right now with so much fear of a recession next year, LendingClub is tightening its underwriting, pursuing borrowers less likely to default and with higher Fair Isaac FICO scores. In Q3, the average FICO score on loans the company holds on its balance sheet increased to 730. LendingClub further tightened its underwriting standards and only originated 10% to 12% of its total loan originations to near-prime borrowers, down from prior quarters.
This will help the company be more resilient if the economy does tip into a severe recession, but less risky borrowers also mean lower-yielding loans. So the combination of higher funding costs and lower-yielding loans is also pressuring LendingClub's margins right now.
LendingClub needs to take a step back
LendingClub's stock is down more than 57% this year, and as a shareholder, I'll admit it hasn't been easy to watch, especially after achieving such high levels last year. But if we take a step back, it's easy to see how much progress LendingClub has made.
LC data by YCharts. TTM = trailing 12 months.
The company is trading at a lower price than it did at times in 2019, yet went from losing a ton of money prior to the pandemic to now becoming much more profitable. This year, roughly half of the profits are from the reversal of a deferred tax asset. Even then, the company is quite profitable compared to when it was consistently losing tens of millions pre-pandemic.
Furthermore, although LendingClub's stock was hammered this year, the company closed the gap with several peers that, while operating different business models, are also in the online personal lending space. This suggests that when conditions stabilize and stocks rebound, LendingClub now has much more potential, although 2021 levels were likely unsustainable.
LC Market Cap data by YCharts.
Temporary struggles for LendingClub
It's obviously hard to fight the Fed, but LendingClub is doing a good job of managing the factors within its control. The purchase of the bank made the company much more resilient and better able to withstand difficult conditions. I also think LendingClub is prudently preparing for a potential recession.
Marketplace revenue will take a hit in the near term, with more institutional investors temporarily on the sidelines, and LendingClub's margins could also continue to be pressured in the near term.
But this should be temporary. The Fed may soon be done with its aggressive rate hikes, which would allow LendingClub to get back to business as usual. Credit card balances have also rebounded to pre-pandemic levels, providing a sizable opportunity once conditions stabilize. Shares of LendingClub are now on sale, and the company is significantly more profitable and durable than it was pre-pandemic.
