This rising interest rate environment the U.S. finds itself in has made turning a profit very difficult for fintech specialists in the consumer finance space. Examples of this can be found at companies like Upstart, SoFi Technologies, and MoneyLion, among others.
But the difficult economic environment didn't keep digital marketplace bank LendingClub (LC 2.40%) from turning a profit in every quarter since Q2 of 2021. While the environment remains challenging, I do expect the company to maintain a small level of profitability until market conditions get more favorable for the business model. With the stock now trading at a discount, I see this as a good time to get in. Here's why.
Understanding LendingClub's business model
LendingClub's main business is helping largely prime borrowers and above consolidate their credit card debt. This generates a high-yielding, short-duration loan for LendingClub while also saving borrowers lots of money in interest payments on their remaining credit card balances.
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LendingClub became a bank after completing its acquisition of Radius Bank in 2021, and as a result, it has access to deposits to fund loans and has a good framework in place for putting loans on its balance sheet and collecting recurring interest income payments. Over the life of a loan, loans on the balance sheet are three times more profitable than those sold to investors in LendingClub's marketplace.
But the marketplace plays a critical role in the model because it allows LendingClub to originate more loans. When the marketplace is operating at full capacity, the fees from selling loans can pretty much cover LendingClub's expense base. When conditions are like this, profits from loans held on the balance sheet after setting aside capital to cover potential loan losses pretty much fall straight to the bottom line.
Flexibility in the challenging environment
Unfortunately, the high interest rate environment raised the cost of capital for certain parties that buy LendingClub loans (asset managers, for instance). Also, with a potential recession looming, investors are nervous about credit quality. This has made marketplace investors request higher returns on loans. LendingClub can reprice the interest rates on its loans as credit card loans reprice, but it takes time, and with the Fed not having slowed its aggressive rate-hiking campaign for over a year now, the company hasn't been able to reprice loans fast enough to keep up with the increased cost of funding for investors.
But this is where having the flexibility of the bank has been huge. With the capital markets frozen for most consumer fintech businesses, which are struggling to find investors to buy their loans, LendingClub can simply go raise more deposits and then hold more loans on its balance sheet. Indeed, LendingClub grew deposits by 13% in the first quarter.
The company does have to pay up for these deposits in this kind of environment, but with its main product -- unsecured personal loans -- still yielding more than 13%, it can handle the higher funding costs. LendingClub retained $1 billion of loans on its balance sheet in Q1, which is up from $700 million in the fourth quarter.
Putting loans on the balance sheet also puts the company on the hook for loan losses. But LendingClub has been setting aside reserves each quarter to cover future losses and has enough set aside to cover the equivalent of 6.4% of losses on its entire loan book. The annualized projected loan loss rate in Q1 came in at 3.8%. Losses are likely to keep rising but LendingClub does have a cushion.
LendingClub is still feeling the heat and saw margin compression due to higher funding costs and not being able to fully reprice its loans. Profits in the first quarter fell 66% year over year but the key is that the company is profitable in an unprecedented rising interest rate environment.
The stock trades at an attractive valuation
Investors are clearly worried about credit quality and the trajectory of interest rates. But once the Fed pauses, allowing LendingClub to fully reprice its loans, and there is more clarity on the economy, the marketplace will recover. LendingClub CEO Scott Sanborn said that can happen very quickly.
The opportunity for LendingClub remains larger than ever, with revolving consumer debt now at all-time highs of $1.2 trillion and interest rates on credit cards now surpassing 20%.
LendingClub is not having any issues drumming up borrower demand; it just needs to find places to put the loans because it can only grow its balance sheet so quickly due to regulatory capital restrictions. With the stock trading at just 77% of its tangible book value, investors can buy LendingClub stock at an attractive valuation before an eventual recovery.
