Despite the regional banking crisis that rattled markets and the economy earlier this year, SoFi Technologies (SOFI -0.73%) has been a notable winner. Its shares are up 68% this year (as of Sept. 28), even though they have come down significantly since the start of August.
Some investors might automatically view SoFi stock as a buy right now, not only because its shares are selling at a price-to-sales multiple below their historical average, but also due to a near-term catalyst.
Before doing that, though, there's one huge red flag that can't be ignored. Let's take a closer look.
Payments for student loans resume
SoFi was founded in 2011 with the primary goal of helping students find ways to pay for the rising cost of college. Consequently, refinancing student loans was the company's main product line. This expanded to a wider range of financial services, which has created the successful digital bank that we are all familiar with today.
The Department of Education recently ended its pause on student loan payments, and they are set to resume in October after being put on hold following the onset of the coronavirus pandemic. This is major news for the economy, as there are 44 million people with federal student loans totaling a whopping $1.6 trillion.
The effects on the greater economy can be sizable, but SoFi could benefit. With inflation still at elevated levels, coupled with an uncertain economic backdrop, most borrowers might struggle to find the extra income needed to make payments on time. And this could be a boon for SoFi. Refinancing activity could pick up, leading to higher revenue for the company.
In the first six months of 2023, net revenue increased 40% on a year-over-year basis. And the leadership team expects adjusted net revenue to jump 30% (at the midpoint) for the full year, with the business reaching GAAP (Generally Accepted Accounting Principles) profitability in the fourth quarter. This is already a strong outlook, but it could be underestimating SoFi's prospects should student loan business bounce back nicely.
Risk of higher defaults
Since the start of 2022, SoFi has originated $16.5 billion worth of a different product, personal loans, which represented almost 80% of the company's overall lending activity in the last six quarters. For comparison's sake, student loans made up just 15% of the total.
"Our underwriting model and our focus on high-quality credit have resulted in dependable performance of these loans as our annualized net charge-off rate was lower quarter-over-quarter at 2.94%," CEO Anthony Noto said on the second-quarter 2023 earnings call about the growth of personal loans.
That might instill some confidence, but investors need to understand a huge risk that's on the horizon. Personal loans can be used for many things, like debt consolidation, funeral costs, or medical expenses, while student loans have one purpose. Moreover, personal loans typically carry higher interest rates.
What happens if the economic backdrop deteriorates? While the economy has shown its resilience, there's still the possibility of a recession. If recent financial results from major retailers like Costco, Home Depot, and Target are any indication, investors should remain cautious. Sales growth is slowing dramatically at these companies.
For SoFi, this means that there's the chance that defaults on these personal loans, which made up 69% of the loan book as of June 30, could rise significantly should the macro picture worsen. This would result in mounting losses for the business. Targeting a higher-income customer definitely provides a bit of a safety cushion, but even these borrowers will feel the pinch in a severe recessionary scenario.
Of course, what will happen with the economy in the near term is impossible to predict. But this gives SoFi shareholders something to pay close attention to in the next few quarters.
