Shares of SoFi Technologies (SOFI 3.69%) started 2024 on a rough note, falling more than 16% last week after Keefe, Bruyette & Woods (KBW) analyst Mike Perito downgraded shares of the banking and fintech services company. More specifically, Perito reduced his rating on SoFi to underperform from market perform, and lowered his per-share price target to $6.50 from $7.50. Shares closed around $8.53 on Monday.
To be fair, SoFi had also just doubled over the previous year, including a more than 40% rally following its impressive third-quarter results in early November. So it's hard to blame some on Wall Street for taking a more cautious stance on the stock. But even putting aside the fact that I'm happy to have a chance to add to my own position at these lower prices, I think this analyst is dead wrong in his bearish call.
Why KBW downgraded SoFi
"SOFI's shares remain polarizing, but noise aside, anytime a growth stock is trading at premium valuations with 15% to 20% downside potential to consensus EBITDA, we believe a more cautious stance is appropriate," KBW wrote in its note to clients.
I typically have no problem, however, investing in stocks that trade at a relative premium, considering that the quality of their underlying businesses often merits that premium price.
But there's another concern raised by KBW that merits a closer look: Interest rates.
In particular, KBW's Perito worries that with the market expecting as many as six cuts to the central bank's federal funds rate in 2024, SoFi's earnings and revenue could take a hit due to the company's fair value accounting methods.
Put another way: A significant part of SoFi's business involves writing loans to consumers, then either holding those loans on the balance sheet (to maximize interest income) or securitizing and reselling them to other companies. And because SoFi marks up the value of those loans to account for every factor from expected future resale prices to interest, fees, and default rates, there's a risk that the mark-to-market value of those loans could be reduced as borrowing costs begin to decline.
More specifically, KBW estimates that every quarter-point reduction to SoFi's fair-market value for its held-for-sale loan portfolio equates to a roughly $50 million headwind to revenue, or roughly five cents per share in earnings. Indeed, SoFi ended last quarter with just under $21 billion of loans held for sale at fair value, one quarter of a percent of which equates to a little over $52 million.
SoFi is well aware of the risks KBW highlighted
Incidentally, I wrote an article last August highlighting that the Fed's repeated rate hikes had served to accelerate SoFi's growth. But in the same article, I also highlighted comments from SoFi CEO Anthony Noto arguing that SoFi would remain in a superior position to continue taking market share by holding its own product's rates much longer and higher than its competitors'.
That brings us to two key problems with KBW's downgrade rationale: It not only seems to assume SoFi management will be caught off guard by those mark-to-market losses within its held-for-sale loan portfolio when rates begin to decline, but also implies that the relative strength of SoFi's remaining businesses wouldn't be able to pick up the slack.
On the latter, it's worth noting that last quarter was the first time in company history that all three of SoFi's core business segments (lending, technology platform, and financial services) individually posted a positive quarterly contribution profit.
Meanwhile, given SoFi management's detailed conversations and masterful navigation of the topic for the past several years, I have a hard time believing they'll be caught off guard by the effect of falling rates this year.
As of the end of October 2023, SoFi had sold over $14.5 billion and securitized over $13.7 billion of personal loan collateral -- two figures the company updated for investors along with a new $375 million securitization agreement with BlackRock that it announced in October and closed in November. Also in November, SoFi not only sold a $100 million tranche of loans at a 105.1% execution level (above its 104% mark) to an unnamed partner, but came to terms on a $2 billion forward flow agreement to sell additional loans at similar execution level with the same partner going forward.
Of course, that could all change if SoFi's mark-to-market valuation ticks steadily lower on that massive held-for-sale loan portfolio. But we should also keep in mind that SoFi enjoys unusual flexibility with regard to how it decides to maximize its return on equity (ROE) from loans.
In fact, Noto was asked about this very concern during SoFi's first-quarter 2023 conference call last May. He answered that the company's strategy has been essentially the same since 2018 as it pertains to optimizing ROE, but has also grown continually stronger thanks to its improving liquidity. As of the end of Q3 2023, SoFi had $8.4 billion of warehouse finance facility capacity and $3 billion of equity capital, and saw deposits at SoFi bank grow by 23% sequentially from the previous quarter, to $15.7 billion.
"That source of funding allows us to be very nimble in what we decide to hold versus what we decide to sell," Noto explained. "It also allows us to be very nimble as it relates to loan purchases of SoFi loans and other opportunities that we have on deals over time."
What's next for SoFi stock?
With management so hyper-aware of both the effect of their fair-value accounting and of this year's impending rate cuts by the Federal Reserve, I would be shocked if SoFi wasn't already positioning itself to continue winning regardless of where interest rates are headed.
We can be fairly sure, then, that management will offer some clarity on the issue once again when SoFi releases its fourth-quarter 2023 results later this month. If the company can successfully appease Wall Street's concerns to that end, I suspect this pullback won't last long.
