This is it. This is the moment we've all been waiting for. After thousands of years, a new company has emerged that promises to revolutionize lending. Banks are to this company as Blockbuster Video is to Netflix.
Well, that's the story anyway.
The investor relations department of Lending Club (NYSE:LC) had been working overtime the past few months, diligently building the case as the young company prepared to go public. I see things a little bit differently though, and if I'm right, this could get pretty ugly for investors.
Lending Club is definitely on a hot streak
The company, which IPO'd earlier this month, is currently riding high as the next big thing in finance. The stock is up more than 15% since the IPO, riding some smoking-hot growth, and even hotter investor excitement.
In the company's IPO filings with the SEC, it reported that total assets have grown from $1.9 billion at December 31, 2013, to more than $2.8 billion at September 30, 2014. That's a 47% jump in just nine short months.
Compare that to barely 1% growth at Bank of America (NYSE:BAC) and 7.2% growth at Wells Fargo (NYSE:WFC). The banking industry, as a whole, has only seen about 5% annual growth during the past few quarters.
That is a lot of growth, and if the long-term promise is true -- and I am wrong -- then it makes sense for Lending Club to trade at a steep premium. It's all about the upside, right? Let's dig in.
What exactly does Lending Club do?
Lending Club is an online service that functions like a self-service loan platform. Potential borrowers log into the site, apply for a loan, and wait. Lending Club underwrites the loan, assigns a credit risk grade, and then prices the loan with a standardized, risk-based system. Other individuals looking for a better-than-bank-deposit yield on their cash can fund the loans for the borrowers, and voila, we have a loan.
Lending Club is the middle man between those in the community with cash and those in need of cash in the form of loans. Lending Club makes its money by taking a fee in the process.
Lending Club claims that the company is not a bank; it's a technology company, they say. But doesn't that business model sound awfully similar to a bank?
Depositors give their cash to the bank, the bank then makes loans using that cash, and pockets the difference in interest rates. The two models are strikingly similar, if not six of one and half a dozen of the other.
Valued as a lender, Lending Club looks expensive
Bear with me for a moment for some back-of-the-envelope math as it relates to Lending Club's current valuation. We'll use the price-to-book ratio, which is the most common metric used for valuing banks.
As of September 30, 2014, Lending Club reported a book value of $141 million. The company sold all of the available shares in the IPO, raising about $1 billion in total. Of that billion, about $800 million, give or take, will net to the company after fees, commissions, and other related expenses. Of that, about $50 million will be used to pay off an existing term loan on the company's balance sheet.
That leaves approximately $750 million to be used to add capital into the company, plus the $141 million of existing book value. The company's new book value is somewhere near $900 million post-IPO. The company's market cap, as of the time of this writing, is $1.65 billion, for an approximate price-to-book value of 1.8 times.
For banks, a price-to-book ratio above two is generally considered expensive, and below one is generally considered to be cheap. Wells Fargo trades at 1.7 times price to book. M&T Bank trades at 1.4 times.
Lending Club reported a net loss of about $25 million for the nine months ending Sept. 30. Does a lending company with net losses deserve a valuation that high? Does this company warrant a trading multiple more than twice Bank of America's 0.8 times? More than Wells Fargo and M&T, two top-notch firms?
Are we really comfortable with the idea that this upstart will do a better job matching deposits to loans than these established, FDIC-insured, and regulated institutions?
One key difference between banks and this new model, per Lending Club, is that Lending Club doesn't take on any credit risk. All of that risk is assumed by the investors who actually fund the loans -- that's everyday people like you or me. Think about that for a moment.
What happens when there's a rash of loan defaults? The credit cycle will eventually turn sour again; that's a fact of life. What happens to all those willing investors when loans fail to repay on time and there is no FDIC insurance protecting their cash? Credit risk may not be a direct risk to Lending Club, but it is clearly still a risk, even if an indirect one.
Or what happens to this revolutionary business model when the Consumer Financial Protection Bureau decides that all these willing investors were not properly informed of the risks inherent to these loans? That's a very possible scenario with very dire consequences for Lending Club. How many billions of dollars are on the line for Lending Club if their compliance program is not perfectly written and executed. In fact, the CFPB already has an ongoing investigation into potentially unlawful marketing, issuance, and servicing of loans for healthcare-related financing.
I may be wrong about this. Lending Club may prove itself to be an ingenious and revolutionary platform. Or more likely still, Lending Club could prove to be a very profitable, yet not-quite-revolutionary success story. I think the latter is likely.
However, as it stands today, I think that this is a company that still has a whole lot to prove, and a valuation that fails to build in the risk that the company could fail in its grandiose ambitions. Investors beware... at least for now.