OnDeck Capital (NYSE:ONDK) shareholders have been on a wild roller-coaster ride. The stock traded as high as $28 per share on the day of its December 2014 IPO, only to trade at half that price by mid-January. The price has since recovered to about $17 per share.
While investors can chalk up the company's rapid valuation swings to the market's moodiness, its share price volatility also reflects the difficulty of forecasting OnDeck's future.
What it does
OnDeck is in the business of making short-term loans to America's small businesses, with an amortization schedule most would never believe. While loans are generally paid back in monthly installments, OnDeck makes automatic daily or weekly deductions straight from its borrower's bank accounts.
In one documented example, an interested OnDeck customer was offered a $20,000 loan ($19,500 after fees) that he would repay via 125 daily payments. In total, the borrower would pay $24,000, an effective annual interest rate of 88% per year.
No two borrowers are the same, and the costs vary with the length and amount of the loan. But this is still a very expensive way to borrow. OnDeck reported that its entire loan portfolio generated an effective yield of 38.7% in the fourth quarter of 2014, multiples of what credit card lenders earn in net interest income on their loan books.
OnDeck's recent share price slump can be attributed to one analyst who turned bearish on the stock, suggesting it might be worth no more than $15.75 per share. Arguing the business is "more finance than tech," its loan growth, credit trends, and potential regulatory issues would be under investors' microscope of its investors.
He suggested that as a tech company, OnDeck could more easily justify a high valuation based solely on its revenue and growth rate. Financial stocks are rarely, if ever, valued based on multiples of revenue or their revenue growth rates.
Looking at the company as a financial business, it has much to prove. It suffers from adverse selection: Borrowing from OnDeck is a last resort to borrowing via lower-cost bank loans or credit cards. Naturally, with the core customer being a higher-risk borrower, loan losses will inevitably take a sizable share of loan originations.
We have a general idea of just how much OnDeck will lose with each loan deployed. In its annual report filed with the SEC, the company broke out loan performance by static pool, which shows how much of its loans were lost based on year of origination. Static pools have the quality of removing the impact of loan growth on credit metrics. (If a lender grows fast enough, newer performing loans will always dwarf underperforming loans, which take time to develop.)
Although this chart indicates loan losses are minimal relative to beefy loan yields, there are some caveats. In the same filing, OnDeck indirectly revealed that a hefty portion of originations are simply refinanced balances. Roughly 13.5% of OnDeck's loan volume in 2014 went to paying back an older loan at OnDeck, consistent with the 13% figure from 2013.
Alarm bells ring when lenders repeatedly refinance the debts of their existing borrowers. Any borrower can stay current on a loan so long as you lend him or her more and more money. Balances rolled over in 2014 represented 34% of 2013's originations. Just how many of its borrowers would be in default if not for OnDeck's willingness to lend them more money?
High refinancing volume also draws regulators' attention. One of the most compelling arguments the Consumer Financial Protection Bureau has levied against the similarly high-cost payday loan industry is that its borrowers never escape a cycle of borrowing just to repay old loans.
Alas, consumer protections and usury laws on interest rates typically apply to people, not businesses. But there is an argument to be made that a typical small business isn't that far removed from an individual, given that OnDeck has a policy of asking that borrowers personally guarantee their loans. If regulators target its lending terms, it would completely derail its business model. OnDeck currently competes with a small, fragmented collection of "merchant cash advance providers," which extend credit to borrowers who absolutely need the money. If it were to rise in the credit spectrum and lend to better risks at lower interest rates, the company would compete for business with traditional banks, no easy thing to do. Banks have access to cheap deposit funding; OnDeck does not.
What about the bull case?
It wouldn't be fair to ignore the bull case for online lenders, which rests largely on the idea that what happens today doesn't matter, but what happens in the future does.
Just as technology companies often burn through billions of dollars before earning a profit, OnDeck can follow a similar path. In due time, its rapid growth will provide it with sufficient data to find the borrowers with the best risk-vs.-reward characteristics. Its loan losses will drop, and it will find an equilibrium between how much it can charge and how much its borrowers can actually afford to pay.
Likewise, as it grows, its fixed costs will come down as a percentage of its loan book. And there is room to cut its variable costs, too -- while third-party funding advisors generated 56.4% of its loan volume in 2013, they generated only 41.4% in 2014.
Recent reports have suggested OnDeck is eliminating the role advisors play in making loans to repeat customers, contacting business owners directly. Advisors are allowed to mark up the cost of the loan by as much as 10 points, or 10% of the loan amount. OnDeck would prefer to put those fees in its pocket.
Investors must understand that OnDeck is very much a lottery-ticket type of stock. Many of its risks, particularly regulatory risks, are binary -- regulators will crack down or they won't. Likewise, the model of high-risk, high-return lending to small businesses will work, or it simply won't. In many ways, this is an untried business model in which OnDeck serves as a test case.
Nothing has fundamentally changed with the company since its IPO; investors are just recalibrating their expectations. The share price movements merely reflect investors' perception of the odds that OnDeck can be an enormously profitable lender to America's small businesses. For what it's worth, they're a little less optimistic today than they were at its IPO.