Market Gives LendingClub Too Much Credit

In our view, lending is a transactional business in which participants must compete primarily on price.

The company's near-term growth is likely to remain strong, in our view, but we are skeptical that LendingClub will achieve the lofty expectations of the market. After reaching a high of $28 soon after its IPO, LendingClub's stock is down more than 50%. We've established a $12 fair value estimate under our baseline expectations, which could be cut in half in a downside scenario.

Success Is Measured in Origination Volume Characterized as a future disrupter of lending markets when it went public in late 2014, LendingClub draws upon the rise of the "sharing" economy, which seeks to supplant traditional business models considered to be outdated and inefficient. From LendingClub's point of view, banks and traditional lenders of capital represent an obsolete system for facilitating the flow of money from those with excess funds to those that have a productive use or need of money. Logically, it makes sense that, in today's world, a business no longer needs hundreds of physical locations and employees to serve this very transactional function as technology allows for greater automation of the process. With that said, we think banks will continue to hold advantages over the likes of LendingClub because they provide far more services than just loans and, as a result, benefit from customer switching costs that a pure lender can't duplicate. Money is just about the most commodified product there is, reducing competition to a price war that will drive LendingClub's margins lower over time.

LendingClub employs a simple business model that requires only a few primary functions. At a basic level, the company operates an online "marketplace" that matches borrowers with lenders. LendingClub earns a fee if a loan gets funded and earns recurring revenue through the servicing of those loans over time. In this regard, the company's main goal is to simply generate as much loan volume as it possibly can. Given that the goal is to maximize loan volume but the company is not exposed to losses on loans, we have concerns that LendingClub will be encouraged to continually loosen its credit standards to drive growth. However, LendingClub has a vested interest in originating quality loans as future revenue would be negatively affected by loan defaults--recurring servicing revenue ceases on defaulted loans--and a reputation for poor underwriting would sour loan investor interest, leading to fewer origination fees and a breakdown in the business model.

LendingClub's Origination Volume Began to Accelerate in 2012 LendingClub has been originating consumer loans since 2007, but it wasn't until 2012 that the company's growth began to accelerate. In 2011, $261 million of loans were originated on the LendingClub platform, an amount that shot up to $718 million in 2012 and $1.9 billion in 2013. In 2014, the year LendingClub became a public company, $3.5 billion of loans were originated on the platform. In our view, the large ramp-up is a function of several factors that separately influenced the investor base and the borrowing base. First, the loan investor pool expanded significantly in 2012 when the company began allowing investors to purchase whole loans versus only fractional interests in individual loans previously. This attracted institutional investors to the platform as it established the scale necessary for large investors to participate. Further attracting investors was that borrowing rates on the platform, and therefore the expected investor returns, were on the rise. For most credit grades established by LendingClub, interest rates peaked sometime during 2013.

While the expanded investor pool improved the company's potential to generate loan growth--without willing investors, zero loans would get funded--the demand side for LendingClub's loans was propelled by two important themes. First, the company introduced a 60-month loan offering in 2010, giving potential borrowers more financial flexibility than the 36-month loan already on offer. The second, in our view, is related to the risk aversion of traditional lenders. In 2010, one third of all loans originated by LendingClub were to borrowers with a FICO score below 700. By 2014, roughly two thirds of loans originated were to borrowers with sub-700 FICO scores. When you also consider that all of LendingClub's loans are unsecured and the majority are intended for debt consolidation, it's easy to understand why banks, most of which have been highly risk-averse since the financial crisis, were not competing for these borrowers. We're not suggesting that LendingClub is focusing only on subprime borrowers, simply that competition has been limited, something we don't believe will continue.

We've highlighted the factors of past growth because we don't believe, as some investors do, that the company's growth is a function of a network effect that will continue to inherently attract both borrowers and investors. In our view, lending is a highly transactional business in which participants must compete primarily on price. With that in mind, LendingClub faces a significant challenge in that it must compete for customers but also for investor capital, a disadvantage versus credit card companies that utilize internal capital and banks that can accept low-cost deposits. In addition to increased competition from traditional lenders, we expect new and existing online lenders will make it very difficult for LendingClub to achieve the sky-high expectations of the market.

Supply of Funds Will Be Affected by Expected Returns on Lending LendingClub hasn't had much trouble attracting lenders to its platform since the option to purchase whole loans was added in 2012, and rising borrowing rates through 2013 contributed to investor growth. However, we think the headwinds to investor growth are building. The company began a process of gradually lowering borrowing rates in 2013. While this serves to attract borrowers, it reduces the potential returns to investors and could hinder continued growth of the investor base. LendingClub's website provides some useful data regarding investor returns and shows that after 30 months, the average investor account has realized an annualized return of 7.4% after fees. This has proved attractive to income-hungry investors during the recent period of low market interest rates, but if LendingClub's rates continue to fall--as we expect they will--and market rates rise, the relative attractiveness of investing in the highly risky asset class of unsecured consumer credit will suffer.

An additional downward pressure to investor returns is that credit losses and late payments across LendingClub's loans are likely to rise, in our view. This isn't surprising or necessarily problematic, and expected defaults should be priced into headline borrowing rates, but a gradual decline in average FICO scores suggests that delinquency rates may rise. What is troubling, however, is that the deterioration of credit quality is somewhat veiled in the company's credit grading system, which assigns a proprietary credit grade to individual borrowers. The loan data supplied on LendingClub's website shows that FICO scores have consistently declined for several of the company's grading buckets. For instance, in 2011, a borrower with a FICO score of 715 would probably have been rated B2, whereas in 2014, a similar FICO score of 715 was likely to be rated three subgrades higher at A4.

We're also wary of the prevalence of repeat borrowers on the platform. Management recently revealed that nearly 30% of borrowers from previous years have returned to borrow again through the platform. This is good for LendingClub's bottom line because it lowers customer acquisition costs and leads to better margins, but we're unconvinced that the trend is exclusively positive. Almost 90% of loans generated in 2014 were for the purpose of debt consolidation, which suggests there are some returning borrowers who have now consolidated debt twice through LendingClub. If this is the case, many returning borrowers may simply be carrying too much debt and will eventually default.

This all means that historical delinquency data--which really shouldn't be used to project future losses but commonly is--reported by grade bucket will be a poor indicator of expected credit losses moving forward, in our view. If investors use these historical performance metrics as a basis to calculate expected returns on a new funding decision but later realize much lower returns, confidence in the platform could deteriorate. These problems could be masked for perhaps two years or more, because defaults typically do not occur early in the life of a loan. If it does happen, LendingClub could suffer reputational damage that would deter investors in the future.

LendingClub May Have to Reduce Origination Margins to Attract More Borrowers Under a true peer-to-peer lending platform, LendingClub would always have been forced to compete for investor dollars to expand its lending operation. While the company's not abandoning the peer-to-peer model, the platform will perhaps become less significant compared with its custom loan program--loans not offered on its marketplace platform--that will be fueled by strategic partnerships with large-scale potential. The company has lined up partnership agreements with third parties primarily as a way to funnel borrowers to the platform, but they also provide a stable source of investor funds.

Borrower acquisition costs have been one of the company's largest expenses. In our view, LendingClub will have to lower origination costs on its loans as a part of attracting borrowers, but partnership agreements can be an important part of driving down marketing costs to limit margin pressures. In the case of its deal with BancAlliance, a national consortium of 200 community banks, potential borrowers are referred to LendingClub by the individual banks when a customer is looking for a personal loan. Many community banks have not been able to offer personal loans to their customers because of the cost to underwrite these loans and a lack of resources. With the partnership, community banks will generate modest revenue from referrals, but more important, it strengthens the customer relationship. Further, the banks will be able to invest in loans on the platform. Community banks have had difficulty gaining exposure to consumer credit in recent years, and the addition of consumer credit will increase portfolio diversification and improve interest income. LendingClub, meanwhile, gains access to the bank branch distribution channel at virtually no cost.

In 2014, LendingClub began its efforts to originate small-business loans, opening another avenue to drive loan growth. While the company allows any business borrowers to apply for loans, the matching of borrowers and lenders is different from its legacy operations. Small-business loans are not listed for investment on the retail platform and are only offered to a select group of investors. The strategy to pursue small-business lending pits LendingClub directly against major U.S. banks, but the company faces an uphill battle, in our view. Banks develop deep relationships with business clients by providing far more than financing, which increases customer switching costs. LendingClub only possesses the ability to serve borrowers with financing at this point. The presence of switching costs means LendingClub will not simply be able to wrestle market share from banks with modestly better rates. It might take significantly better rates to attract borrowers to make up for a business' lost convenience of consolidating its financial needs into one relationship.

LendingClub's most effective strategy to break into small-business lending may also involve partnerships; the company has already established deals with Google and Alibaba. With its Google deal, distribution and services partners of Google can apply for two-year loans of up to $600,000 to invest in growth initiatives. LendingClub will receive revenue to service the loans, but funding will be provided by Google. The deal with Alibaba is essentially a sales financing offering, in which U.S. small businesses would be able to apply for a line of credit for up to $300,000 to make payments to suppliers on Alibaba.com. These deals could prove to be highly profitable for LendingClub, as the built-in customer base with each of the partners virtually eliminates LendingClub's customer acquisition costs.

We think the partnership strategy is perhaps the best route for LendingClub to generate growth, but it doesn't ensure long-term success. As the company works to establish additional partnerships, it becomes increasingly reliant on third parties to drive business. Further, pricing power of the partners is likely to increase, in our view. LendingClub needs two things for its business to work: borrowers and capital. As designed, these requirements are fulfilled by the partner. This is why some in the lending industry have categorized LendingClub as "the pipes" that deliver capital, the real product in question. This notion is difficult to reject, in our view, and may actually overstate LendingClub's position. While actual pipelines can benefit from barriers to entry because of physical limitations, there are few barriers to compete in the lending "pipeline" business. With this in mind, we expect that LendingClub will be forced to sacrifice margin to its partners to maintain these deals, diluting the benefits of the strategy to LendingClub over time.

Marketplace and Online Lending Already Crowded With Competitors Until recently, LendingClub has not faced much competition. It gained notoriety as the fastest-growing company in peer-to-peer lending, fueling speculation that the efficiency of its technology-driven distribution channel will eventually disrupt traditional lending markets. But the company's real niche, and part of the reason for its low-cost model, has been a focus on personal loans for borrowers who have been locked out of traditional credit markets. These types of loans are fairly standardized, allowing for automation of the lending process. LendingClub proved that the simplicity of its online model makes this lending category much more profitable, which has attracted a host of new entrants. It will encourage major banks to get involved as well.

Central to the thesis that banks will lose share to marketplace lenders is the superior efficiency of the online and largely automated businesses model because it doesn't require considerable overhead costs in branches and head count. This is a misguided comparison, in our view. We expect several major banks to invest in the creation of an online distribution channel for personal loans that is separate from its traditional origination process. The largest banks in the United States have significant capital to spend in this effort, and we expect these offerings to be highly competitive as a result. While Goldman Sachs is the only major bank to date that has been even rumored to be developing an online process, we anticipate others to follow suit, particularly given the increasing trend toward mobile and low-touch banking products and services by all of the largest banks.

Borrowing Rates Will Fall, Hurting LendingClub's Investor Base Following the financial crisis, many willing borrowers have found it difficult to secure personal credit. To reduce risk, banks shied away from less-safe types of lending like unsecured consumer loans or small-business loans to unseasoned companies. As a part of that process, riskier borrowers turned to credit cards to finance purchases, sometimes at burdensome interest rates. The lack of supply for personal loans left a gap for LendingClub to attract borrowers on the premise that it could provide lower rates than traditional credit cards. It is true that LendingClub's actual rates are lower for some borrowers; however, total borrowing costs are not always lower. Two primary factors limit LendingClub from being able to lower rates to gain a cost advantage, in our view. First, there will be a constant pull from the loan investor side to keep rates high. Second, we don't believe LendingClub has a cost advantage over its lending peers to be able to undercut them on price. While LendingClub's technology-driven origination process is more efficient than a bank with the expense of physical branches, LendingClub provides only lending services, and therefore, customer (borrower) switching costs are effectively zero. Meanwhile, banks have a wide breadth of products and services on offer to spread these costs and a loyal customer base for cross-selling opportunities. With LendingClub's elevated customer acquisition costs, which amounted to nearly 3% of originated loan balances and 63% of origination revenue in 2014, the company will be forced to accept lower margins to attract borrowers with lower rates, in our view.

To provide context, we evaluate the estimated costs of a $10,000, 36-month loan through LendingClub versus the costs to finance a $10,000 purchase with a credit card, a promotional balance transfer with a credit card, or a personal loan through a credit card company such as Discover. Our analysis is driven by our assumption of credit card interest rates that borrowers in the A-D LendingClub credit groupings may be able to find. Although it appears that borrowing through LendingClub may be cheaper than simply using a credit card for high-quality borrowers, it does not necessarily provide significantly reduced costs for lower-quality borrowers because of a relatively large origination fee of 4%-5% imposed on any non-A rated borrowers. At the same time, even A rated borrowers may have less costly options. Using credit cards would be cheaper for borrowers who have an ability to transfer balances to new or existing cards at promotional APR rates. Considering that in 2014, 62% of LendingClub borrowers had more unused revolving credit balances than the size of their loans, this could be a viable option, though does carry risks. Further, high-quality borrowers may have the ability to put up collateral to back a loan for cheaper rates. Of LendingClub's A graded borrowers in 2014, 65% listed themselves as homeowners or had a mortgage. Assuming that these borrowers have available equity in their home to borrow against, a home equity loan or line of credit would almost certainly be a cheaper option than borrowing through LendingClub. A simple search for HELOC loan pricing on Bankrate.com suggests borrowers could find rates below 5% with low-cost origination fees.

Since we view lending as a transactional business driven by price, the existence of cheaper alternatives versus LendingClub leads us to believe that the platform is primarily attractive only to consumers with limited access to traditional credit markets. Over 80% of loans in 2014 were for debt consolidation purposes, strengthening this interpretation. If credit availability is indeed a major driver of LendingClub's customer base, the leadership should be moderately concerned that the company's addressable market is shrinking. According to data from the New York Fed, average FICO scores across the country have risen from 689 in 2010 to 699 at the end of March 2015, suggesting that fewer consumers will face the problem of being locked out in coming years. With this in mind, along with our expectation for increased competition to serve the credit-strained population, we expect LendingClub will have to sacrifice margin to reduce borrowing costs and drive origination volume. We believe there is little room to simply reduce rates at the cost of investors, because it would reduce the appeal to fund loans.

Market's Expectations Too High LendingClub's revenue is tied primarily to volume, and thus our loan origination and margin forecasts are the primary driver of valuation. While we expect LendingClub to generate healthy profit margins and solid returns on invested capital within a few years, we believe growth expectations are too great, leading to an overvalued stock. And even though we anticipate continually impressive growth over the next three to four years, we remain skeptical that LendingClub will cause long-term disruption. Our valuation focuses on the long-term opportunity for LendingClub, but we're highlighting intermediate-term assumptions in 2019 as a basis for when we expect the rapid growth of the company's early years will begin to fade toward more normalized levels.

Near-term growth will be fueled by partnerships aimed at small-business lending, a key component of our forecast for origination volume to reach $31 billion in 2019, up from over $4 billion in 2014 and an expected $8 billion in 2015. For perspective, this translates to a roughly 25-basis-point share of the current small-business lending market and 40 basis points of market share of the current consumer credit industry. In 2014, the company's origination margins were 4.5% of loan volume, but we believe increased competition will pressure margins lower to 2.5% by 2019 before leveling off just north of 2% in the long term. Our volume forecasts provide the basis for the servicing book and therefore servicing revenue. Under our base-case assumptions, LendingClub's servicing book may reach $45 billion by the end of 2018, up from just $3.5 billion to end 2014, and servicing margins should rise to 0.6% of total loans in that year before receding just a few basis points in the long term. Put in context, this is an expansion from 0.4% in 2014, but this metric is skewed downward because of rapid loan growth. Given these assumptions, our revenue forecast crosses over $1 billion for 2019.

LendingClub's competitive position is defined by the operational leverage that can be created by scaling up its business. LendingClub's underwriting costs may be low compared with traditional lenders, but the company's high customer acquisition costs thwart a sustainable cost advantage from developing, in our view. We estimate that LendingClub spent roughly $250 on marketing and sales for every loan that was originated on its marketplace platform in 2014, which equates to 2% of loan balances originated in that year. Add in servicing costs of the business, and LendingClub's production costs as a percentage of originated loans equated to 3% in 2014. We think these costs can fall to below 2% in 2019 with increased scale, ultimately falling further to 1% over a long-term outlook. Using a discounted free cash flow valuation model and a 9% estimated cost of capital--the company has no debt--we arrive at a $12 fair value estimate for LendingClub.

Our fair value uncertainty rating is set at very high due to what we view as a wide range of possible growth outcomes. A potentially large divergence from our base-case set of assumptions could drive our fair value estimate as high as $22 per share and as low as $7.50 per share.