Today Lending Club disclosed an interest rate change. Compared to the previous rates, it’s a relatively large adjustment to the risky grades. This is to address the higher-than-average default rates we’ve seen in the D and E grade loans. It’s refreshing to see that Lending Club is adjusting the rates according to default rate changes so quickly to balance risks. Here’s how the new interest rates stack against the previous ones:
Lending Club opened 14 new states to retail investors in 2015, which made the platform available to over 92 million Americans (+29% of the U.S. population). The biggest states were Texas and Michigan. This was in the works since the company went IPO in late 2014, which made it easier to open up new states for investors in its platform.
When we rank all the newly eligible states by population, it’s clear that Lending Club pushed for making their platform available to the everyone. The remaining states that are not yet eligible are (in order of population rank): Pennsylvania, Ohio, North Carolina, Maryland, New Mexico, North Dakota, and Alaska.
To sum it up, Lending Club now has 43 eligible investor states, covering over 276 million people (86% of the U.S. population), up from 201 million people a year ago.
Lending Club increased interest rates just days after the Fed raised the Fed Funds rate by 0.25%, being one of the first in the industry to do so. However, an environment with interest rate hikes is foreign to P2P investors and many of us have questions on its implications. Here are our thoughts from a few angles:
Loan Interest Rates
We expect interest rates to rise inline with, and promptly after, future Fed rate hikes. Since Lending Club also adjust interest rates periodically based on market conditions and model changes, they will likely piggy back a Fed rate hike to make the net changes. However, do not expect the rate adjustment to benefit every grade level by the same amount. For example, our most recent Fed rate hike and Lending Club rate adjustment had a weighted interest rate change of 0.25% across all of its loan grades, but the changes were mostly in the mid- and high-risk grades. Lending Alpha’s strategies are expected to see a +0.23% to +0.46% interest rate increase for the latest adjustments, which a good thing:
Higher interest rates mean a higher cost of financing for new borrowers. We don’t expect interest rates to move up quickly, and any move will be gradual (+0.5% to +1% per year). The net impact to the borrower due to financing cost should be minimal due and would imply that it’s a small contributor to any increases in default rates.
Investor returns should increase due to the higher interest rates, especially those employing strategies that optimizes for rate changes over time (like Lending Alpha’s strategies). We could see default rates stabilizing in the near future, supported by an improving employment environment.
Lending Club Corporation
Lending Club generates the bulk of their revenue from loan originations and higher interest rates is negative to their business as cost of borrowing increases with the interest rates. Lending Club will continue to create new consumer loan products such as Direct Pay Loan to reach new population segments to continue growing their (personal loan) business.
Lending Club changed their interest rates again effective 5/13/2015. Here’s how it compares against the last change from February 2015:
Compared to the February 2015 interest rate changes, the May 2015 changes seem to focus on the extreme ends of the risk spectrum (A1-A4 and E2-G5). Here are some highlights:
- There were no changes to interest rates for A5-E1, as most of the adjustments last time (February 2015) were focused in that range.
- The A1 sub grade was adjusted down -0.61%, or 1/10th of the raw interest rate. There may be a goal to move the A1 sub-grade loans closer to the U.S. Prime rate + 1% after LendingClub’s investor fee (3.25% + 1.00% + 0.67% = 4.92%). A1 rates currently stands at 5.32%.
- For the high yield seekers who favored E and F grade loans, the rates were cut across the board by up to 1%
- However, at the extreme end of the grade scale, F5-G5 loans saw an increase in interest rates. Previously, F5 vs. G5 loans only had a 0.49% interest rate spread. Now, we see a 3.21% spread.
Finally, how does this impact the typical investor return on an annual basis? Nothing significant…a loss of 0.01%/year.
LendingClub (LC) reports earnings tomorrow after the market’s close as confirmed late last month, their first time ever since they IPOed on 12/15/2014. They will be hosting a webcast/conference call at 5:00pm EST (2:00pm PST) to discuss their financial performance for the period ending on December 31, 2014. Let’s look at three things:
1) Key Focus
The key focus will be on originations performance, which origination fees could make up the majority of their revenues (>90%), and how it is sustaining originations growth through competitive pressure from existing and new players in their markets. Recent institutional investor interest (for loans) in the platform leaves little to doubt that they have continued to enjoy significant growth in this space.
2) Recent Financial Results from OnDeck Capital
OnDeck (ONDK) reported earlier today and beat expectations (top and bottom line) and is up 5.3% during after-hours trading. OnDeck’s core business focuses on small business loans. LendingClub shares have been strong earlier today ahead of earnings, closing up +3.8% for the day at $23.78 and up +30% from the low two weeks ago of $18.30.
3) Recent Analyst Coverage
Finally, let’s review what analysts have published so far on the company since their IPO. Analyst 12-month market prices have been all over the place, from as low as $17.75 to as high as $31.00 per share. This could be because of LC’s disruptive business model forces analysts to reply heavily on scale-changing assumptions, which many are not comfortable doing just yet until the future as the company continues to execute their grand plans:
Here are select analyst comments from recent analyst coverage:
The Company has automated traditional bank-based lending functions to save time and money and develop better credit granting decisioning. As such, LC has developed a disruptive business model that poses a threat to the traditional banking industry, particularly in today’s low interest rate and regulatory environment
— FinTrust Brokerage Services
LendingClub is a classic online marketplace model. Growth in revenue and profits will come from growing both sides of the marketplace; efficiently acquiring high-quality borrowers while diversifying its investor base across individuals and institutions.
— Goldman Sachs
Overall, network effects have helped Lending Club grow significantly faster than its peers over the past few years to become the largest peer-to-peer lending marketplace in the world. Barring a material deterioration in loan performance, network effects should help Lending Club continue to be the leader in the category.
— Stifel Nicolaus
We note that LC’s attractive value proposition, in which the company takes advantage of much lower infrastructure costs than credit card-issuing banks to allow borrowers to reduce their borrowing costs by an average of 680bps, puts it in position to attract a significant portion of outstanding U.S. revolving consumer credit.
Withe the recent partnership with Alliance Partners, which controls over 200 community banks under BancAlliance, it gives LendingClub a business advantage. Here is my take on its implications:
- Lower and more stable borrower acquisition costs – The details of the partnership terms aren’t public, but I assume that LC is sharing some of the originations revenue with the Alliance. My guess would be up to half since that’s closer to the market average for borrower acquisition costs (50%* 5% fee * $15k avg. loan size = $375). This is a good deal since it’s increasingly competitive to acquire new borrowers given the new competitive environment. Prosper, up until very recently, were seeing losses because their borrower acquisition costs were higher than originations revenue. Also, the bread-and-butter borrower lead generation has been mostly using mailers (snail-mail solicitations), but with players aggressively coming into the game, this strategy will become ineffective in the long run (cost-benefit).
- Wider borrower network reach/more loan dollars/future opportunities – Partnerships generate 40% of Prosper’s new loans, so partnerships are a also big part of borrower lead generation. This is significantly more so for Small Business loans due to targeted solicitation costs. BancAlliance’s 200+ banks make up the 4th largest bank when measured by the number of branches/banking centers. This may be equivalent to $200-300 billion in customer assets. New community banks ($100M-$10B in assets) may also join the BancAlliance network and provide additional growth over time. Ultimately, this relationship allows LC to penetrate further in the consumer loan market share. It also sets them up for small business lending in the future through this ecosystem/existing partnership.
- More stable/institutional investor dollars – One of the harder things to do in marketplace lending is to find investors on the other side of the market. More importantly, institutional dollars have historically been fickle, but this type of partnership from a bank would be a more consistent provider of capital to fund loans. Many of the smaller marketplace lending platforms struggle because the lack of investor dollars, which hinders the borrower’s experience as loans don’t get funded. So, any large scale partnership that aids borrower acquisition probably will continue to be coupled with the other side to provide capital.
- Higher availability of riskier loans – Typically, banks as investors focus on investing on lower lower risk loans (grades AA, A, and B). This works out well for the other investors in LC’s marketplace because of an increase in availability of riskier loans (grades C, D, E, F/G). As of today, there’s a short supply of these loans for investors that I often see new loans in this tranche snatched up within 15 seconds of a new loan cycle.
- Small Banks are on LC’s Side – Though LC’s disrupting the traditional banking model, smaller community banks will side with LC because consumer lending has been a declining business for smaller banks against the big banks for over the last two decades. Smaller bank partnerships with LC offers a competitive advantage against the big banks in consumer lending, all while enjoying higher margins on both the originations and investing side of the transaction (due to LC’s business model efficiency) than their native consumer lending operations.
- Market share exclusivity – LC’s partnerships lock up potential partnerships from Prosper and other marketplace lenders in the future. This could translate to stronger market share retention (stickiness) and higher borrower acquisition costs for LC’s competitors.
Lending Club updated their interest rates earlier this week. In addition, they published the expected charge off rates per grade. Using the new interest rates, expected charge off rates, and loan grade distribution, we observe the following:
- The biggest investor squeeze measured by relative difference (Net Return Difference versus Previous Investor Net Return), A and B loans have the largest impact.
- Consistently, the investor squeeze affects grades A through F.
- Accounting with the origination distribution volume, the weighted investor net return impact is -0.37%. The platform’s weighted expected return is now at 7.10%, down from 7.46% per year.
- The investor squeeze theoretically will increase borrower demand due to lower rates, but it may also be a necessary move given the increasingly competitive refinancing options in the markets today (0% APR credit cards, competitor lending marketplaces, improving FICO scores).
From our perspective, if you invest using a taxable account and do not optimize and diversify your portfolio by focusing on a higher risk loans, the net returns may be inefficient. That’s where Lending Alpha’s services shine by generating higher net returns and a more efficient investor returns profile that makes this asset class a worthy consideration when evaluating where to invest your money.
Effective on February 4, 2015, Lending Club made changes to their interest rates across most sub-grades for consumer loans. The last time they made such a change was on October 29, 2014, which by most standards was not too long ago. What has changed? Here’s what we found:
- The largest relative changes were for low risk loans, sub-grades A3 through B5, where interest rates have fallen significantly relative to the total interest rate.
- Surprisingly, the interest rate for riskier loans from sub-grades D2 through D4 increased moderately by about 0.5%. The increase in interest rate is surprising given a relatively strong economic condition and 5 Yr U.S. Treasury Notes have fallen 0.3% since the last interest rate adjustment in October 29, 2014.
- Moderately lower interest rates of about 0.33% across the medium risk-grades C1 through D5. This change is not as surprising and has relatively small impact to net returns given the higher overall interest rates.
- Finally, there were no interest rate changes to sub-grades F1 through G5. Volume for this category has been pretty low and interest rate spread between these ten sub-grades is only 3% (2% between F2 and G5). We believe these two sub-grades will soon be consolidated into one subgrade in the future given the risk spread and the low volume of origination.
Correction: Removed assumption that LC lowered some of the interest rates because default rates are expected to be lowered. Based on their latest estimates of future charge offs, they are expecting it to be higher, thus this means that they’re squeezing the overall expected profitability from the investors in order to expand origination volume growth. More on the investor squeeze is available in the next post.
Credit Suisse published their stock analysis for LendingClub today. They initiated coverage a day after 5 other analysts at $24.00 per share and a Neutral rating while citing volatility. The current stock price is $19.49.
Published: 1/21/2015 | 12-mo Price Target: $24.00 | Rating: Neutral (Volatile)
Summary: LendingClub is a leading player in a nascent and large addressable market (consumer credit), which exhibits tranches of up to $1.2 trillion in TAM (total addressable market). They have built an infrastructure-light marketplace with network effects that allows growth and scale. They should continue to expand long-term margin from the 9% adjusted EBITDA margin in 2014 to the 40% margin in the long-term. The $24.00 target price valuation is based on discounted cash flows, using a 11% WACC and 3% terminal growth rate. Only valuation holds us back from a more favorable stance, as LC shares currently trade within 10% of our valuation.
Today marks the end of the quiet period for the LendingClub (LC) IPO. That means that LC’s IPO underwriters are now able to publish their analyst coverage of the company. From a high level, the major analysts on average are targeting $22.50/sh and a neutral rating, with upside potential in the long-term should LC is able to continue to execute their high-growth and industry-disruptive model.
Below is a summary from each analyst report since the inception of the stock as well as the link to download the full report. Current stock price: $22.06.
Latest Analyst Reports
Published: 1/20/2015 | 12-mo Price Target: $22.00 | Rating: Neutral
Summary: We are initiating coverage of LendingClub with a Neutral rating and $22, 12-month price target. LendingClub is an online peer-to-peer lending marketplace that connects individual and SMB borrowers to individual and institutional investors. While LendingClub has seen early success in developing an online marketplace for the large addressable market of US revolving consumer credit with the ability to grow the market and enter adjacent product categories, with the stock trading at 86X 2016E EV/EBITDA (16X EV/Sales, we believe this outsized growth is largely reflected in its valuation. Therefore, we initiate with a Neutral rating.
Published: 1/20/2015 | 12-mo Price Target: $22.00 | Rating: Equal-weight
Summary: Lending Club has leveraged technology to redefine the borrower and lender experience and establish itself as the leading marketplace lending platform. We see a significant runway for growth given a large addressable market, but valuation appears full at current levels. Initiate at EW with a $22 PT.
Published: 1/20/2015 | 12-mo Price Target: $23.00 | Rating: Hold
Summary: We are initiating coverage of LendingClub Corporation with a Hold rating and $23 fair value estimate. Lending Club is the world’s largest online peer-to-peer lending marketplace and matches borrowers and investors without taking on direct credit risk. In our view, the company has assembled a solid management team with a balance of technology and traditional underwriting and risk management expertise, and has demonstrated foresight in its young history in choosing its business model and in being proactive with regulators. While we believe the company has an attractive long-term opportunity, we remain on the sidelines given what we view as the company’s premium valuation.
Published: 1/20/2015 | 12-mo Price Target: N/A | Rating: Outperform
Summary: Lending Club is a clear leader addressing a large market opportunity in lending. The company has a high-growth model with scalable margins that is expected increase EBITDA margin from 9.1% in 2014 to 18.0% in 2016, though still below the long-term targeted EBITDA margin of more than 40%. It also continues to engage in multiple opportunities to address new market segments by leveraging their cost structure advantage versus traditional banks. These new segments could include the student and automible loans that make up a combined $2.3 trillion market. Moreover, Lending Club offers a disruptive platform that provides value to borrowers and investors. From a risk perspective, the company is subject to significantly more regulatory oversight than other Internet marketplace company, changes in investor demand during a rising interest rate environment, competition creating price pressure, and unforeseen challenges when entering new loan markets.
- Recent Default Rates Influenced by Two Sectors
- Interest Rate Change: +1% for Risky Grades
- Direct Pay Loans
- 2015 – A Big Year for Eligible Investor States
- Lending Club Raises Interest Rates by 0.25%
- New Investor States: Texas, Arizona, Arkansas, Iowa, and Oklahoma
- Interest Rate Changes – Sub-grade Analysis
- LendingClub Moving Office Across the Street
- LC Partnership with Citi and Varadero Capital
- Now Hiring: 90 Job Openings at LendingClub
- LendingClub (LC) Q414 and FY14 Earnings Results
- LendingClub Reports First Earnings Results Tomorrow
- LendingClub New IRA Account Promotion
- How the Partnership with BancAlliance Helps LendingClub
- Lending Club Partners with Alliance Partners
- Lending Club’s Investor Returns Squeeze
- Lending Club Interest Rate Changes
- LendingClub Analyst Coverage – Credit Suisse
- LendingClub Analyst Coverage and Price Targets
- Learn More About P2P Lending