October 26, 2020

Despite Cost Controls, LendingClub Is Still A Shrinking Business (NYSE:LC)

Once a fintech darling that was called one of the most innovative tech companies to revolutionize consumer finance, LendingClub (LC) has taken a stark fall from grace this year. Already struggling with slowing investor demand before the pandemic, LendingClub got hit hard by a spike in defaults (largely expected across the industry, as smaller lenders like LendingClub and the biggest banks in the U.S. both got hit hard) and suffered a further capital flight from the investors that drive LendingClub’s business.

In its private days, LendingClub was once worth up to $3.8 billion. With shares down ~70% year to date, LendingClub’s ~$320 million market cap is now only a shadow of what it was once worth in the past.

Data by YCharts

It’s fair to say, in my view, that LendingClub is shrinking – not just from a valuation perspective, but also in the scope of its business. We’ll take you through the most recent quarterly results shortly, but the high-level themes are this:

  • LendingClub’s originations are cranking to a near-halt, though originations at one point made up ~80% of LendingClub’s overall revneue
  • The company has been reduced to relying on servicing fees. These are loans that are off the company’s own books, but because borrowers still use LendingClub as the conduit to manage and pay their loans, LendingClub collects a small (~30bps) fee.

In recognition that investor demand is weak and that LendingClub has to rely almost exclusively on servicing revenues to sustain itself, the company has done a good job at slashing expenses and preserving liquidity.

So the bottom line on LendingClub is this: while LendingClub’s emergency reactions to maintain liquidity mean that there is no near-term risk of a flameout in this company, neither do we see a path to normalization. Servicing can’t be the entirety of this company forever – as loans retire/borrowers default, the portfolio will shrink and LendingClub will have to turn on the originations machine again, if it can win back investors’ trust. With no signals that this will happen in the near future, I’m still content to sit this stock out from the sidelines.

The good news: for the moment, LendingClub is solvent

Let’s at least start with some of the good news: liquidity maintenance and cost cuts.

Despite a challenging Q2 with near-zero revenue, LendingClub managed to enforce its cost cuts, hitting its target of reducing operating expenses by ~$70 million (versus Q4, which LendingClub refers to as its last non-pandemic quarter) by virtually cutting all marketing expenses, reducing discretionary spending, reining in its real estate footprint, cutting 460 employees out of the workforce, and reducing compensation for senior executives, the CEO, and board members.

We can see the impacts of these cost cuts in the charts below. Origination and servicing costs, plus sales and marketing costs (which for LendingClub can be thought of the “cost of goods sold” that are netted out pre-gross margin) have fallen to $22.5 million in Q2, a ~$46 million sequential reduction and a ~$65 million reduction from Q4.

Figure 1. LendingClub cost trends

Source: LendingClub Q2 earnings deck

Likewise, LendingClub’s cash operating costs (excluding stock comp, depreciation/amortization, and other non-cash/one-time items) benefited from the company’s headcount reduction and salary cuts, and these operating expenses are down ~$11 million sequentially and ~$13 million from Q4 to $49.0 million.

Figure 2. LendingClub operating cost trends

Source: LendingClub Q2 earnings deck

So despite revenue pressure, LendingClub managed to preserve its liquidity. As of the end of Q2, LendingClub calculates its liquidity at $554 million versus $550 million as of the end of Q1. I’d also consider this asset mix to be of a higher quality than in Q1, because the company managed to reduce its loans held for sale by ~$50 million and pump more into cash and cash equivalents.

Figure 3. LendingClub Q2 liquidity walkSource: LendingClub Q2 earnings deck

So the bottom line here: with about ~$71.5 million in combined cash costs (add up $22.5 million of origination/servicing sales and marketing costs from the first chart, to $49.0 million of operating costs in the second chart), LendingClub’s ~$554 million in liquidity leaves it in a good position to weather the current crisis.

The bad news: the business is shrinking

These stringent cost cuts, however, were a stark necessity when the business is completely shrinking.

As you can see in the chart below, LendingClub originated only $326 million in new loans in Q2 – a 90% y/y reduction versus $3.13 billion in 2Q19. As I mentioned previously, originations used to be the primary driver for the business, with total transactional revenues making up ~80% of the company’s overall revenue.

Figure 4. LendingClub originations trends

Source: LendingClub Q2 earnings deck

We can attribute the originations decline both to internal and external factors. Recognizing that credit quality was of the utmost importance, LendingClub itself stopped originating to its most speculative segment of borrowers, and the average LendingClub borrower now has a FICO score of 721 and annual income of ~$108k, a substantial improvement versus 708/$93k in 2019.

But at the same time, LendingClub has also seen a capital flight from institutional money, which finances the loans it originates. You can see in the chart below that institutional investors, which historically have provided ~20% of LendingClub’s loan funding, has completely exited the picture in Q2. And while the chart below suggests that banks have taken a heavier hand in LendingClub’s originations, note that the mix-based chart below doesn’t take volumes into account. Banks’ 68% share of $326 million in Q2 originations is still only ~$222 million, versus 45% of $3.13 billion last year amounting to a much bigger $1.41 billion contribution from banks.

Figure 5. LendingClub investor mix

Source: LendingClub Q2 earnings deck

Scott Sanborn, LendingClub’s CEO, noted that investors are slowly coming back to the table – but as can be seen from the originations trends above, normalization is still a long ways off. A bit more context from Sanborn’s prepared remarks on the Q2 earnings call:

The returns that we are expecting to deliver is slowly bringing investors back to the platform, albeit at a reduced volume with the first ones to return being those with their own strong views on credit. That includes companies who build businesses and credit models focused on marketplace investing. We expect all of our investors to be closely watching the performance of new vintages to our higher-quality member base manifest over the next few months and we anticipate that this future book will provide attractive risk-adjusted returns for a broad range of investors, including for LendingClub as we become a bank and buy loans on the same basis as our current platform investors.”

The prime issue here is that LendingClub is expecting its pre-COVID loan “vintages” to return only ~3%, which is barely above government/high-grade corporate bonds – far from enough to compensate investors for the risk associated with unsecured personal loans.

So for now, LendingClub has been reduced to relying on its servicing portfolio. Servicing drove $44.4 million of adjusted revenue in Q2, or about ~60% of the company’s ongoing expenses. That’s fine for now, but note that LendingClub’s servicing portfolio is shrinking, down -6% y/y in Q2 (the first time over the past year that the portfolio has shrunk).

Figure 6. LendingClub servicing trendsSource: LendingClub Q2 earnings deck

Turnover is rapid in LendingClub loans, especially in a time with frequent borrower defaults. It’s clear here that even with servicing fees providing the bulk of LendingClub’s current revenue, LendingClub will need to stimulate new originations demand in order to keep the portfolio afloat.

Key takeaways

LendingClub is a very messy business right now, especially as the company plows ahead with its acquisition of Radius Bank in the attempt to become a bank and collect deposits to finance its loans. Given the uncertainty as well as sharply lower originations trends, I’m still content to stay out of LendingClub.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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