Take Out a Loan, Just Don’t Buy the Stocks

The Internet is supplanting taxi drivers, travel agents, and investment advisors. Why not bankers?

Online lending sites like Lending Club LC 2.183406113537118% LendingClub Corp. U.S.: NYSE USD18.72 0.4 2.183406113537118% /Date(1433538026494-0500)/ Volume (Delayed 15m) : 2519715 AFTER HOURS USD18.73 0.01 0.053418803418803416% Volume (Delayed 15m) : 32322 P/E Ratio N/A Market Cap 6969717737.51633 Dividend Yield N/A Rev. per Employee 771216 More quote details and news » and On Deck Capital ONDK 0.1342281879194631% On Deck Capital Inc. U.S.: NYSE USD14.92 0.02 0.1342281879194631% /Date(1433538123395-0500)/ Volume (Delayed 15m) : 230452 P/E Ratio N/A Market Cap 1037223443.41423 Dividend Yield N/A Rev. per Employee 356000 More quote details and news » are popping up everywhere—offering borrowers rates below those of banks and credit-card companies, with loan funds supplied by investors happy to earn more than banks pay for deposits these days. So far, these upstarts account for just a sliver of lending to consumers and small businesses, but their efficiency and growth have caught the attention of banking chiefs such as Jamie Dimon of JPMorgan, who alerted shareholders in his latest annual letter that “Silicon Valley is coming” to the lending industry.

Shares of the largest online lending outfit, San Francisco–based Lending Club (ticker: LC), quickly doubled from a December 2014 initial-public-offering price of $ 15 before settling back to a recent $ 18.40. Small-business lender On Deck (ONDK) debuted at $ 20 on the heels of Lending Club’s IPO. After a spurt to $ 29, the New York company’s stock now goes for $ 14.80.

But even at current prices, the two unprofitable online lenders trade at multiples typical of, well, Internet stocks. Lending Club’s market cap of $ 8 billion is nearly nine times its tangible book value and 13 times the average forecast for next year’s revenues, while On Deck’s billion-dollar valuation is 3.5 times book and three times next year’s revenue forecast. By way of comparison, house-hunting Website Zillow Z 1.935483870967742% Zillow Group Inc. Cl A U.S.: Nasdaq USD90.06 1.71 1.935483870967742% /Date(1433538000195-0500)/ Volume (Delayed 15m) : 1752797 AFTER HOURS USD90.02 -0.04 -0.04441483455474128% Volume (Delayed 15m) : P/E Ratio N/A Market Cap 5286922309.52399 Dividend Yield N/A Rev. per Employee 318455 More quote details and news » (Z) goes for six times the forecast for next year’s revenues, and credit-card lenders like Capital One Financial COF 2.103618223344152% Capital One Financial Corp. U.S.: NYSE USD84.94 1.75 2.103618223344152% /Date(1433538095251-0500)/ Volume (Delayed 15m) : 3936781 AFTER HOURS USD84.64 -0.3 -0.3531904874028726% Volume (Delayed 15m) : P/E Ratio 11.132372214941022 Market Cap 46413256847.959 Dividend Yield 1.8836825994819872% Rev. per Employee 523043 More quote details and news » (COF) and Discover Financial Services DFS 0.2407152682255846% Discover Financial Services U.S.: NYSE USD58.3 0.14 0.2407152682255846% /Date(1433538049933-0500)/ Volume (Delayed 15m) : 2389538 AFTER HOURS USD58.37 0.07 0.12006861063464837% Volume (Delayed 15m) : P/E Ratio 11.971252566735114 Market Cap 25798041447.0634 Dividend Yield 1.9210977701543739% Rev. per Employee 655424 More quote details and news » (DFS) trade at about twice tangible book.

In a world determined to use the Internet for everything but brain surgery, there’s headroom for this new industry to take some share of the existing markets for credit-card debt, small-business loans, and mortgages, which account for trillions of dollars in the U.S. “We plan to enable about $ 7.6 billion in loans this year,” says Lending Club CEO Renaud Laplanche. “That’s essentially as much as our past eight years combined.” Over time, Laplanche aims to offer a range of credit products, from auto loans to mortgages.

Even investors who don’t mind paying crazy multiples for a fast-growing Internet business like Lending Club should step to the sidelines as the IPO lockup—the period in which insiders agree not to sell their stock—expires for most shares on June 9. On Deck’s lockup expires on the 15th. As a well-run marketplace that earns fees for matching lenders with borrowers, Lending Club someday may settle down to a multiple like 25 times earnings that a sober investor would pay.

On Deck is a different business. Its profits come from using its own balance sheet to make risky, high-interest rate loans to small businesses. With rivals as large as Goldman Sachs gathering around these companies’ shallow high-tech moats, the competition for quality borrowers will make it tougher for On Deck to keep growing loan originations near a triple-digit pace without loosening underwriting standards. Even in today’s benign conditions, On Deck charges off more than 12% of its loans annually, while its yields on those risky loans have declined for nine straight quarters. It’s a subprime lender in dot-com clothing.

The “peer to peer” lending style of sites like Lending Club is analogous to Uber’s matching of independent drivers with riders. The marketplace assigns risk grades and interest rates to borrowers, based on a mostly computerized analysis of the borrowers’ online application, credit scores, and the marketplace’s own experience over thousands of similar loans. Individuals and institutions fund the loans by investing small or large amounts in portfolios of loans with the level of risk and return they desire. Thanks to the marketplace’s automation and the avoided cost of bank regulations and branch offices, borrowers can get lower interest rates, while investors can earn returns that beat those of a certificate of deposit. At Lending Club, for example, investors get 7% to 8%. Borrowers pay about 13% annually for a three-year loan to refinance credit-card debt that might have been costing them 15% to 18%. Turnaround time on a loan can be just hours.

A pure marketplace like Lending Club makes money by charging borrowers an origination fee of 1% to 5% of the loan amount and by charging investors a fee of about 1%. On Deck is a hybrid: It operates a marketplace but has made most of its money from the 50%-plus annualized rates it charged for its short-term loans to small businesses.

THE PEER-TO-PEER INDUSTRY got off the ground a decade ago, when Lending Club and its still-private rival, Prosper Marketplace, debuted, just in time to encounter the financial crisis. The early going was rough. In 2009, Prosper’s loan-default rates reached 30%, and it faced an SEC cease-and-desist action, alleging that by raising funds from small investors, Prosper was selling unregistered securities. A liquidity crunch forced Prosper to recapitalize and bring in new management. Now, it files shelf registrations with the SEC—just as Lending Club has from the start—and a recent round of venture financing valued it near $ 2 billion.

Those SEC registrations let Lending Club and Prosper deploy money from large and small investors in increments as tiny as $ 25. Other marketplaces raise lending capital only from institutions and accredited investors. In 2014, online lenders originated about $ 10 billion in consumer and small-business loans. The business has already lured lots of venture-backed start-ups, as well as incumbents like commercial financier CIT Group CIT 0.4287245444801715% CIT Group Inc. U.S.: NYSE USD46.85 0.2 0.4287245444801715% /Date(1433538039764-0500)/ Volume (Delayed 15m) : 711115 AFTER HOURS USD46.85 % Volume (Delayed 15m) : P/E Ratio 10.337371196575539 Market Cap 8154288844.2215 Dividend Yield 1.2806830309498398% Rev. per Employee 1071370 More quote details and news » (CIT) and Enova ENVA 1.942257217847769% Enova International Inc. U.S.: NYSE USD19.42 0.37 1.942257217847769% /Date(1433538123165-0500)/ Volume (Delayed 15m) : 135863 AFTER HOURS USD19.42 % Volume (Delayed 15m) : P/E Ratio N/A Market Cap 640860002.5177 Dividend Yield N/A Rev. per Employee 703594 More quote details and news » (ENVA), a spinoff from payday lender Cash America CSH 0.8267568583239384% Cash America International Inc. U.S.: NYSE USD26.83 0.22 0.8267568583239384% /Date(1433538122152-0500)/ Volume (Delayed 15m) : 135128 AFTER HOURS USD26.83 % Volume (Delayed 15m) : P/E Ratio 12.899038461538462 Market Cap 737234755.098114 Dividend Yield 0.7454342154304883% Rev. per Employee 231653 More quote details and news » (CSH).

Most Lending Club borrowers are consumers who take out term loans of less than $ 35,000 to consolidate credit-card debt, though the company has expanded into medical, educational, and small-business lending. Unlike On Deck, Lending Club takes no referrals from loan brokers—who stoked much of the past decade’s irresponsible lending. “We worry about the reputational risk that could come with brokers,” says Laplanche. “We are focused on developing our brand as being the good guys of banking.”

LENDING CLUB’S fee revenues doubled, year over year, in the March 2015 quarter, to $ 81 million, narrowing its operating loss to about $ 6 million, or two cents a share. Analysts generally don’t expect the company to turn the sort of profits recognizable under generally accepted accounting principles until 2017.

On Deck’s March-quarter revenue quadrupled to $ 28 million, after netting gross revenue for a hefty $ 28 million in loan-loss provisions and funding costs. Operating losses for the 2015 quarter were $ 5 million, or eight cents a share. Continuing a two-year decline, the annualized rate of return that On Deck achieved on its outstanding loans in the March quarter dropped to 36.7% from a March 2014 level of 41%. The average forecast calls for 20 cents in earnings next year.

Repeat customers accounted for half of On Deck’s loans in 2014, with more than a quarter of that repeat-loan volume going toward rolling an old loan over into a new loan. On Deck says it fully expects to encounter substantial charge-offs on this lending, but figures it can earn handsome yields for the risk. The company’s financial chief, Howard Katzenberg, said that On Deck is getting better all the time at risk-scoring its borrowers. Its loans last an average of 12 weeks, so Katzenberg said the company has been through 20 complete vintages since 2007.

In that time, On Deck has evaluated the credit of thousands of borrowers—about 30% of them in business for fewer than five years. No online lender gives details on individual borrowers, but two of On Deck’s borrowers show up in the SEC’s database of public-company filings. One is an unprofitable vendor of metal detectors with falling sales and negative shareholder equity. It borrowed from On Deck to pay off a loan from another online lender. The other publicly held On Deck borrower lost $ 7.5 million on $ 1.5 million in software sales last year, while spinning off a unit that has an idea for an inflatable refrigerator for college dorms.

Online lending holds promise, but investors should let the shares chill a bit.

E-mail: editors@barrons.com

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