OnDeck Capital Inc (NYSE: ONDK)

01/03/2017

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Company Overview:

OnDeck is the leading online platform for small business lending. OnDeck is transforming small business lending by making it more efficient and more convenient for small businesses to access capital. The company’s proprietary credit underwriting approach with the OnDeck Score® coupled with an online focus enables immediate lending decisions with same day funding. In comparison, traditional banks often take weeks to review, approve, and fund a loan, but most of the time won’t even consider lending to a small business.

Investment Conclusion:

Our favorable outlook for the business considers: (i) a sizeable addressable market opportunity; (ii) the value of the proprietary OnDeck Score®; (iii) future opportunity for white label partnerships, as seen with JP Morgan; (iv) the emerging strategic partnership channel opening up the mass market; (v) room for international expansion; (vi) greater credit stability than many appreciate; and (vii) the inflection point for positive EBITDA quickly approaching.

We value OnDeck’s stock to be worth at least $8 per share, which represents 70% upside from current levels. OnDeck currently trades for 1.2x 3Q’16 book value of $4.00 versus many traditional banks that trade for >2.0x. However, OnDeck is growing loans at an annual clip of >75% versus the traditional banks who are struggling to deliver growth of just low-single digits. Moreover, the white label agreement between OnDeck and JP Morgan confirms there is tremendous interest and value in the proprietary OnDeck Score®, which we think could lead to OnDeck being acquired by a large financial technology vendor near the IPO price of $20 per share.

 

 

Investment Highlights:

(i) A sizeable addressable market opportunity. OnDeck currently caters to only ~40,000 of ~28 million small businesses in the United States. Its 3Q’16 ending loan balance under management was just ~$1.1 billion, compared to (1) ~$180 billion of addressable opportunity for all outstanding business loans under $250,000, according to FDIC statistics; and (2) another estimated ~$80-$120 billion of addressable opportunity for traditionally unmet demand. We believe OnDeck is well positioned to continue taking market share from traditional bank channels due to its superior funding speed. The company is also well positioned to continue capturing previously unmet loan demand due to its advanced underwriting methods, in our view.

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(ii) The value of the proprietary OnDeck Score®. The OnDeck Score is a breakthrough credit scoring system for Main Street businesses based on 100+ external data sources, a proprietary database of 10+ million small businesses, and 2,000+ data points per application. OnDeck’s analysis indicates that the fifth generation score is “85% more accurate” at predicting bad credit risk in small businesses across a range of credit risk profiles. As a result, OnDeck is able to lend more money more frequently to small businesses, compared to traditional lenders who compensate for limited analytical models through more restrictive underwriting.

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(iii) Future opportunity for white label partnerships, as seen with JP Morgan. Following comments from JP Morgan Chase CEO Jamie Dimon at a financial institutions forum at the U.S. Treasury regarding a partnership with a “peer-to-peer” lender, OnDeck confirmed in an 8K filing that it has entered into a strategic partnership with the global bank. The new agreement is essentially a technology licensing arrangement, whereby JP Morgan will license the white-labeled credit scoring and underwriting technology from OnDeck and will retain all loans on the bank’s balance sheet. Further, lending will be aimed at the current small business borrower profile at JP Morgan. This is not an effort for JP Morgan to move down-market to more risky loans.

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(iv) The emerging strategic partnership channel opening up the mass market. The world’s most trusted banks, payment processors, and small business focused service providers are increasingly re-selling the OnDeck platform. Strategic partners provide OnDeck with an avenue into the mass market via access to large pools of established small businesses. For example, in May 2014, BBVA Compass established a referral arrangement with OnDeck to better serve the bank’s small business customers who are looking for access to credit. In April 2015, Angie’s List teamed with OnDeck to connect 1.3+ million service providers with access to capital. The strategic partnership channel represented 14% of new loans in 2014 versus only 8% in 2012, as unit volume increased nearly 8x to 3,870 loans over the period.

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(v) Room for international expansion. OnDeck’s international expansion strategy targets markets that possess reliable data, credit, and payment infrastructure, significant unmet demand, and a predisposition to the online channel. OnDeck started providing loans in Canada in 2Q14 and, more recently, announced the joint venture OnDeck Australia (55% owned by ONDK, 30% owned by MYOB, and 15% owned by a local group) to target ~$33 billion of loans under $410,000 in the region. In addition to further geographic expansion opportunities in Europe and Latin America, we also see emerging opportunities for OnDeck to expand deeper into existing geographies through new loan categories, such as equipment leasing or developing a strategy to monetize the OnDeck Score.

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(vi) Greater credit stability than many appreciate. On the most recent earnings call, credit trends spooked investors. Management’s qualitative commentary suggested no macro signs of emerging credit stress and it believes loss rates were performing in line with the expected range. Further, and generally consistent with 3Q reporting by other unsecured consumer lenders, the company noted that sequentially rising delinquency rate and loss rates were just the result of normalization from historically low levels and portfolio seasoning. So where’s the mixed message? The results included a $5 million provision build to reserve for greater than expected losses on existing term loans, which are experiencing higher than expected delinquency roll rates. Management says the issue is related to lower cure rates of late-stage delinquencies as opposed to an absolute increase in the delinquency rate. So we see no flashing red lights on the credit front. And what most people don’t appreciate is that the loan structure with 3-24 month terms is so short in a down cycle the loan portfolio will benefit greatly from the structure of short duration.

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(vii) The inflection point for positive EBITDA quickly approaching. The company has not backed away from its June Analyst Day forecast of achieving positive Adjusted EBITDA in 2017 (back-end weighted) and an adjusted operating yield of 1-3% by 4Q17. Based on the improvements in operating leverage we are seeing in custom acquisition costs and the stabilization in yields, OnDeck appears to be well positioned to become profitable sooner than it is targeting.

Key Risks:

(i) Competition from other online lenders. Kabbage and CAN Capital are the primary online competitors. Though other online lenders like Lending Club and Prosper are also considered in the peer group. The key distinction is that OnDeck fund’s part of its own loan originations with capital from its balance sheet. In contrast, Lending Club and Prosper are originate to sell business models where third party capital is needed to fund the loan.

The good news is that the frothy competitive environment for online small business lending, which seemed to reach a fever pitch in late 2015 and into 2016, seems to be easing as funding for marginal players has dried up. We have anecdotally been noticing a steep drop in radio advertisements over the past six months and the company claims it is seeing more application volume as a result. How has this translated into recent performance? First, effective interest yield (EIY), a measure of average pricing, is declining at a less rapid rate versus the previous six quarters. Notwithstanding nuances around channel mix and underwriting, it seems as though price competition is abating. Second, originations grew at an impressive 27% rate (albeit below our aggressive 39% forecast) and the company is seeing improved application flows. Lastly, Sales & Marketing expense has been flat each quarter this year, yet is driving sequential improvements in origination volumes.

Kabbage is the key competitor to keep an eye on, in our view. Kabbage completed another round of fundraising not long ago for $135 million. The round, which increased its total financing to over $240 million, was led by Reverence Capital Partners, ING, Santander InnoVentures, and Scotiabank. In addition, Kabbage expanded its credit facility from roughly $300 million to over $900 million. According to Kabbage’s press release and interviews, a considerable portion of the new capital will actually be deployed toward building out the company’s consumer lending platform (Karrot) and expanding internationally. The company announced a partnership with ING to launch its platform throughout Spain. With annual origination volume now exceeding $1 billion, Kabbage has less than one-half the expected volume of OnDeck, but it has been marketing aggressively and is also taking a leading role in licensing its underwriting technology.

(ii) Emerging competition. Several investors specifically are asking about whether Square Capital and PayPal Credit are emerging as threats. In both cases, the company commented that it does not run across these businesses. Both Square and PayPal are typically advancing much smaller loan amounts to smaller businesses, and in the case of Square, it is really not performing underwriting; the advances are determined more on the basis of historical credit and debit card transactional data. PayPal merchants are overwhelmingly online businesses and OnDeck is typically lending to a traditional brick-and-mortar business.

(iii) Permanent capital. The originate to sell business models of Lending Club and Prosper are under much scrutiny, which is spilling over to OnDeck as the company partially funds its loans through third party capital. The concern is over the reliance on third party capital, since should we see a down turn in economic activity or the credit cycle then we could see third party capital flows dry up, in turn hampering growth for businesses depending upon them.

Many are already speculating there will be a shake-out at some point in the not too distant future. In fact, we have seen this occur in online consumer lending in the UK and to a lesser extent in the US, so we expect a similar pattern to play out among small business lenders. The good news is that OnDeck is considered to be one of the larger, well-capitalized companies that can weather a storm. In fact, OnDeck notes that it is increasingly being asked to look at other platforms that may now be looking for an exit. 

While OnDeck’s business model as a direct lender is distinct from marketplace operations such as Lending Club and Prosper, the company nevertheless continues to find itself partially reliant upon funding sources that could only be characterized as “transient”. That said, management has recently been more vocal about this recognition of the risks and working to address them. The company’s exposure to Jefferies Capital and the steep premiums it was earning on loan sales put its earnings guidance at risk and this came to pass after the pullback in “marketplace” originations in 1Q16. In hindsight, the company suggests that it became overly exposed to one purchaser and we believe its scaled-back origination and loan sale targets for 2016 reflect more than just a cooling off for this channel. We believe the company is intent on building a funding model that is more predictable and durable for investors. In addition to its expectation of becoming a more regular securitizer, OnDeck currently has five warehouse lines in place (with Deutsche Bank, BofA, SunTrust, Jefferies, and Waterfall Capital) that are short-term commitments (one year). It sounded like a clear priority is to ultimately renegotiate longer-term facilities.