Searching for the Priceline of Fintech after Lending Market Meltdown Week

You could have bought Priceline stock below $10 in 2001. For many years you had little to show for it. From then until 2008, you had some appreciation, but not much. Then the stock shot up above $1,000 (as of writing it is $1,261). Yes that is 100x return from a liquid public company! Could Ondeck ($ONDK) or Lending Club ($LC) be a similar story today? Or could one of the still private ventures such as Prosper, SOFI, Funding Circle and Kabbage seize the day?

Ondeck – first in, maybe first out.

Ondeck was the first Lending Market to go public, before Lending Club. Both have been hammered since their IPO and last week was a blood bath that we call Lending Market Meltdown Week, with gloomy news from Lending Club and earlier layoffs from Prosper and an earnings miss from Ondeck. There are three scenarios for Ondeck. One is that Ondeck is the bargain of a lifetime, like buying Priceline after the Dot Com crash. The opposite scenario is that Ondeck is headed to the deadpool. Or Ondeck could be bought by a bargain hunting PE firm for a small premium – possibly after further pain.

We outlined the Ondeck bear case when Ondeck did its IPO.

In November 2014 we took a negative view of Ondeck based on an analysis of their Customer Acquisition Costs and their APR %. Investors who heeded that warning would have saved a bundle. Sign up for Daily Fintech by email so you get your insights ahead of the pack – its free.

In Nov 2014 we wrote:

“The weakness in the Alternative Credit model is a very old-fashioned metric – Customer Acquisition Cost. If they have to pay a lot of money to brokers or to advertise, their CAC maybe too high.

A high CAC is fine if you get a lot of repeat business. That translates to a high Life Time Value (LTV). The metric to track is CAC/LTV. That works in a SAAS business. You spend a lot of money to acquire the customer because the churn rate is low, your CAC/LTV ratio is still OK. If you spend a lot of money to acquire the customer and the churn rate is high, your CAC/LTV ratio will be bad and that translates into a profitability problem.

This is where Alternative Credit businesses that offer short term “stop gap” funding have a fundamental CAC/LTV issue. When pressed about the high APR rates (which you get to by multiplying the interest on a 30 day loan by 12 or a one day loan by 365), the response from Alternative Credit businesses is that the APR rate does not apply in their case because the borrower only needs that “stop gap” financing occasionally.

If that is true, they have a churn problem aka a CAC/LTV issue. If it is not true, because borrowers become reliant on “stop gap” funding, then those APR rates are true and that puts the borrower into financial difficulties. That is where you can end up on the front page in a bad way, like Wonga. Reputation risk and regulatory risk are closely related in the social media age.”

We went looking in the latest 10Q to see if anything has changed in those 18 months.What we wanted to see was whether they were either getting more repeat business (ie lower CAC) or making money on lower APR % (ie getting higher credit quality borrowers). Either is fine and might signal opportunity.

The Priceline story

That 100x return from a liquid public company had three ingredients:

• Total crash in sentiment (all tech was dead).
• Fundamental tail winds – the Priceline model was right and the Internet was just getting started.
• Patient smart management that executed well.

Could that be the story for Ondeck? Or Lending Club?

Most likely Ondeck scenario is a cheap buyout

We discarded the quick trip to the deadpool thesis because Ondeck has plenty of cash compared to any that it might be burning.

Nor did we see any evidence of the big upside Priceline of Fintech story. We don’t see any evidence of a big uptick in credit quality or of repeat customers. It is possible that Ondeck is doing this but the results are not yet visible. If you have some insights in that regard, please share them in comments.

So, Ondeck is a boring story – no sudden death and no rebirth to greater glory. Some sharp-pencilled analyst at a PE fund will figure out a value story and take it private. At below $400m market cap, Ondeck is too far below the small cap hell threshold of $2bn to survive as a public company unless there is evidence of a Priceline type story. We suspect that many PE firms had been looking at Ondeck before last week and the valuation just became more compelling. This is all about valuation and timing. Wait a bit longer and you may get it cheaper. Wait too long and somebody else snaps it up.

Kabbage is hoping to shred Ondeck into coleslaw

Kabbage is in the same game as Ondeck – SME loans – but they stayed private. Their marketing emphasises the K in their name – cute does sell as anybody who looks at kittens online will attest – or should I say kute? However an SME owner will go for a really boringly named venture if their lending terms are even fractionally better. No matter who wins the SME lending market (it is big enough for multiple winners), the SME owners will benefit from the competition and that will be good for the overall economy.

The Daily Fintech thesis is that SME Lending is a market opportunity big enough to drive a truck through. Looking globally we see the micro entrepreneur intersecting with what we traditionally call consumer lending. That is why we devote one day a week to this subject – Wednesday’s coverage by Jessica Ellerm.

Priceline had a unique model. If you have a unique model you are ignored, laughed at, fought and then you win (in the 0.1% cases where a unique model is actually correct – you have to be contrarian and right). It is unclear that Ondeck has a unique model. The basic value is faster, more efficient loan processing than banks using digital forms and big data analytics. That is valuable. There is an arbitrage between what it costs a bank to process a loan and what an AltFi originator such as Ondeck, Kabbage or SOFI manages. The inefficiency of bank loan processing leaves plenty of room – but like all arbitrage plays, winning is about speed of execution.

This leaves Ondeck vulnerable to a better, faster, cheaper alternative. The technical innovation around digital forms and big data analytics makes it possible for many new entrants. One is reaching some reasonable scale – Kabbage. This Atlanta based private venture raised a $135m Series E in October 2015, so they are well capitalised. Investors were already in a “show me” mood in October 2015, so although we do not have access to the financials because Kabbage is private, we take the $135m Series E as a proxy for good traction.

Nerdwallet has a good comparison of Kabbage vs Ondeck vs Paypal. FitsSmallBusiness adds PayPal into the SME owners short list. WeRockYourWeb adds Lending Tree and Lending Club into the mix. SME owners who know how to use Google can quickly add FundBox, Prosper, CAN Capital and Funding Circle into the mix. In short, SME owners who annoyed their local bank manager by beating them at bridge have more options (ok, enough Mr Smith Goes to Washington fantasies, we understand that Banks have depersonalised service and you are unlikely to ever meet a bank manager).

One venture success mantra that works is “build xxx that does not suck”. The AltFi Loan originators are doing “loan application processing that does not suck”. Google with email and Amazon with hosting are examples of hugely competitive markets that rewarded a better, faster, cheaper alternative. They also had patient capital – you know, like somebody buying Priceline in 2002 and waiting 14 years for a 100x return. VC funds are constrained by need to give liquidity to to LPs and public market investors think they have to exercise the liquidity option (unless they are Warren Buffet); but that is another story. The point is that a great user experience and great customer service is what matters. Zappos is another “build xxx that does not suck” in an overcrowded competitive market. Banks and Altfi management teams should study Zappos more than Lending Club as this is a service business.

SOFI shows how fast follower should be done 

Sofi (as in Social Finance) bills themselves as “a modern finance company that’s fueling the shift to a bankless world”. SOFI is a startup financial services business that uses technology. This is an example of what we call the Great Fintech Convergence  – who cares whether it is a tech powered Financial Institution or a tech company that is regulated, as long as the terms are right? You can come from Fin or you can come from Tech – the destination is the same.

SOFI made a smart move. They started with student loan refinancing. The bet was that this would lead them to consumers who would become good credit risks, because their earning power would increase as their career took off (as the ROI on education is still strong because the R part is good even if the I part has suffered from horrendous inflation). From this market entry they moved into Mortgages and now their site is also talking about Personal Loans and Wealth Management. This HENRY strategy (High Earning Not Rich Yet) is explained well in this A16Z post.

SOFI is not touting any tech secret sauce. Nor is this a network effects game. This is a strong management team using everything in their arsenal to go after the big picture – the vertically integrated bank model morphing into a networked marketplace model.

Founded a few short years ago in 2011, SOFI raised a whopping $1 billion in September 2015 (billed at the time as enabling them to delay IPO until the market is ready). Although SOFI is based in San Francisco, the approach feels more like a Wall Street approach, with seasoned ex Bankers on the team. For another big shot at this brass ring, this time from core Wall Street, see Goldman Sachs moving into retail banking.

Could Lending Club be the Netscape moment in a bad way

When Lending Club had their IPO we called it the Netscape moment for Fintech. The first part of that story played out. Venture capital rushed into Fintech in 2015. Students of tech history will recall that the Netscape story did not end well  – they ended up being crushed by Microsoft.

We see no signs of the second part of that story in the case of Lending Club. There is no equivalent of Microsoft – a single behemoth competitor run by a brilliant and tough CEO. Lending Club has over $600m in cash with a cash burn that puts the company in no danger of a liquidity crisis. At a market cap around $1.5bn they have moved into small cap hell territory and trader’s mantra is “don’t catch a falling knife”, so we can expect further pain in the stock price. Lending Club is now a cheap stock. Wow.

Lendacademy has a good summary of what went wrong that led to the CEO resignation as well as a look at their latest financials.

The positive way to read the announcement was that Lending Club has an active and responsible Board that came across something bad and took quick action. There is always the suspicion that “if you see one cockroach, there must be more” and that suspicion will be a drag on the stock for a bit longer; but if you take a longer term view (like those smart enough to hold onto Priceline) you could be handsomely rewarded.

Unlike Ondeck, Lending Club has network effects on its side. This could be a a Priceline story. Two out of three ingredients are here:

• Total crash in sentiment. Tick – all Lending Marketplaces are dead.
• Fundamental tail winds. Tick – we are not going back to a vertically integrated bank model and Lending Club has enough network effects to be at least one of a couple of big global winners.
• Patient smart management that executed well. TBD. Lets see who the new CEO is.

If you incline to the view that Lending Club’s trajectory is southbound, this HBR article about negative network effects will reinforce your thinking. TL;DR, network effects are about trust and trust can be lost. One assumes that the Lending Club Board fully understand this. The new CEO will come in after this Tylenol Moment. The immediate actions of the new CEO will be interesting to watch.

Prosper could have it right with Prosper Daily

Prosper started even earlier than Lending Club – in 2005. They went through a near death experience thanks to a brush with regulators that they did not handle well and re-emerged in 2013 with new investors and new management. This is a battle-tested team. They clearly opted to stay private and they got their painful cuts over before the Lending Club scandal broke.

The reason I think Prosper may have got this right is their acquisition of Billguard in September 2015.  This Israeli venture found a clever way to find all those small errors in your credit card bills. They offered it free, because this was a networks effects game – other users saw a wrong charge and highlighted it so that you could take action. In March 2016, post acquisition, it was rebranded as Prosper Daily.

The name Prosper Daily signals that Prosper aims to pass the  toothbrush test.  The reason this is so important is that regular use means low CAC – see our November 2014 analysis of why Ondeck was flawed. This is why banks have done so well for so long. Because we used them all the time for our current account needs, we were more likely to turn to them when we wanted a loan.

The sort of customer who checks for small errors in their credit card bills is more likely to be the kind of prudent customer who is a good credit risk and who may still want loans when other have become credit averse – a subject we covered here.

Funding Circle

In our 2016 Predictions we had # 9 as “Calls for regulating Fintech startups more intensely will follow at least one high profile blow up.” Tick that box after Lending Club CEO resignation (actually two ticks as the Zenefits story has the same trajectory). The regulatory backlash after Lending Market Meltdown Week will take time to play out, so more pain is to come.

This is were Funding Circle is interesting. We wrote about Funding Circle in October 2015 as the only UK lending marketplace crossing the Atlantic to take on the US market; all the other big players are American. Funding Circle has done a lot of innovation in this market  – the first listed investment vehicle to buy lending marketplace loans, Europe’s first peer-to-peer ABS – but it is their proactive leadership in setting up the Peer to Peer Finance Association (together with Zopa and Rate Setter) that may help them stay a step ahead of the regulatory mess coming out the Lending Club news.

Lending Marketplace Meltdown Week caused blood in the streets, which brings out those who  are greedy when others are fearful.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.