Digital banking and one-stop-shop financial services company SoFi (SOFI -0.67%) beat analysts' consensus estimates for the fourth quarter.
Perhaps more importantly for investors, management also guided for higher adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for 2023. After the fourth-quarter report, shares rose.
While I like SoFi's strategy of trying to be the complete banking solution for higher earners, I find the company's high valuation disconcerting, as I don't see it maintaining a substantial moat at the moment. I also don't think the company is providing adequate information, which could make it difficult to evaluate its lending franchise. These issues, in my opinion, make SoFi too confusing to invest in right now.
what a ditch
SoFi has surpassed 5.2 million members, which it defines as “someone who has a lending relationship with us through origination and/or servicing, has opened a financial services account, has linked an external account to our platform, or has enrolled in our credit score monitoring service.”
It has also rapidly grown its balance sheet and now has nearly $1.5 billion in personal loans and $4.6 billion in student loans on its books, as well as $7.3 billion in deposits.
While all this sounds great, SoFi actually built these balances by winning on price, which is typically a poor banking strategy. The bank offered up to 3.75% annual percentage return and no account fees, as well as a $250 bonus when people sign up for direct deposit. When SoFi began offering this promotion, the Federal Reserve's benchmark overnight lending rate, the federal funds rate, was between 4.25% and 4.5%. SoFi offers a lot to its clients, but from a business perspective, it's still an incredibly high cost of funding.
It's entirely possible that many of these deposit relationships aren't very profitable or are costing the company money. SoFi reported a $1.43 million loss in its financial services division in the fourth quarter. Management has said it believes it can turn this division profitable by the end of 2023, which would be impressive, but I have my doubts.
Few revelations
SoFi uses an interesting business model. Instead of immediately selling the loans it originates, it holds them on its balance sheet for about six months before selling them.
It does this so it can designate the loans as "held for sale," which allows the company to receive recurring monthly interest payments for a set period, but also means it doesn't have to set aside lifetime reserves for these loans, which can significantly hurt earnings.
The risk is that if demand for SoFi's loans declines, it will have to absorb the losses itself or sell the loans below fair value to investors. To hedge some of this risk, the company hedges virtually all of the loans on its balance sheet, primarily through interest rate swaps.
Image source: SoFi Technologies.
SoFi provides quarterly loan loss figures, which is helpful, but it lumps loan originations, loan sales, and loan fair value adjustments into a single line item, making analysis difficult.
SoFi serves a high-quality clientele: its average borrower has a FICO score of 747. Management said in its fourth-quarter earnings call that its personal loan annualized net charge-off rate as a percentage of total personal loans was 2.47%, while its 90-day personal loan delinquency rate was 0.34%.
These are very good numbers, although the 30-day delinquency rate would be more useful to see which loans have delinquent most recently. An update on how credit card lending is holding up would also have been helpful, as delinquencies were quite high in the third quarter.
I don't understand why SoFi can't do a better job detailing some of these metrics in its earnings reports and not keep investors waiting to see its regulatory filings. It would help if, on earnings day, SoFi provided its 30-, 60-, and 90-day delinquencies, as well as its loan loss rates. I would also be interested in regular sales profit margins for loans sold in the quarter. Sometimes some of this data is released during the earnings call, but not always.
Why does the company receive a premium rating?
I think I understand SoFi's business strategy and like it for the most part. But I don't understand why the company can't provide better information or why its stock is valued at a premium.
Their deposit growth is fueled by high-cost deposits and promotions. Trying to win customers over interest rates hasn't typically been a winning strategy for banks. While SoFi's hedging strategy appears to be working, I still believe the way it holds loans and designates them as held for sale leaves it vulnerable in the event of a major recession.
SoFi is unprofitable, but management says it expects to reach quarterly profitability by the end of the year. This would require a very strong performance in the second half of the year. It's possible, but in my opinion, it's not a lock. I might be more interested in investing in SoFi if it were trading at a more reasonable valuation, but the stock is changing hands at over 26 times its 2023 adjusted EBITDA forecast (at the upper end of its guidance range) and at 246% of its tangible book value.
Bram Berkowitz holds no positions in any of the stocks mentioned. The Motley Fool has no position in any of the securities mentioned. The Motley Fool has a disclosure policy.
