Earnings Call Transcript - LC Q2 2023

Operator, Operator

Hello, everyone. Thank you for joining LendingClub's Second Quarter Earnings Conference Call. My name is Sierra, and I will be your moderator today. All lines will be muted during the presentation, but we will have a Q&A session at the end. I would now like to hand the call over to Artem Nalivayko, Vice President of Finance with LendingClub. Please proceed.

Artem Nalivayko, Vice President of Finance

Thank you, and good afternoon. Welcome to LendingClub's second quarter earnings conference call. Joining me today to talk about our results and recent events are Scott Sanborn, CEO, and Drew LaBenne, CFO. You can find the presentation accompanying our earnings release on the Investor Relations section of our website. On the call, in addition to the questions from analysts, we will also be answering some of the questions that were submitted for consideration via email. Our remarks today will include forward-looking statements that are based on our current expectations and forecasts, and involve risks and uncertainties. These statements include, but are not limited to, our competitive advantages and strategy, macroeconomic conditions and outlook, platform volume, future products and services, and future business, loan and financial performance. Our actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are described in today's press release and our most recent Form 10-K as filed with the SEC, as well as our subsequent filings made with the Securities and Exchange Commission, including our upcoming Form 10-Q. Any forward-looking statements that we make on this call are based on assumptions as of today, and we undertake no obligation to update these statements as a result of new information or future events. Our remarks today also include non-GAAP measures relating to our performance, including tangible book value per common share and pre-provision net revenue. We believe these non-GAAP measures provide useful supplemental information. You can find more information on our use of non-GAAP measures and a reconciliation to the most directly comparable GAAP measures in the presentation accompanying our earnings release. And now, I'd like to turn the call over to Scott.

Scott Sanborn, CEO

All right. Thanks, Artem. Welcome, everyone. We delivered solid results in the quarter, thanks to disciplined execution and by continuing to leverage the strategic advantages of our marketplace bank model. The quarter's $2 billion in originations was in line with our guidance, reflecting planned lower balance sheet retention. Total revenue was $232 million, and pre-provision net revenue, which is revenue less non-interest expenses, was $81 million, which exceeded the high end of our guidance range and was made possible by continued marketing and operating expense efficiencies. As a result, we delivered our ninth straight quarter of profitability. Now, let me provide some context on the current operating dynamic. The bank portion of our business is demonstrating its resilience with net interest income stable quarter-over-quarter. However, we are facing, what we believe to be, temporary headwinds in the marketplace, which is resulting in pressure on our outlook for our non-interest income. First, as we signaled last quarter and as is evident in regional bank earnings reported thus far, banks are currently moving to the sidelines as they address their capital and liquidity concerns. Their pullback will have an impact on our near-term origination volume. And while we continue to have productive discussions with our bank partners, and though the appeal of our high-yield short-duration asset is more clear now than ever, banks' capacity to invest is, for now, likely to remain restricted. And second, to strengthen their capital position, banks are selling loan portfolios at deep discounts. That's adding significant supply to a market that's already saturated with investment options. On the positive side, asset managers are raising capital, and they are stepping in to buy; however, they're seeking higher yields to offset their higher cost of capital, and this is putting pressure on loan sales pricing. We don't believe that this market dynamic is sustainable. And in the meantime, we're leaning into our bank advantages to create new profitable structures to support marketplace volumes. I mentioned our structured loan certificate program last quarter, which is essentially a two-tier private securitization in which LendingClub retains the senior note and sells the residual certificate on a pool of loans to a marketplace buyer at a predetermined price. This effectively provides low friction, low-cost financing for the buyer, and in exchange, LendingClub earns an attractive yield with remote credit risk and without upfront CECL provisioning. So as a bank, this is something we are uniquely positioned to deliver for our marketplace investors. We've had good initial reception to the program, and we have a solid pipeline of forward interest. Another advantage of our bank is our ability to hold and season loans for investors, earning interest income for LendingClub while increasing the certainty around future credit performance for the buyer, which is especially important in this environment. We recently sold $200 million of seasoned loans at a gain, and we are receiving interest from investors to broaden the program. I should also note that to deliver the returns required by loan investors in this rate environment, we are continuing to raise coupons. We've now priced in the majority of the Fed rate increases for near-prime originations where we generally compete with non-bank lenders. Our pricing on our prime portfolio, where we generally compete with banks, is now up roughly 265 basis points. We're being deliberate and disciplined here to avoid adverse selection, and we're continuing to test our way up on pricing. Now let's turn to credit, where our data advantage from over $85 billion in loans, our flexible infrastructure, and our seasoned team has enabled us to continue delivering losses below the competition. And while we're pleased with our credit outperformance and the strong returns we're generating in our held-for-investment portfolio, delinquencies are modestly above our expectations on vintages booked before the prolonged inflation fully manifested and before we evolved our underwriting strategies and models. The actions we have taken since then have resulted in consistent credit performance, and we'll continue to read the signals and adapt to maintain strong credit for loan investors and for ourselves. Looking ahead, federal student loan payments are set to resume this fall after a multi-year hiatus. And while we're carefully preparing ourselves and our members for this new financial reality, we currently believe that any impacts to the portfolio will be muted, given a 12-month on-ramp period the government is providing, the many reduced payment options available, and proactive credit actions we've taken to reduce exposure to what we believe are the higher risk segments of this population. Even so, we are taking additional steps to ensure our members stay on track, including educational outreach to ensure that student loan debtors understand the size and timing of upcoming payments, are aware of the reduced payment options available to them from the government, and, if needed, of custom hardship plans on their LendingClub loan if they need to bridge a gap. As we demonstrated during COVID, a high-touch, proactive approach to helping our members can result in lower delinquency rates and increased loyalty. Our long-term ambition remains growing our member base and surrounding them with products and services that help them keep more of what they earn and earn more on what they save. We have continued to innovate, and starting over the next six months, we plan to test and launch an integrated mobile app that combines lending, spending, and savings into a single experience; a debt monitoring and management tools fully integrated into this mobile experience, allowing members to easily view their debts, prioritize, and optimize their payments to reduce costs; and a pre-approved installment line of credit that allows existing members to seamlessly sweep any new credit balances into a loan at a fixed rate. Importantly, this last feature will be built on a new revolving platform that will eventually support additional new products. So, as I said earlier, the environment will continue to challenge our ability to drive meaningful growth for at least the remainder of 2023. But we do believe this period is temporary, resulting from a confluence of macro events that won't persist over the long term, and we remain prepared to accelerate when the environment stabilizes and we see the following: the Fed stops raising interest rates and, ideally, begins to lower them; banks have repositioned their capital and liquidity levels, enabling their return to the marketplace; and/or the current oversupply of investment options subsides. As the partner of choice in this asset class, we expect to be a primary beneficiary of a return to more normal market conditions. And we believe that we are well positioned to capture historic opportunity to refinance record high credit card balances at record high rates. Until that happens, we're leveraging the benefits of our marketplace bank business model to maintain near-term profitability, bolster our long-term resiliency, and create a more differentiated member experience. As always, I want to thank the LendingClub employees for their continued hard work and commitment to building towards our bigger future. And with that, I'll turn it over to you, Drew.

Drew LaBenne, CFO

Thanks, Scott, and hello, everyone. Let me walk you through the details of the results. I'll start with originations in the second quarter. Originations were $2 billion compared to $2.3 billion in the prior quarter and $3.8 billion in the second quarter of 2022. Of the $2 billion in originations, marketplace sold loans were $1.4 billion, up $67 million compared to the previous quarter. As Scott mentioned, we've had early success in facilitating marketplace sales through the structured certificates. We issued approximately $180 million in the quarter, which helped drive growth in marketplace sales. Loan retention came back within our expected 30% to 40% range to $657 million, down from $1 billion in the first quarter as we normalized retention levels in line with our available earnings. Now let's move on to pre-provision net revenue, or PPNR. PPNR was $81 million for the quarter compared to $88 million in the prior quarter and $121 million in the second quarter of 2022. The outperformance compared to our guidance was driven by a $3 million revenue gain from a pending portfolio sale that was completed in early July, and a $6 million sequential improvement in expenses, primarily due to our previous streamlining of operations as well as proactive expense management in marketing and other areas. As Scott mentioned, we are seeing increasing investor demand for personal loans that have been seasoned, and we are originating a portfolio of approximately $250 million in loans for this purpose in the third quarter. These loans will come on the books at fair value with a discount that approximates our observed whole loan sale prices. Total revenue for the quarter was $232 million compared to $246 million in the prior quarter and $330 million in the same quarter of the prior year. Let's dig into the two components of our revenue. You can find revenue details starting at Page 9 of our earnings presentation. First, net interest income was $147 million, flat sequentially and up 26% over the prior year. Our net interest margin was 7.1% compared to 7.5% in the prior quarter and 8.5% in the prior year. The change was primarily due to higher average cash balances as well as increased cost of interest-bearing deposits, which was partially offset by a higher yield on unsecured consumer loans. Marketplace revenue was $83 million in the quarter compared to $96 million in the prior quarter and $206 million in the same quarter of the prior year. The change in marketplace revenue was primarily due to lower loan pricing, as well as a non-recurring $9 million benefit in the first quarter. Now, please turn to Page 13 of our earnings presentation, where I'll discuss expenses. Non-interest expense of $151 million in the quarter compared favorably to $157 million in the prior quarter and $209 million in the same quarter last year. The sequential reduction was primarily due to lower variable expenses in marketing and operations. Compensation and benefits also improved as a result of slowing our pace of hiring across the company. Our expense run rate fully reflects the $30 million annual cost savings target we had communicated at the beginning of the year, and we are on track to exceed. Now let's turn to provision. Provision for credit losses was $67 million for the quarter compared to $71 million in both the prior quarter and the second quarter of 2022. The sequential decrease was primarily the result of lower day one CECL due to fewer loans retained in the quarter, partially offset by more accretion on a larger back book of loans and an increase in reserves on the 2021 and 2022 vintage. As you will see on Page 15 of our earnings presentation, we have modestly increased our range of estimates for the expected net lifetime loss rates on the 2021 and 2022 vintage, which reflects the impacts of inflationary pressure on borrowers. While it's still early to judge the ultimate performance of the 2023 vintage, our initial observations are that it is now showing stable performance, benefiting from the tightened underwriting we've implemented over the last several quarters. On Page 16, we have updated our marginal return on equity on personal loans to a range of 25% to 30% to reflect a lower net interest margin due to higher funding costs and higher quality mix. In addition, we thought it would be helpful to share the marginal returns on our structured certificates, which generated a marginal ROE of approximately 20% using our current balance sheet leverage. It is also important to note that the risk weighting on these securities is 20%, which means that these returns are even more attractive on a risk-adjusted basis. Now, let's move to taxes. Taxes in the quarter were $4.7 million, or 32% of pre-tax income. As I mentioned in the last quarter, we will have some variability in the effective rate from quarter to quarter. Our effective tax rate is 27% year-to-date, and we continue to expect that to be in line with our long-term tax rate. Now, let me touch on the balance sheet. Few things to note here. Total assets were $8.3 billion for the quarter compared to $8.8 billion at the end of the previous quarter. The decrease was primarily due to lower cash balances as a result of the planned maturity of brokered deposits. Our securities portfolio grew to $524 million in the quarter. The increase of $143 million primarily reflects growth in our structured certificate program. As I mentioned earlier, we retained the senior tranche of the security and hold it on our balance sheet. In addition to the senior tranche, we also hold a 5% whole loan security as required by Dodd Frank. You will see the securities portfolio continuing to grow as the program scales. Loans held for sale at fair value were $250 million at the end of the quarter as we moved approximately $200 million in held-for-investment loans into held-for-sale for the transaction that was completed in early July, which I spoke to earlier. As I mentioned, we are seeing increased demand for these types of seasoned loans. We are planning on growing this program and completing more transactions in the future. Our consolidated capital levels remained strong with 12.4% Tier 1 leverage and 16.1% CET1. Our available liquidity remains healthy with $1.2 billion of cash on hand, and 85% of our deposits are insured. Additionally, we continue to maintain substantial amounts of unused borrowing capacity at both the Federal Home Loan Bank and Federal Reserve Bank, with a total of approximately $4 billion at June 30. Now let's move to our guidance for the third quarter. As Scott mentioned, we expect bank demand to be constricted with marketplace volume going primarily to asset managers at lower prices. This is informing our outlook. For the third quarter, we expect originations between $1.4 billion and $1.7 billion. And we expect PPNR to range from $40 million to $50 million, which includes up to $10 million of one-time benefit related to recouping volume-based purchase incentives from the bank investor channel. It is our objective to remain profitable for the quarter on a GAAP basis by continuing to execute with discipline on expenses, and reducing our held-for-investment loan retention. Our guidance for the quarter assumes 30% to 40% balance sheet retention, which includes both held-for-investment and held-for-sale originations. Putting it all together, we are planning to maintain the size of our balance sheet in the third quarter through a combination of held-for-investment whole loans, growing the structured certificates program, and held-for-sale extended seasoning. Held-for-investment loans will reflect the upfront CECL provisioning of structured certificates, and held-for-sale loans will be under fair value accounting. We continue to diversify our balance sheet through these new structures and programs, which will enable us to earn attractive recurring revenue via interest income while also helping to facilitate marketplace sales. We believe that a recovery in the marketplace will take longer than initially expected given the continued pressure on banks and aggressively priced secondary loan sales. While we're not giving fourth quarter guidance at this time, we expect these pressures to continue at least for the remainder of the year. But regardless of the market conditions, we have a resilient business, and we will remain focused on profitability versus growth. As we look further ahead, there's a massive opportunity in front of us. We are well positioned to accelerate quickly as conditions improve. In the meantime, we will continue to execute with discipline, innovate on our offerings, and leverage our strategic advantages as a bank to evolve the marketplace. With that, we'll open it up for Q&A.

Operator, Operator

Our first question comes from Bill Ryan with Seaport Research Partners. Please proceed.

Bill Ryan, Analyst

Good afternoon. I appreciate the opportunity to ask my questions. My first question is about your origination volume. It appears that you stayed within guidance last quarter. Looking at the year-over-year figures, it seems like you may be tightening up on credit again since the range you provided compared to a year ago suggests a potential decline in volume on a year-over-year basis. Are you adjusting your origination based on the current investor demand and what can be placed on the balance sheet?

Scott Sanborn, CEO

Hey, Bill. This is Scott. Yes, it's really about the impact of bank purchases. As we mentioned in the prepared remarks, we're originating based on the available investor demand and the economics that we find acceptable. So, it's not a credit issue. We are, of course, continuing to manage credit as always, but origination volumes are really focused on the demand at the prices we are willing to accept.

Bill Ryan, Analyst

Okay. And a follow-up question just on the NIM. We...

Scott Sanborn, CEO

And I'm sorry, Bill. Just...

Bill Ryan, Analyst

Yes.

Scott Sanborn, CEO

The total addressable market right now is enormous. We mentioned it earlier, but credit card interest rates have increased again, currently sitting at 20.7%, the highest they've ever been, with over $1 trillion in assets. This situation is not about borrower demand.

Bill Ryan, Analyst

Okay. And just to follow up on the NIM outlook. You guided last quarter that it would be down, talking about the structured certificates buildup of liquidity on the balance sheet. Sort of looking forward, are we getting close to a bottom here, or do you see potentially a little bit further margin compression from here?

Drew LaBenne, CFO

Hey, Bill. It's Drew. First of all, you're right about the decrease in NIM from Q1 to Q2; about half of that drop was due to the increase in cash. Looking ahead, I anticipate we'll experience some modest pressure on NIM for a quarter or two, but it will depend on any actions the Fed takes and the dynamics of the deposit market. If those factors remain steady, I believe we're nearing the bottom on NIM, although there might be a bit more to go.

Bill Ryan, Analyst

Okay. Thanks.

Operator, Operator

Our next question comes from Reggie Smith with JPMorgan. Please proceed.

Reggie Smith, Analyst

Good evening, and thanks for taking the question. I guess a follow-up to Bill's question earlier. So, it sounds like, like you said, the volume or rather the demand for loans is still high. And just kind of looking across the landscape, it feels as though most personal loan issuers are kind of pulling back now. So my question is, with that dynamic, why aren't you able or maybe you are able to charge more either APR or origination fee? Like, what's the sensitivity? Because it would seem that with a smaller origination basis, you could probably squeeze in pricing out. What am I missing there?

Scott Sanborn, CEO

Sure. It depends on the segment of the market we're discussing. In the near-prime area of our portfolio, where our competitors are non-bank lenders, including fintech and specialty finance companies, we can pass on pricing changes, and we've already done so. The pricing for our near-prime offerings is closely aligned with the recent Fed rate increases. However, in the prime segment, we've shifted towards higher credit quality in response to the current environment. We've also raised our origination upmarket to meet the interests of investors, as we're competing with banks. Our pricing adjustments somewhat track the movements of bank deposit rates, which lag behind their funding costs. We continuously test various price points in the market to ensure we understand the stability of our customer base. As we observe take rates stabilize at higher price points and a stable population, we adjust accordingly, but competing with banks means those adjustments happen at a different pace.

Reggie Smith, Analyst

Got it. Okay. I understand. If I could sneak one more question in. Did you suggest that the decline in marketplace yield, which you mentioned was a $9 million non-recurring benefit in the first quarter, accounts for most of the decrease in your marketplace revenues as a percentage of marketplace volume?

Scott Sanborn, CEO

I'll let Drew address the specific details regarding the $9 million. However, in general terms, over the past year, we've observed pressure on loan pricing, primarily driven by the rising cost of funding. In the current environment, especially among asset managers, their cost of funding has increased along the forward curve based on the Fed's anticipated actions. This has resulted in higher yield requirements, which is reflected in marketplace prices. We believe that the current situation, while it may seem difficult, is temporary. Alongside the need for higher yields due to this increased funding cost, there's also an oversupply of paper available in the market right now. For instance, a former competitor is looking to sell a $4.5 billion loan portfolio, and there are portfolios from failed institutions earlier this year also on the market. Additionally, many regional banks are attempting to clean up their balance sheets by selling off loans, including RV and auto loan portfolios. While not all this activity is in our direct space, asset managers currently have a significant variety to choose from. The positive aspect is that capital is forming and responding to these needs. However, the downside, at least in the short term, is that the oversupply is exerting further pressure on prices. This trend was partly reflected in our Q2 results, and we expect this pressure to persist and potentially increase in Q3. The bank buyers with lower capital costs can afford to pay higher prices than asset managers, which leads to some volume being transferred to these lower-priced buyers. That summarizes the general situation; I'm not sure if Drew has anything to add.

Drew LaBenne, CFO

Yes, I forgot what Reggie was asking. No, I'm just kidding. Yes, in terms of the decline in marketplace revenue, Reggie, Q1 to Q2, so the $9 million is part of the answer. And as a reminder, that was because of slower prepayments that we are seeing in the portfolio causing an upward valuation in the servicing asset. That was the primary reason for that. But on top of that, we are getting lower pricing on loan sales. So that's the other impact on marketplace revenue this quarter. And as we indicated from the comments, we expect that pricing pressure will increase as we get into Q3, which is included in our guidance.

Reggie Smith, Analyst

Got it. You mentioned this in your presentation, but even with that, do you still expect your pre-provision profit estimate for the next quarter to remain at least neutral from a GAAP earnings perspective?

Drew LaBenne, CFO

Yes. We're targeting being profitable on a GAAP basis for Q3.

Operator, Operator

Thank you for your questions. There are no further questions waiting, so I would like to turn the call over to Artem Nalivayko for answers and questions submitted by email.

Artem Nalivayko, Vice President of Finance

All right. Thanks, Sierra. So, Scott and Drew, we do have a few questions here for you that were submitted via email by our shareholders. So the first question here is, has LendingClub looked into launching any new products with something like better credit cards for your members?

Scott Sanborn, CEO

So I touched on this very, very briefly on the calls. We are, in the next quarter, in Q3, going to be launching on a new revolving platform. The first use case of the revolving platform is going to be enabling an installment line of credit for existing customers who build back up credit card balances or for whom we didn't pay off all their credit card balance in the first go, and they've demonstrated good payment, and we can go after the rest. That'll be in combination with this debt management and monitoring dashboard that we're working on to help them see that. That'll be the first use case of the revolving platform. We also have our purchase finance business that currently has a revolving product that we partner for to distribute that, that we could capture more economics by taking that over long term. 99% of our customers have credit cards. We know what kind of cards they have. We know what they use them for. So that's certainly something when conditions allow that we would be interested in exploring and we think that our customers would be open to.

Artem Nalivayko, Vice President of Finance

Great. Thank you. And the second question is, would you consider signing any funding agreements or forward flow agreements and announcing these publicly to drive further origination growth?

Drew LaBenne, CFO

Sure, I'll handle that. First, I want to emphasize that we frequently sign agreements with our loan buyers. Often, these agreements include financial incentives such as rebates if a buyer continues to make purchases throughout the duration of the agreement. As noted in our Q3 guidance, it seems likely that one of these rebates might be returning to us since a couple of bank buyers have halted their purchases. We prefer to structure deals that provide a long-term flow and include some financial incentives. Regarding the idea of establishing long-term committed capital, I want to point out that these agreements can be quite challenging, and in the current environment, setting them up would be costly. Additionally, there's no guarantee they would be fulfilled in a more difficult market. Therefore, we're cautious about committing to an extended agreement that might not be favorable for us or our shareholders at this time.

Artem Nalivayko, Vice President of Finance

All right. Great. Thanks, Drew. So with that, we will wrap up our second quarter earnings conference call. Thanks for joining us. And if you have any questions, please feel free to email us at ir@lendingclub.com.

Operator, Operator

That will conclude today's conference call. Thank you all for your participation. You may now disconnect your line.