BLND - Blend Labs: A Long Way To Go

2023-07-31 04:21:45 ET

Summary

• Blend Labs, a fintech company offering software solutions for financial institutions, is being closely watched by investors as shares have fallen by 85%.
• The company's primary business segments include automating routine processes for banks and a title search service to facilitate mortgage lending closings.
• Despite challenges in the mortgage lending market, Blend Labs aims to provide cost-effective solutions for banks looking to streamline their operations without sacrificing performance.
• BLND stock needs to achieve large revenue growth objectives while maintaining cost discipline in order to show it can hit operating profitability and start generating free cash flow.

The health of the mortgage lending are an area of the market that I try to keep an eye on, and specifically have found for myself that I like the mortgage insurance space from an investment standpoint. But one development I have also been attempting to follow is the rise of more fintech that is geared towards financial institutions (as opposed as to consumer borrowers), and one name where these areas of interest have crossed paths is Blend Labs ( BLND ). I started following the company after reading a Seeking Alpha article in December 2021 (the article has since been removed; I do not know why). I did not invest then, but added to my watchlist, and shares have fallen by some 85% since then, and at times have been even deeper in the red.

As shares appear to have formed something of a stable bottom, I decided I wanted to look into this name a little more and see if I could find an investment thesis with merit.

Introduction to Blend Labs

Blend Labs has two primary businesses segments. The first is being a subscription software provider for financial institutions (i.e. banks) that can help automate and make more efficient some routine processes, like consumer and mortgage lending applications from customers, income verification steps, and other back-end functions that can be time consuming for lenders. The second segment, referred to as professional services and title, comes from the 2021 acquisition of the business Title365, and is a title search service largely intended to supplement the mortgage lending component to facilitate closings. While Blend Labs does offer more than mortgage banking related products, for the moment, the mortgage space is its key point of focus. Its suite of products is intended to largely streamline the mortgage lending process for lenders, from application through close.

As the volume of mortgage business has cooled off, however, the company is working to expand its offerings into consumer banking (deposit accounts, etc.). For an excellent review of both the history, changes and challenges facing Blend Labs, I highly recommend this recent spotlight article by Connie Kim at HousingWire for context. Its only drawback is being written in April 2023, so Q1 results were not available at that time (I believe HousingWire.com allows non-members access to at least one free article per month). A highlight from the article, the author notes that:

In the ensuing years (since 2015), Blend brought on hundreds of clients, including Wells Fargo, First Republic Bank, Mr. Cooper and U.S. Bank. When the mortgage industry generated more than $8.5 trillion in origination volume in 2020 and 2021 and posted record profits, it was Blend's digital technology that powered about a quarter of those mortgages. Blend's clients could originate a mortgage a week faster with Blend's technology, and they saved hundreds of dollars per loan in operations costs. The platform seamlessly integrated with CoreLogic for credit scores, Plaid for bank account information, Google Maps for location data, as well as popular mortgage programs from Black Knight, ICE Mortgage Technology and others. . . [CEO Nima] Ghamsari is now faced with a familiar problem: he needs to convince the marketplace that Blend's latest evolution-to a platform-as-a-service company -will transform consumer banking, just as it did mortgage a few years ago. He'll also have to do it before the money runs out.

As has already been well publicized with the failures of some notable banks earlier in 2023, there is some market concern evident in the health of regional and community banks, and the challenges in mortgage lending at the moment are not helping matters. Banks large and small are cutting back staff in mortgage lending, with U.S. Bancorp ( USB ) among the most recent to announce layoffs. While the larger issue for the regional banks is probably their exposure to commercial real estate, any opportunity to squeeze out costs without sacrificing performance is sure to be welcome. It is exactly this sort of niche space that Blend Labs wants to sell its software solutions.

Takeaway From the 1st Quarter

Signing on banks as new customers or upselling existing clients when the banking sector is a little shaky may be making things more challenging, but overall, Blend Labs seems to be getting some traction. 2nd quarter results will probably not be released until mid-August, so the best we can do for now is review Q1 relative to prior periods, and look for trends and guidance.

First quarter revenue came in at $37.3 million, nearly a 50% drop compared the $71.5 million in the same period in 2022. The vast bulk of the difference is from the Title segment, which accounted for $39 million of 2022 Q1 results, when the mortgage market was still relative hot, at least compared to the quarters since then. For Q1 of 2023, that Title segment revenue dropped by more than two-thirds, down to $12.6 million, and the cost of sales for this segment exceeded revenue, essentially contributing $0 to gross profits, versus a small but positive contribution to gross profits in 2022. Software sales fell off as well, down to $23.0 million from $30.6 million last year. The overall impact was much narrower gross profits for the quarter, $15.9 million, but hitting an improved gross margin of 43%, as opposed to $28.9 million gross profit in 2022, and a 40% gross margin.

Operating expenses did trend down overall year over year, however not anywhere close to matching the sharp drop in topline results. The net result was loss for the quarter of ($67.5 million), of ($0.28) per share. Turning to the cash flows, that worked out to a use of cash from operations of ($46.7 million), largely in-line with the prior year. Along with other uses of cash, Blend Labs' combined cash and marketable securities position has gone from a balance of $354.1 million at 3/31/22, down to a Q1 2023 balance of $306.9 million, so there no immediate cash crunch.

In his prepared statement for the Q1 earnings call, Blend's CEO Nima Ghamsari made the following observations:

our gross profit came in ahead of our expectations. We view ourselves as a software company first and foremost . . .our outlook [is] for sequential revenue growth throughout the year, we expect our net loss will continue to decline each quarter from here forward. On the debt, our debt is due in July of 2026. More than three years out. We expect to be free cash flow positive well before then. Given the performance of our business in Q1, we are ahead of our previous long-term plan and now show that we expect we'll generate positive operating income in the fourth quarter of 2024. In summary, we believe the company is fully funded.

Two comments really stood out to me here, specifically on becoming free-cash flow positive "well before" July 2026 and have positive operating income by the end of next year.

Valuation Angles

Getting a handle on a fair and proper valuation for an enterprise that is unprofitable on both earnings and EBITDA basis, but possibly has high growth prospects, is not straightforward. I do not find sales or revenue multiples to be that meaningful for framing the valuation question. Book value could be a starting point for valuation, but does not capture any growth potential. In isolation, no multiple will say very much anyways without market peers for comparison. I can identify a couple, including nCino ( NCNO ), MeridianLink ( MLNK ), and Alkami Technology ( ALKT ). They are specialized software providers for banks and credit unions that might be thought of as playing in a similar space to Blend Labs, so some basic comparisons can be considered.

On a Price/Sales basis, Blend Labs trails these comps by a significant margin, but on Price/Book Value, they are all more closely grouped in the 3.1x - 4.5x sort of range. Neither of these really helps paint a strong picture of fair value.

Ideally, there would be free cash flow to measure, and in the case of Blend Labs, this could be the case soon enough if management's comment on the matter can be borne out, and thus strikes me as an opportunity to investigate what that claim would require.

The actual use of cash in operations each quarter has sort of hovered around between ($40 million) and ($50 million) since Q4 of 2021, and this is where the heart of free cash generation will be solved. The main adjustment to net income each quarter to derive operating cash flow is adding back in stock-based compensation, with a few smaller or irregular items from working capital moving around a bit.

Encouragingly, gross margin expansion is giving a little bit of breathing room, but at the current operating expense run rate of $240 million per year and stock-based compensation averaging around $80 million, revenue will really have to ramp up to approach positive operating cash flow. By my rough math, even at 45% gross margins and holding operating expenses and stock-based compensation in-line, it would take annual revenue approaching $400 million to return $20 million in operating cash. Given that revenue has been trending down and currently is on track to come to an annualized total of $160 million (management laid out expectations for Q2 revenue of ~$40 million, versus $37.3 million in Q1), getting to $400 million, especially over the next 36 months, is a healthy challenge. I will caveat by clarifying that Blend Labs does have a cost containment plan in place, and has cut back staffing significantly, so the operating expense assumption could be too high, but I leave it in place to be conservative.

Assuming what I think is a best-case scenario and Blend manages to more than double revenue and get positive operating cash flow within three years' time, what should that suggest about the value of shares today? Given there are ~240 million shares outstanding at 3/31/23, even on generous terms, say discounting at 15% and assuming free cash flows grow quickly from $20 million to $90 million over 4 years (while giving a free pass to the next three years) without increasing the number of shares, that still just comes to ~$0.50 per share, or less than half of the current price per share. I know that the DCF framework for valuation is not necessarily a great one for software or high-growth companies, but management opened the door somewhat with their words on the earnings call, so I think it merited an investigation.

Concluding Thoughts

There are valid reasons why valuations for software companies in growth mode are not done strictly by cash flow assumptions, but in this case I think the market is being justifiably cautious.

Blend Labs needs to find both large and sustainable revenue growth. There are multiple contributing factors to try and achieve this, between pricing, onboarding new clients, and expanding customer engagement. For example, Blend is just starting to roll out its consumer banking product, and noted that $5.2 of Q1 revenue came from this effort and is expected to grow at a good clip. Ultimately, however, I believe mortgage lending will need to pick up again rapidly to really help drive revenue high enough. As that is a macroeconomic factor well out of Blend Labs' control, it is hard to rely on it happening in assessing the value.

I am reluctant to consider Blend Labs a hard sell (bearish) rating since what goes in and out of favor over any twelve month period is unpredictable and shares may well gain ground, but I not see a strong bull thesis to invest now, as the growth challenges loom large.

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