SOFIW - SoFi: The Good Bad And Ugly Of One Of 2023's Top Battleground Stocks

2023-11-07 12:32:28 ET

Summary

• SoFi is gaining attention and rapidly growing its deposit base with a savvy advertising strategy and high-interest savings accounts.
• The resumption of student loans is expected to help SoFi move toward profitability, and the stock has a cult following among retail investors.
• However, SoFi's business is not currently profitable, with high levels of stock-based compensation and significant dilution of shares. SoFi is too speculative to buy here, and investors should look elsewhere.

California-based SoFi Technologies (SOFI) has been in the spotlight this past year for offering 4.6% on savings accounts , running an ad campaign with LA Chargers QB Justin Herbert, and suing the Biden administration for trying to extend the three-year moratorium on student loans. The company has a cult following among retail investors, and it's grabbing deposits while legitimately disrupting the US banking system. SoFi is crushing the competition with its savings accounts. However, the company's breakneck growth belies the fact that the business is not making any money, leaving me to conclude that you're likely better off depositing your money into SoFi than buying the stock.

The Good:

First, let's talk about what SoFi has going for it. The company has been wildly successful at getting media attention and growing its deposit base. I'd venture that sponsoring an NFL stadium is usually negatively correlated with investment returns. However, being a retail-facing company, I find that SoFi's advertising strategies are quite effective. Chase ( JPM ) and BofA ( BAC ) still offer less than 0.1% APR on savings accounts, while SoFi is offering 4.6%. If you offer 46x what your competitors pay and advertise it heavily on NFL Sundays, you're going to get a boatload of deposits. This is exactly what SoFi is doing, and they're taking advantage of the oligopoly that US banking has become among the biggest banks. As an aside to my readers, you can of course get a bit more APR in money market funds from the likes of Vanguard and Schwab if you're savvy. 4.6% is much more than the megabanks are paying, but dropping your money in a Vanguard money market will actually earn you about 5.4% annually at current rates. Still, this article is about SoFi, and the company's higher rates than competitors will continue to vacuum up deposits.

Second, student loans have resumed, which is great for SoFi. SOFI stock bulls believe that resuming student loans among its affluent borrower base will help push the company toward profitability. This seems reasonable. To these points, I believe SoFi's lawsuit was misunderstood by the American Left - SoFi's average student loan borrower makes $180,000 per year . They lend heavily to six-figure-earning graduate borrowers like doctors and lawyers. These borrowers enjoyed much bigger reductions in payments than community college dropouts, and I'd argue that including wealthy borrowers in the pause was done in large part to secure votes from the upper middle class for Democrats. SoFi argued that this was unfair and that it hurt its business, both of which I agree with. Before SoFi's lawsuit could be considered, the U.S. Supreme Court dropped the hammer on the Biden admin's student loan plans, so SoFi's lawsuit was moot.

The Bad:

If SOFI's business is doing so great, why do they trade for roughly $7 per share? That's because they don't make any money. In fact, they've lost money for six straight years . There's only so far that publicity can carry you, and SoFi is now going to need to chart a path to profitability. The prior quarter was better than the previous ones for SoFi, but the company still logged an operating loss of a bit less than $20 million. We'll now see whether the company's growth and the resumption of student loans can erase the red ink. If we look at what analysts are saying , the company is expected to roughly break even next year, with the lowest analyst earnings estimate for 2024 at $-0.05 per share, the average at $0.05, and the highest at $0.16.

These figures seem reasonable to me, and looking out to 2025 it doesn't appear that SoFi is going to explode in profitability, though the company is capable of turning a profit. That's the upshot to spending big on marketing and offering 4.6% on savings accounts - while you win business you don't have a whole lot of margin to work with. It's conceivable that the company could make it up on volume, but you have to look out to 2026 before the current valuation of the company would be justified by the underlying profit. This also assumes that Sofi didn't cut any corners on lending standards to grow.

Years ago, I had flagged SoFi as one of the California mortgage lenders that was offering really aggressive terms to borrowers- the value of collateral went up so they likely are going to get away with some questionable underwriting (i.e. offering 10% down loans on $2.5 million houses, relying too much on borrower bonus/stock compensation income, and lax appraisals of value). Many of these lenders would argue that their borrowers have high incomes and high credit scores so traditional underwriting is passé, but many of them just made bets that asset prices would keep going up and interest rates would stay low. The outcome of these bets is still to be determined. These days, it appears SoFi securitized and sold a lot of loans, but continues to service them. SoFi is a somewhat unconventional lender, so if you're buying the stock you want to be careful that you understand what kind of loans they still have and what the sensitivity is to the business cycle, especially as financial conditions continue to tighten. Short sellers also seem to be taking an interest in SoFi stock, with roughly 12% of the shares sold short.

The Ugly:

The ugly part of SoFi likely isn't what you think it is. SoFi is a bank. But it pays its management and employees like it's a tech startup. The real problem here is that they have very high levels of stock-based compensation. Last year, stock-based compensation was 19% of revenue . That's huge. Management says it's down to 12% this year, but that's still enormous, considering this is quoted as a percentage of revenue, not profit. For reference on SBC, I'll share a study by Morgan Stanley analysts on what reasonable amounts of SBC are and the pros and cons of the practice. For reference, the average SBC as a percentage of revenue is 4% of revenue at tech companies, and 2.3% at financial companies. SOFI's SBC is coming in at 3x to 5x the normal range, making it hard for shareholders to realize their share of the company's rapid growth.

If you look at the company's balance sheet, you can see the total number of shares outstanding has ballooned from roughly 828 million in December 2021 to roughly 958 million now. That's about 16% dilution in less than two years. You generally can't make money in any company that issues shares this quickly, unless they can cure cancer or build a Mars colony with it. To be fair, SoFi is making acquisitions with its cash pile, but given that the company isn't turning a profit and the SBC numbers are huge, it's a reasonable assumption that the dilution is largely going to compensate its employees and management, underscoring the lack of underlying profitability. Could I be proved wrong here? Sure. But we'd need to see a rapid rise in profitability for the underlying business, which doesn't seem to be in the cards going forward with where we are in the business cycle. We'll see.

Bottom Line

SoFi is one of this year's top battleground stocks. While they have competitive offerings for savings accounts and are disrupting the financial industry, a cursory look at the company's financials shows that its underlying business isn't very profitable. Investors looking to play a slowing economy and a consumer squeeze from student loans restarting might consider investing in stocks like Walmart ( WMT ), with positive momentum in the business and share price. SoFi is too speculative to safely buy at this point in time.

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