SOFI - SoFi: Why I Am No Longer Short

2024-01-11 14:08:59 ET

Summary

• I initially recommended shorting SOFI at above $10, but I am now upgrading my rating to a "hold".
• The bear case for SOFI includes its high valuation and risks in a hard landing macro scenario.
• The bull case highlights a "soft landing" in the US economy and an inflection point in the Tech division's revenue growth.

In my prior article on SoFi Technologies ( SOFI ) I set out my belief that it makes an abundance of sense to short SOFI at above $10.

And as you can see from the price action above, I was correct in my prediction. The share price momentarily breached the $10 mark and then quickly retreated.

Having said that, I have now upgraded my view on SOFI to "hold". I think the upside and downside risks are broadly balanced due to the apparent soft landing of the economy and the potential inflection point in SOFI's Tech division.

These could be risky times to short the stock.

The Bear Case

My bear case regarding SOFI was formed on two aspects:

1. SOFI's high Valuation; and
2. Risks in a hard landing macro scenario.

At a share price of $10, SOFI is trading at a price-to-tangible book value of ~3x (and a higher multiple if adjusting for CECL provisions in line with peers). This is a very high valuation for a bank, especially for a consumer bank company with a large percentage of its balance sheet in unsecured personal loans. Typically, these banks have a higher cost of capital than their less risky and diversified brethren.

To warrant such a valuation, SOFI needs to sustainably earn ROTCE greater than 30% which is no mean feat. It generally requires a bank to generate a substantial amount of capital-light revenue and profitability. This is precisely the reason a bank like Morgan Stanley ( MS ), with its capital-light wealth management monster franchise, is rewarded with high price-to-book value multiples.

SOFI's recent growth in contribution margins was predominantly driven by the Lending segment which was growing off a low base. There were unique industry dynamics where peers were forced to conserve capital, whereas SOFI had excess capital available to fund balance sheet growth, and this introduced material credit exposure to SOFI's balance sheet. In short, this is what the institutional folks would classify as low-quality growth.

I also assessed that SOFI is exposed to material balance sheet and credit risks. The key culprit for this is their accounting treatment. As described in detail in my prior article, SOFI's accounting treatment translates to the upfronting of profits (timing difference only) compared to peers which includes recording a notional gain of sale on day 1 of loan originations whilst avoiding recording expected lifetime losses as per the CECL requirements.

In a nasty macro scenario (e.g. a deep recession), in my view, SOFI runs the material risk of breaching capital ratios and equity dilution at a very unattractive (for shareholders) share price. This is a key reason why institutional investors see SOFI as a proxy for an adverse macro hedge. It makes sense and also explains the frequent high short interest in the stock.

I do understand the bull's counter-argument that SOFI loans are high FICO and therefore should fare well in a recession and that certainly may be a mitigating factor. However, the reality of the matter, whether that argument holds or not, the pendulum of Mr. Market will swing far and wide in a nasty scenario. Mr. Market tends to shoot first and then ask questions.

The Bull Case (or what has changed?)

First and foremost, it looks like there is a "soft landing" or "no landing" when it comes to the U.S. economy. This is an important outcome. Whilst SOFI, in my view, was taking a risky bet on the health of the U.S. economy in 2022 and 2023, it seemed to have paid off as unemployment remains exceptionally low. This means that the tail risk of a "nasty macro" is not (yet) coming home to roost. In such a scenario, the accounting outcomes and risks become more of an academic discussion point, and a tail risk has not manifested as a high-probability outcome.

The second important point that many of the bears are potentially missing is the inflection point in the Tech division's revenue growth. The signs are very promising based on management's assertion of the pivot in revenue growth from the Lending segment to the Financial Services ("FS") and Tech division where management guided ~50% of revenue in 2024 to come from capital-light divisions (i.e. Tech and FS). Taking this guidance from management at face value implies that the Tech division will grow at a clip of at least 40%.

The thesis is further supported by management's guidance in the recent shareholders' Q+A session where the CFO noted:

We are nearing a growth inflection point in our tech platform segment and demand for our combined product suite from large attractive players is the highest that we've ever seen.

And also in the Stephens Annual Investment Conference :

And then you're going to see an acceleration of revenue in our Tech Platform business as a result of the change in strategy to focus on more durable, larger financial institutions and larger customers with large installed bases.

We've never been more excited about the demand that we see in the Tech Platform business. We're in conversations with a number of the top financial institutions right now in RFPs, and couldn't be more excited about the revenue opportunity there.

Final Thoughts

SOFI has undoubtedly executed very well in recent years on the banking side. Members and deposit growth have been phenomenal, but the banking divisions should be valued as a bank . In my back of the napkin estimate of SOFI, I could see it delivering around 15% to 20% ROE if it continues to execute extremely well. However, it won't get to a valuation of 4x to 5x TBV or ~$15+ share price without acceleration of revenue in the Tech division. SOFI's guidance implies that spectacular Tech division growth is just around the corner and it may be as high as 40%+ for 2024 alone. If indeed, this is the case, then it is a complete game-changer for the valuation multiples. Simply put, for me, it is all about the Tech division revenue growth and this is what I am monitoring very closely. To date, the Tech division has been somewhat of a black box and SOFI management has provided very few granular disclosures.

In the interim, with a likely "soft landing" and potential inflection point in the Tech division, shorting SOFI is too risky in my view. I am currently on the sidelines but expect to be nimble (long or short) depending on the facts presented. I will likely go long if I see concrete evidence of the Tech division's inflection point regarding revenue growth.

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