2023-10-04 13:44:55 ET
Summary
- SoFi Technologies stock has underperformed the broader financial sector with declines in recent months, which is a divergence from its relative strength on a year-to-date basis.
- Despite a solid Q2 beat-and-raise, and resuming student loan repayments to jump start originations for relevant refinancing, SOFI stock is falling to the hands of weakness in the broader financial sector.
- However, SoFi's differentiated business model relative to its traditional peers remains intact, and has proven to be an advantage in keeping the company better-positioned against near-term macroeconomic risks.
SoFi's stock ( SOFI ) has slipped close to 40% since reaching its year-to-date high after an impressive Q2 beat and raise. Despite the resumption of student loan repayments, which is a long time coming for SoFi's lending business following a three-year pandemic-induced moratorium, confidence in the stock has remained weak.
This is likely a reflection of increasing risk-off sentiment in the broader financial sector, as the reality of higher for longer rates harbingers further tightening of credit conditions adverse to bank fundamentals. 10-year Treasury yields have been on a relentless run-up towards a 16-year high with no signs of abatement. Further exacerbating the situation is the removal of House Speaker Kevin McCarthy, which casts significant uncertainty over prospects of reaching a spending deal within the government before the November 17 deadline to avert a shutdown. Recent data also supports the picture of an economy that is running too hot for the Fed's liking, reinforcing the higher for longer narrative on borrowing costs.
However, SoFi's flywheel business model is likely positioned to be a gainer amid a rising rate environment, relative to large financial institutions' exposure to massive held-to-maturity asset portfolios that have been depreciating at rapid rates as bond yields soar. While the company's lending-driven business increases its exposure to rising delinquency risks, the combination of improving charge-off rates, high quality credit requirements on extended loans, and a healthy capital ratio of 16% are strong net positives to weather potential spillover risks from broader financial sector weakness.
Student Loan Repayments Resumed
Student loan refinancing is a key component of SoFi's lending business. At its peak, relevant volumes accounted for close to 60% of the company's total loan portfolio. However, since the March 2020 pandemic-era moratorium applied on outstanding student loans, the company has estimated a permanent loss of $400 million and $200 million in prospective revenues and profits, respectively.
Essentially, the resumption of student loan repayments is the resumption of a key business component for SoFi, despite it coming at a time of tightening financial conditions for consumers. Interest accruals on outstanding student loans resumed on September 1, with repayments restarting this month. It is estimated that the resumption of student loan repayments could displace as much as $100 billion in annualized discretionary spending, affecting GDP growth by 0.1% in the current year and 0.3% in 2024.
As for SoFi, this improves the visibility on potential incoming student loan refinancing origination volumes going into Q4. We are also optimistic about SoFi's relatively lower funding costs, given its ability to facilitate most of its loans through cash from customer deposits. This also allows SoFi to better capitalize on the high-rate environment relative to the business model of traditional financial institutions (discussed in detail later).
However, as management had previously warned, student loan refinancing volumes are unlikely to reach pre-COVID levels, given the higher costs of borrowing today. Specifically, the interest rate on new undergraduate student loans starting July 1 will rise from 4.99% to 5.5% - the highest level since 2013 - while the cost of new graduate student loans increase from the current 6.54% to 7.05% and PLUS loans surge above 8% from the current 7.54%. With the added refinancing premium, SoFi charges as much as 9.84% depending on the loan type, size and terms, among other considerations on borrowers' credibility. It is more likely that financially capable borrowers would pay off the loans than to refinance them, as there are limited options to park the cash for better yield. This is in line with recent data that shows an upsurge in monthly student loan repayments by as much as 5x this year prior to the resumption of deadlines.
Systemic Risks in the Financial Sector
While the resumption of student loan repayments is a net positive for SoFi, the development adds incremental weight to already tightening financial conditions. The brewing financial stress has been a lingering headwind for the broader financial sector, consistent with weakness observed earlier this year in the string of regional bank failures. And this sector-wide headwind is likely what has been weighing on the SoFi's recent stock performance.
With the Fed reiterating its call for higher for longer rates, helped by recent data that shows an economy that is still running hotter than expected, the 10-year Treasury yield has been on a steep run-up past 4.8% this week, breaching a 16-year high. In this scenario, customers are likely to take their cash deposits to higher yielding investments/assets. This is consistent with slow-growing deposits at banks this year.
Not only does this macroeconomic setup diminish traditional banks' access to lower-cost funding, but also subjects them to a reduced market appetite for lending due to high interest rates. This has largely incentivized banks to pile up on held-to-maturity investments in the past with their excess cash from deposits, including U.S. Treasury which has been rapidly depreciating in value this year as higher interest rates drive up yield. Because these assets are essentially risk-free and designated as held-to-maturity, accounting rules do not require the mark-to-market gains/losses to be reported.
But this is where the narrative takes a dive - while elevated interest rates discourage lending, rising yields are also incentivizing a further rotation of cash out of deposits and into higher return investments. This has essentially required some banks to draw on liquidity from their held-to-maturity investment portfolios by selling the assets, such as long-term Treasuries, at substantial depreciation, with marked losses subsequently impacting their P&L and equity values. The substantial losses reported have been a signal of brewing trouble at the banks to depositors and investors. The subsequent trigger of both bank runs and stock-selling had required the FDIC to step in, with the ensuing increase of fear subsequently sending Silicon Valley Bank, Signature Bank, and First Republic Bank to their demise this year.
The increasing systemic risk of financial names has likely been a key driver of weakness in SoFi's recent stock performance. But SoFi's differentiated business model from the traditional financial institutions should not be overlooked.
SoFi's Flywheel Advantage
Recall from our initiating coverage of the stock when we discussed SoFi's flywheel business model - or "Financial Services Productivity Loop" - in detail. The company's diversified portfolio of financial service offerings - spanning day-to-day digital banking, lending and other digital payment solutions - is set up to increase members' lifetime values. This accordingly increases engagement, which subsequently generates incremental funding for the company to reinvest into future growth initiatives, thus attracting more engagement, and so on and so forth to reinforce a self-sufficient business model.
More importantly, the approval of a national bank charter for SoFi with its acquisition of Golden Pacific Bancorp in 2021 has allowed the company to better take advantage of low-cost funding through customer deposits for its core lending business. With deposits expanding at a healthy pace of about $2 billion per quarter, SoFi is able to fund half of its originated loans at a lower cost, thus expanding its net interest income and net interest margin in recent quarters, while its traditional peers are experiencing contractions on the metric. Specifically, the company has reported 216 bps of benefit between deposit and warehouse facility costs, with NIM posting sequential expansion to 5.74% during the second quarter, underscoring impressive returns generated on loans held for investment. Meanwhile, recent loan portfolio sales have also been met with healthy execution, despite a higher discount due to rising interest rates.
Looking ahead, SoFi is likely to be better positioned in acquiring deposits and facilitating loan demand in the near term relative to traditional financial institutions. In addition to increasing consistent membership net adds, SoFi is also receiving an increasing mix of "sticky direct deposits", which reinforces its access to lower-cost funding. Taken together with robust personal loan demand in recent quarters - likely underpinned by the appeal of SoFi's convenient and better value-for-money digital banking ecosystem to younger demographics - the company continues to be in a position of advantage amid a rising interest rate environment. Specifically, SoFi pays about 4.3% on consumer deposits, while charging as high as 25.81% APR on fixed rate personal loans.
The anticipated recovery of student loan refinancing origination volumes is likely to reinforce SoFi's NIM and NII expansion. As discussed in the earlier section, SoFi charges a hefty premium on relevant volumes, despite anticipation for further headwinds on total funding costs due to continued rate hikes. While the anticipated mix shift in originated volumes could impact SoFi's NII and NIM composition, increased exposure to loan demand will allow the company to better take advantage of the spread between low-cost funding from consumer deposits and high interest rates.
The company's balance sheet also remains well capitalized to take advantage of higher interest lending under the current market climate. SoFi reported $20+ billion in total lending capacity available at the end of Q2, with $13 billion in consumer deposits that are expected to grow at a quarterly run-rate of $2 billion, $8+ billion in warehouse facilities, and $3 billion of equity capital. SoFi also has most of its investments in available-for-sale ("AFS") designation, which means transparency in reported unrealized gains/losses due to changes in the assets' market value. Even if the company needs to liquidate some of its investments, it is unlikely to trigger any surprises. SoFi has also limited its AFS investments at less than 5% of deposits, which mitigates the company's exposure to material losses capable of triggering a crisis like those observed at traditional regional banks earlier this year.
Rising Delinquency Risks
Another potential driver of the stock's recent decline is likely the gradual rise of loan delinquency rates. We believe this is the most relevant and imminent risk facing SoFi, given its concentrated exposure to consumer lending and rising delinquency rates. Specifically, the most common consumer borrowings - spanning auto, credit card, home mortgages, and student loans - are rapidly trending towards pre-pandemic levels .
Meanwhile, household savings are also starting to see the impact of pandemic stimulus exhaustion. This coincides with rising risks of labour market weakness, given the full impact of interest rate hikes typically starts to affect this relatively resilient corner of the economy after 18 to 24 months .
With the majority of SoFi's customer deposits being used to fund personal loans, which are subsequently exposed to rising delinquency risks, the stock accordingly faces heightened downside implications. However, given SoFi's rigorous underwriting model to ensure high credit quality loans, coupled with its healthy capital ratio and lending capacity, the risks of a sequence-driven downward spiral is unlikely. Specifically, SoFi limits the extension of personal loans to $100,000, with the average size at approximately $30,000 in 2022. Meanwhile, the weighted average income of personal loan borrowers is $164,000 with a weighted average FICO score of 745, which fits in the " very good " credibility range, or one below "exceptional" at 800+. The 90-day delinquency rate on SoFi's personal loan book is also substantially lower than the industry's at 40 bps during Q2. While the company saw an increase in personal loan charge-offs on an absolute basis during the second quarter due to higher interest rates, the annualized charge-off rate actually improved sequentially to 2.94%.
Similar credit quality is observed for SoFi's home and student loan portfolio, offering better downside protection to the impending impact from broader macroeconomic weakness. But despite SoFi's capital positioning being within a reasonable range in our opinion, with sufficient liquidity to deploy and fund ongoing operations, relevant risks should not be overlooked.
Final Thoughts
SoFi's stock has largely underperformed the broader financial sector ( XLF ) over the past month, declining almost 18% and still in the red today (October 4). This diverges from the stock's outperformance on a year-to-date basis with more than 56% gains, compared to the riskier peer group's 5%+ declines observed over the same period. We believe the recent downward shift in sentiment for SoFi reflects increasing concerns about its core lending business' concentrated exposure to rising consumer loan delinquency risks, which drives up the stock's sensitivity to weakness in the broader financial sector.
While we believe SoFi's business model has a flywheel advantage over traditional banks, with its balance sheet still sustainably positioned to better benefit from rising interest rates, the market's risk-off sentiment - especially considering the company's concentrated exposure to rising delinquencies - is likely to drive further volatility to the stock. We expect potential for further exposure to downsides in tandem with the broader financial sector's underperformance in the near term, especially as SoFi's Q3 results are unlikely to top the Q2 beat and raise given management's expectation for a Q4-weighted year based on guidance.
However, near-term macroeconomic uncertainties have not resulted in structural deterioration of SoFi's flywheel advantage and self-sufficiency. Its business model also appears better positioned than the broader financial sector to benefit from an elevated interest rate environment, which lessens concerns on the company's ability to meet its Q4 target for GAAP profitability. This could be the impending catalyst needed to lift SoFi's stock from the current slump and unlock incremental pent-up value - likely heading into 2024, leading up to its year-end earnings. SoFi's recent declines are likely to emerge as a "buy the dip" opportunity with an increasingly compelling risk-reward set-up, rather than a risk-off value trap.
For further details see:
SoFi: Differentiated Business Model Potentially Positions It Better Than Traditional Banks