Olivier Le Moal/iStock via Getty Images
Olivier Le Moal/iStock via Getty Images
The following segment was excerpted from this fund letter.
One of our portfolio holdings that we believe will be relatively resilient is Enova International (down 26% YTD). We last wrote about Enova in our Q3 2018 letter. Since that letter, the trailing twelve-month earnings of the company have quadrupled and tangible book value per share has grown more than 12x. Despite that huge growth, their stock is trading at almost the same price it was back then!
Enova is a subprime lender that uses machine learning methods to provide an automated underwriting of loans for a variety of different loan products. Enova has traded down to an extremely cheap valuation despite having strong organic growth and recently acquiring OnDeck Capital, a small business lender, at a bargain valuation. Enova is still in the process of realizing all of the synergies of combining its core business with OnDeck Capital and we should expect this combination to perform even better in the future.
Enova’s current cheap valuation is the result of two main fears; the regulatory risk against high interest loans and the potential impact that an impending recession will have on the company.
Enova is an online-only subprime lender that originally spun out of Cash America International in 2014. As an online-based business, they have more flexibility to scale up or scale down their lending than the brick-and-mortar lenders they have displaced. Another key advantage is that they are constantly building up data on their interactions with customers and can determine which customers are better credit risks.
New pools of customers tend to be less profitable to Enova than seasoned ones as the company has not yet figured out which customers are good credit risks. Therefore, in periods of business growth, we should expect the company to have compressed margins compared to their steady state. During 2020 and 2021, Enova became more conservative in their underwriting and faced reduced customer demand resulting in their net charge-offs falling dramatically to the lowest levels in the company’s history.
Like many business models based on machine learning and big data techniques, the database of the company builds into a growing competitive moat over time. Once Enova is deeply entrenched in an area of business, they will have enough data to know which customers are good credit risks. A new entrant will have too many nonperforming loans (NPLs) if competing directly on similar terms to Enova.
Most financial companies with a sustainable competitive advantage over peers have either a funding advantage or an underwriting advantage. We believe that Enova’s online-only lending model backed by their database containing hundreds of millions of customer interactions built over almost twenty years in business is an example of an underwriting advantage.
The importance of proper underwriting for these kinds of subprime loans can be seen in the investment of Enova’s human resources. The company spends more on operations and technology ($148M in 2021) and general and administrative expenses ($157M in 2021) than they do on net interest expense ($77M in 2021). This is a different business from traditional prime lending where the net interest expense is a greater component of cost.
Two similar publicly traded online lenders are Curo Group Holdings (CURO) and Elevate Credit (ELVT). Compared to these two businesses, Enova has managed to greatly outperform during the pandemic recession in both gross margins and net charge offs as a percentage of revenue. Curo has attempted to build out a data and algorithm platform for underwriting decision making in order to produce a “Curo Score” for each loan application. They are still lagging behind Enova in both the human resources (engineering and compliance talent) and database size.
Elevate Credit has invested in machine learning data tools for underwriting decisions since early in the company’s history. However, it still lacks the scale of Enova at less than a tenth of Enova’s market capitalization. As this business model requires large fixed investment in building out the IT and legal compliance infrastructure, it will be difficult for Curo or Elevate to compete with Enova long-term.
Investors incorrectly assume that since we’re going into a recession, that this will have a disproportionate effect on subprime lenders. In reality, Enova held up well during 2008 and 2020. As CEO David Fisher explained, “in many ways, recessions have less of an impact on our customers than on prime borrowers.[5]” The increase in non-performing loans to be expected in a recession is relatively small compared to their normal rate of charge-offs. As their business model already assumes high charge-offs, the increase from a recession does not destroy their profitability.
A prime lender needs to have low rates of non-performing loans in their portfolio in order to remain profitable. Additionally, as many of their financial products are short-term, Enova has more of a capacity to adjust underwriting to macro conditions.
Charge-offs (net of recoveries) as a % of average combined loan and finance receivable balance for consumer loans actually fell from 14.1% in Q4 2019 to 5.5% in Q4 2020. As of Q1 2022, they had returned to pre-pandemic levels (14.2% for consumer loans and 1.9% for small business loans).
The company believes that the current environment is ripe for Enova to continue another round of business growth, especially in their small business loans, and Enova has been increasing their marketing spending. Marketing expenses totaled $93 million in Q1 2022 or 24% of revenue compared to $29 million or 11% of revenue in the first quarter of 2021.
In July 2020, Enova reached an agreement to acquire all outstanding shares of OnDeck in a cash and stock transaction valued at approximately $90 million. The transaction was highly accretive as OnDeck was focused on business lending and Enova was focused on consumer lending. The combined entity had many cost and revenue synergies which are still being realized.
The acquisition of OnDeck also makes the company more robust against regulatory risks which limit their ability to lend to subprime risk consumers.
Currently, 17 states and the District of Columbia have passed laws preventing consumer loans that have higher interest than 36%. There are ways for subprime lenders to work around these rules, including through partnerships with nationally chartered banks which are not subject to state usury laws. In that case, the subprime lender would provide the marketing and underwriting while the bank partner makes the actual loan.
On July 28th 2021, Senator Sherrod Brown (D-OH) submitted a bill, Veterans and Consumers Fair Credit Act (US S2508), which would make this rate cap a national limit. If a national 36% cap were to be passed, short-term, unsecured subprime consumer lending would disappear as an industry in the United States.
Customers and other small businesses (May 2022 Enova Investor’s Presentation, research from Enova and KS&R, sample of Enova company)
Customers and other small businesses (May 2022 Enova Investor’s Presentation, research from Enova and KS&R, sample of Enova company)
There have been fears about regulatory threats to subprime lending for over a decade, and investors generally profited from ignoring them. Congress is unlikely to decide to eliminate these loan choices for subprime borrowers, and I predict this bill will die in committee. Some of the reforms that have come to pass have had a significant effect on Enova’s business. For example, the regulatory regime created in the UK led to Enova liquidating their subsidiary in that country and exiting the market.
With Enova’s business model being diversified across different geographies, customer types, and products, they will be able to survive whatever regulatory changes are thrown at them and adapt better than their smaller subprime competitors. However, even if not completely fatal, the impact of a national consumer interest rate cap would have a significantly negative impact on the earnings of Enova going forward.
The OnDeck acquisition gave them the ability to grow with business customers that are not subject to these interest rate caps. These small business loans now make up the majority of Enova’s outstanding loan receivables. According to the company’s surveys, the most common reason businesses take these loans are to bridge short-term cashflow issues.
On May 24th, 2021, Enova received a Civil Investigative Demand (“CID”) from the CFPB relating to a handful of issues, several of which were self-reported. Enova will likely have to provide restitution to customers affected by the issues involved and pay a minor fine. The company said that this CID covered a small subset of customers. I do not anticipate this having a materially negative effect on the company.
Enova has a much higher cost of capital than prime lenders. If a company with a lower cost of capital was willing to bear the losses to copy the business model of Enova and compete against them long enough to establish a useful dataset of borrowers and brand awareness, they could eventually be a competitive threat to Enova.
We have a variant perception from the market consensus about the risks of Enova’s recession impact and regulatory interest rate caps. When the aforementioned interest rate cap bill does not get passed and the company maintains revenue growth and high profitability throughout the recession, Enova may rerate to a higher multiple. Enova’s competitive advantages will grow over time. The relative scale to other online only lenders will expand. Their underwriting algorithms will perform better as customer data increases.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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