R. Christopher Whalen
Sep 7, 20235 min
September 7, 2023 | Premium Service | Over the past 6 weeks, US financials have given back much of the ground covered earlier in the year. JPMorgan (JPM) peaked at $157 around the end of July and has headed downhill along with the rest of the group. Meanwhile in the world of fintech, two of the high-beta names in our surveillance group are floating ever higher on the hype regarding AI and show no concern regarding the economy or credit or mediocre financial results. When you are in a big crowd, nothing else matters.
Source: Bloomberg (09/06/23)
Back in April we noted that Affirm Holdings (ARFM) and Upstart (UPST) were both trading at a steep discount to the rest of our fintech surveillance group. Right on schedule, the entire tech complex led by Nvidia (NVDA) began a frantic climb upward that ran through the end of August and then continued. It’s not that either firm has a particularly good results financially, but this does not prevent the inhabitants of the Sell Side analyst community from pumping the stock. UPST's was up almost 150% YTD at yesterday's close.
AFRM’s public valuation has basically been moving upward in hockey stick fashion as the Sell Side analyst community put all of its weight behind the stock. The key to understanding stocks such as AFRM, UPST and SoFi Technologies (SOF), which became a bank in 2022, is that the conversation is about tech, volumes and customer conversion, and not conventional financial performance.
Just as the crowd pushed up stocks like Block (SQ) in part years, this surge in valuation is about Buy Side managers seeking tech exposure. Notice that SOFI is up 80% YTD, but SQ is actually down. As one manager noted to us last year, becoming a bank helps these former tech darlings lose their luster. Notice that UPST and AFRM trade on betas above 3x the six month average market volatility calculated by Bloomberg, roughly twice the rest of the group.
With AFRM, the Street analysts have convinced themselves that issuing new credit cards is the path to value, but we keep looking at the rising portfolio of loans held for investment by this nonbank finance company. It was not too long ago that the likes of AFRM and UPST got slapped around pretty hard by analysts when they first disclosed to investors that they were retaining rather than selling loans. In an originate-to-sell model, retention is always bad. But obviously Buy Side managers have become comfortable. The chart below is from AFRM’s Q2 2023 disclosure.
The last earnings call (FY Q4 for AFRM) saw CFO Michael Linford setting the stage for AFRM’s business model pivot by noting that the firm’s retained portfolio had grown significantly, generating more income as loan coupons have also risen. He then dropped the bomb, but nobody on the call reacted. Nothing.
“What's important, from our perspective, is the ability to do that at the point of sale. And to do that in a way that doesn't impact conversion really reflects our true technology leadership in a way that I think is pretty difficult for other people to match. With respect to the forward-flow program, or selling whole loans, it is definitely the case that the volatility in the macroeconomic conditions definitely changed the mix of business that we were doing with respect to on-balance-sheet or off-balance-sheet loan funding. That being said, the tone and tenor of conversations with capital partners today is very constructive. We have really differentiated credit performance. That's something that I think loan investors really appreciate about our platform.”
The credit performance of the AFRM paper is OK, somewhat north of Ally Financial (ALLY) in terms of delinquency but below CapitalOne (COF). The chart below shows the delinquency of the various vintages of AFRM paper excluding fallen angel Peloton (PTON). Notice that the delinquency rate on the 2020-2021 vintages produced during QE is well-below the other cohorts.
Of course AFRM is continuing to report large GAAP losses, although the company steers investors to its adjusted results. For AFRM, the point is growing users and getting those users to choose their card so as to capture a “fair share of donuts and coffee.” Yet we feel compelled to point out that ARFM’s operating losses, which more or less equate to the equity award expense for insiders, have grown with revenue rather than being reduced. But, again, the Buy Side is apparently comfortable.
If you go to the last page (49) of the earnings supplement, the reconciliation from GAAP to the “adjusted” results used by AFRM management in their communications with investors lays bare the charade. Of $2.8 billion in revenues, AFRM subtracts $130 million in depreciation and amortization, $450 million in stock based compensation for insiders, $500 million in “Enterprise Warrant & Share Based” compensation for partners such such as Amazon (AMZN), and $43 million in restructuring and other expenses. The result is a $1.6 billion “adjusted” expense number. The relevant table is below.
Clearly the Sell Side analyst community is comfortable with the fact that commercial partners and management are taking hundreds of millions of dollars per quarter in value out of AFRM in return for whatever consideration. With US tech stocks now selling off more broadly, the peak valuation for AFRM this year of ~ $7 billion may come under pressure.
China’s decision to ban the use of Apple (AAPL) iPhones and other factors may take the air out of aspirational stocks such as AFRM. But more to the point of the mania clearly present in stocks with even a hint of technology influence, if you get big profits in a short-term move that seems irrational, take the money off the table. When we took a more than 200% LT gain in Nvidia (NVDA) after it rose above $400 a month ago, we watched as our remaining taxable stake almost touched $500. We felt some remorse, but we also like the pile of cash sitting in T-bills.
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