Despite Impressive Q4 Results, SoFi Is Still Too Confusing to Invest In

Digital bank and one-stop-shop financial services company SoFi (SOFI -0.67%) beat analysts’ consensus estimates for the fourth quarter.

Perhaps more importantly for investors, management also guided for higher adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for 2023. In the wake of the Q4 report, shares surged.

While I do like SoFi’s strategy of trying to be the one-stop banking solution for high-income earners, I find the company’s high valuation perplexing, given that I don’t see it possessing a substantial moat at this time. I also don’t think the company is providing adequate disclosures, which can make it difficult to evaluate its lending franchise. These issues, in my opinion, make SoFi too confusing to invest in right now.

What moat

SoFi has surpassed 5.2 million members, which it defines as “someone who has a lending relationship with us through origination and/or servicing, opened a financial services account, linked an external account to our platform, or signed up for our credit score monitoring service.”

It has also grown its balance sheet quickly, and now has close to $8 billion of personal loans and $4.6 billion of student loans on its books, as well as $7.3 billion of deposits.

While this all sounds great, SoFi has really built these balances by winning on price, which is normally a bad banking strategy. The bank has been offering up to a 3.75% annual percentage yield and no account fees, as well as a $250 bonus when people sign up for direct deposit. When SoFi began offering this promotion, the Federal Reserve’s benchmark overnight lending rate, the federal funds rate, was in the 4.25% to 4.5% range. SoFi is offering a great deal for its customers, but from a business perspective, this is still an incredibly high cost of funding.

It’s very likely that a lot of these deposit relationships are not very profitable for it, or are costing it money. SoFi reported a $43 million loss in its financial services division in the fourth quarter. Management did say they think they can get this division to be contribution profit positive by the end of 2023, which would be impressive, but I have my doubts.

Poor disclosures

SoFi employs an interesting business model. Instead of selling the loans it originates right away, it holds them on its balance sheet for about six months before selling them.

It does this so it can designate the loans as “held for sale,” which allows the company to collect recurring monthly interest payments for a time, but also means it doesn’t have to set aside reserves for lifetime losses on those loans, which can take a big bite out of earnings.

The risk is that if demand for SoFi’s loans falls off, then it will either need to eat the losses on its own or sell the loans below their fair value to investors. In order to protect against some of this risk, the company hedges pretty much all of the loans on its balance sheet, largely through interest rate swaps.

SoFi loan originations and sales fee income.

Image source: SoFi Technologies.

SoFi does provide quarterly loan loss figures, which is helpful, but it clumps originations, loan sales, and fair value adjustments to loans into one line item, which makes it difficult to dissect.

SoFi does serve a pretty high-quality clientele: Its average borrower has a FICO score of 747. Management said on its fourth-quarter earnings call that its annualized personal loan net charge-off rate as a percentage of total personal loans was 2.47%, while its 90-day personal loan delinquency rate was 0.34%.

Those are pretty good figures, although the 30-day delinquency rate would have been more helpful to see which loans more recently became delinquent. An update on how credit card loans are holding up would have been helpful as well because delinquencies were pretty high in the third quarter.

I don’t understand why SoFi can’t do a better job of breaking out some of these metrics in its earnings reports, and not make investors wait to see its regulatory filings. It would be helpful if, on the day of their earnings report, SoFi provided its 30-, 60-, and 90-day delinquencies, as well as its loan loss rates. I’d also be interested in regularly getting the gain-on-sale margins for the loans sold in the quarter. Sometimes, some of this data comes out via the earnings call — but not always.

Why does the business get a premium valuation?

I think I understand SoFi’s business strategy, and I do like it for the most part. But I don’t understand why the company can’t provide better disclosures, or why its stock gets a premium valuation.

Its deposit growth is being fueled by high-cost deposits and promotions. Trying to win over customers on rate has typically not been a winning strategy for banks. While it looks like SoFi’s hedging strategy is working, I still think the way it holds loans and designates them held-for-sale leaves it vulnerable if there is a severe recession.

SoFi is not profitable, but management says it expects to achieve quarterly profitability by the end of the year. This would require some pretty strong performance in the back half of the year. That’s possible, but it’s not a lock, in my opinion. I would perhaps be more interested in investing in SoFi if it were trading at a more reasonable valuation, but shares are changing hands at more than 26 times its expected 2023 adjusted EBITDA (at the high end of its guidance range), and at 246% of its tangible book value.