Full Year 2018 Funding Circle Holdings PLC Earnings Presentation
London Jul 11, 2019 (Thomson StreetEvents) -- Edited Transcript of Funding Circle Holdings PLC earnings conference call or presentation Thursday, March 7, 2019 at 9:30:00am GMT
TEXT version of Transcript
* Samir Desai
Funding Circle Holdings plc - Co-Founder and CEO
* Sean Glithero
Funding Circle Holdings plc - CFO
Samir Desai, Funding Circle Holdings plc - Co-Founder and CEO 
Great. So thank you very much for joining us at our maiden set of annual results. Really pleased to have so many of you here and to have delivered on our IPO guidance. Really pleased with how the past 12 months have gone at Funding Circle. The business is in great shape and we have got some exciting plans for the future.
So I am going to spend a few minutes introducing Funding Circle. I won't spend too long because I know everyone is pretty familiar with it. And then I will hand over to Sean to talk about the financials and then come back to talk about market and some of our plans for this year. And there will be time for Q&A at the end.
And this is my first time as a public CEO, public company CEO, presenting results, so please go easy on me a little bit. But obviously Sean has done this many times before, so you can do what you want with him.
So really pleased with how the year ended. We delivered 55% growth in loans under management to reach GBP3.15 billion. Our platform continues to expand. We have over 60,000 small businesses on the platform now, over 85,000 investors, and we continue to attract large commitments in both the US and UK of $1 billion and GBP1 billion towards the end of last year.
In terms of financials, really pleased to have exceeded our IPO guidance of around 50% revenue growth. We delivered 55% growth in revenue to about GBP142 million. Even at that higher level of revenue, we delivered positive segment adjusted EBITDA margins of about 5%. It is the first time we had delivered positive segment margins. And our adjusted EBITDA margin fell from about negative 27% to negative 20%, despite the fact that we continue to invest in growth and technology and pursued our strategy of growth over profitability.
We raised GBP300 million at the IPO; relatively modest IPO costs of about GBP15 million. So really put us into a very strong position financially. Very strong balance sheet. And we continue to invest in marketing to really increase awareness amongst small businesses. And that is why we kept the marketing spend flat, as we guided to at the IPO.
So as you know, Funding Circle is a platform model. We connect up thousands of different investors with small businesses across multiple geographies to really help them all succeed. The core of our platform is really about delivering an amazing borrower experience, underpinned by cutting-edge technology, very sophisticated data analytics. And really deliver superior investor returns in that kind of 5% to 8% range across our different geographies, which compare very favorably with other fixed income asset classes.
The core of our platform is really about repeat. It's about building these stable predictable relationships with small business customers. We showed this chart at the IPO, but what you can see is that it continues -- various different cohorts of borrowers continue to repeat with us on a very stable linear basis. And that is really because we deliver this great borrower experience. 85% of them tell us that they would always come back to us first in the future.
And we are also pleased to provide some additional financial disclosure around the margins on these existing customers to help underpin our long-term profitability story. Because it is a really important part of what we do.
On the investor side of the platform, we continue to see existing investors increase their commitment through the platform year over year. We added a number of different new commitments and also an upsized commitment from the British Business Bank, which is the UK government.
And really, we are providing access to small business loans as an asset class that has been previously inaccessible to these types of investors. It's really just sat on bank balance sheets and we are really making it available to lots and lots of different types of investors.
I will just hand over to Sean to talk about the financials.
Sean Glithero, Funding Circle Holdings plc - CFO 
Morning, everyone. So going to start the financial analysis talking about loans under management, the driver of our servicing revenue, and originations, the driver of our transaction revenue.
Loans under management grew 55% to over GBP3.1 billion. This followed origination growth of 40%. The growth figures here exclude property lines, and for the geos, growth percentages are shown in local currency.
Loans under management in the UK were well over GBP2 billion by the end of the year, and the US were close to $1 billion, a figure that they exceeded in February this year. In the developing markets, loans under management doubled in both Germany and the Netherlands.
Year-on-year origination growth was tempered by some policy changes. Firstly, the decision in late 2017 to reduce the number of third-party referral partners in both the UK and the US. Secondly, in the US, prior to Q1, we used to require existing borrowers returning for another loan to roll over the remaining principal of their original loan into a new loan, but they didn't pay any additional origination fee on this rollover balance.
Post Q1, borrowers had the choice to roll over into a new consolidated loan or maintain two loans. This actually led to less rollovers and lower new originations, but revenue remained unchanged. So yield actually increased. The impact of these policy changes was most pronounced in the US, where they lost probably about 20 percentage points of origination growth as a result.
Revenue growth of 55% excluding property saw revenue exceed GBP140 million for the year. The growth was faster than the 40% origination improvement due to a combination of three things. Firstly, 18% of revenue coming from servicing revenue that grew in line with loans under management. Secondly, higher other revenue, and lastly, better transaction yield, which improved from 4.6% of originations in 2017 to 4.9% of originations in 2018 and actually exited the year at a yield of over 5%. This higher transaction yield being a function of price rises across all geographic segments rather than any variation in loan 10 years or increased risk.
And revenue from existing customers, which includes servicing fee revenue as well as the transaction fee revenue of repeat borrowing, grew by 67%. This meant existing revenue in 2018 was greater than new revenue in 2017 and represented 43% of total revenue for the year.
At a geographic segment level, the Group reported a profit for the first time of GBP7 million. All geos improved the previous year's levels of profitability. The UK, growing by 29%, with losses in both the US and developing markets reducing. This was very much a function of the business in each territory growing quickly and benefiting from economies of scale as well as building a larger back book of borrowers that firstly drives servicing revenue on loans under management and also fees on repeat borrowing.
This improvement being after continuing to invest for growth, with marketing remaining at 41% of revenue for the Group as a whole. Segment margins also improved markedly in the US and developing markets and only fell slightly in the UK as marketing spend increased to 40% of revenue, including the cost of above-the-line or brand marketing campaigns.
Now I will do some commentary on the individual geos. The UK approached GBP100 million in revenue, up 43%, with faster growth and existing customer revenue now close to 50% of the business. In the past, we reported unit economics on a first loan and a repeat loan basis across the lifetime and this was hard to tie to the P&L. As Samir said earlier, we've listened to the feedback and we have now introduced a P&L view that splits revenue and segment margin between new customers and existing customers, the existing customer base being a key driver of longer-term profitability.
As existing customers are familiar with the product offering, there is no marketing spend, which can drag on margins. And as such, existing customer margins in the UK in 2018 were 64%. Conversely, the investment in marketing restricted the new borrower margin to negative 16%.
In the US, revenue was up 70% in dollar terms to nearly $50 million. As a less mature market than the UK, or a less mature business than the UK, existing customer revenue was only 35% of the total, but it did more than double in the year.
The smaller scale of the business compared to the UK means new and existing customer margins are lower than in the UK. And the weighting towards new borrowers means the overall business was lossmaking in the year, despite marketing spend falling to 42% of revenue. Looking ahead, though, the US will be segment profitable later in 2019.
Developing markets revenue almost trebled in the year to EUR12.7 million with strong growth of new borrowers. And the growing book of loans under management added to existing customer revenue. Germany and the Netherlands are growing at a similar rate, but existing customers are not yet profitable as the business lacks scale and is probably two to three years behind the US.
Adjusted EBITDA at a Group level increased to a GBP28.5 million loss, but the loss margin fell from 27% in 2017 to 20% in 2018. A segment profit of GBP7 million was offset by GBP24.5 million of product development spend charged to the P&L and increased corporate costs that included operating as a PLC post-IPO.
Gross product development costs were GBP35 million, up 46% year on year, with more charged to the P&L compared to 2017 as amounts capitalized as intangible fixed assets were similar each year. The increase in spend being mainly a function of additional software engineers to develop our marketplace ledger platform as well as to automate our processes.
Free cash flow, defined as the sum of operating and investing activities and before financing activities, rose to GBP42 million outflow. The main difference to adjusted EBITDA being the GBP11 million of capitalized development spend, which is treated as intangible fixed assets.
If we look at the statutory P&L format, we see that the share-based payments charge of GBP8.6 million included GBP3.6 million of employers national insurance costs that arose as the business neared IPO. Cash IPO costs of GBP15 million were incurred, with GBP5.9 million booked to the P&L and the balance recorded against share premium. R&D tax credits were again received, totaling GBP1.4 million.
Cash finished the year at GBP333 million with the movement in the year essentially being free cash flow and net IPO proceeds of GBP285 million. From a balance sheet perspective, net equity rose to over GBP400 million following the capital raise.
I am now going to hand back to Samir to talk about the market, but we will be back later to talk about the outlook. But what I would like to say is really pleased with the financial performance of the year and hitting all the metrics that we guided to at IPO. Thank you.
Samir Desai, Funding Circle Holdings plc - Co-Founder and CEO 
Thanks. I am just going to talk a bit about the market and where Funding Circle is positioned and then our long-term strategy. So across all of our markets, we continue to take share. We reached a high of 2.6% market share in the UK, and in the US continue to build, and Netherlands as well.
But you can see that we are still a very small part of the overall addressable market. If you remember at the IPO, we set out how we target loans typically below 500,000 pounds, euros, or dollars, typically in the very prime part of the market. So we exclude larger loans, commercial mortgages, high interest lending, those above 25% APR. So we still think there is a lot of runway to go and that is why we continue to invest in growth over profitability.
What we have set out here is clearly our competitive position versus the banks, as we are a small part of the market. But at the IPO, we also set out the two main categories of other competitors that we saw. That is leading -- that is captive networks, so that is payment companies, e-commerce companies, people you are probably all familiar with. And then typically balance sheet lenders that operate online typically in the higher interest space.
And what you can see is that Funding Circle comfortably is the largest online small business loan provider by loans outstanding. We really do sit head and shoulders above everyone else globally. But clearly, as I said before, the banks are really the biggest part of the market and the main competition.
So a few fun facts. If you look at net new lending, so that is gross lending less repayments that come back from borrowers -- this is really the Bank of England and the Treasury's preferred measure of how much money is going into the economy -- funding Circle actually did more net new lending in 2018 than the entire UK banking system.
So really, you can just start to get a sense of the measure of how much of a contribution we are able to make. Part of the reason the British Business Bank and the UK government like working with us is because we are really helping stimulate the economy, creating jobs, and really helping small business borrowers.
We have not really talked too much about our US business. We went to the US in 2015 -- sorry, 2013, and Germany and Netherlands in 2015. So we have been in the market for about five years. We recently passed $1 billion of loans under management in the US. If we were a bank, and we are not a bank, but if we were a bank, Funding Circle would actually be one of the top 50 banks in loans below $1 million in the US. We can get below $500,000, but you'd imagine we are larger there, and bigger than 5,100 other banks.
So that is really starting to get -- hopefully you can really start to get a sense that we are starting to penetrate markets outside the UK, really starting to make a big difference, although clearly a way to go until we are bigger than American Express and Bank of America. We've got some Bank of America people here.
So in terms of lending trends, small business loans remain below the levels they were at in 2011 and precrisis levels. Banks have been pulling back from this part of the market due to the worse capital treatment on the loans and the fact that they are difficult to serve and really been expanding more in mortgages, larger corporate loans.
It is a different story in consumer lending. So in consumer lending in the UK, you are seeing that rise above levels in 2011 and above precrisis levels. But we are feeling quite good about indebtedness of small business borrowers. They still remain much less indebted that they were precrisis.
And that kind of shows a bit in the insolvency trends. So what this graph shows is insolvencies indexed to 2008 when they started to tick up. All our geographies, we remain well below precrisis levels of insolvency. And we are not seeing anything really on the small business side that concerns us. Small uptick in the UK, but it came down at the end of the year, so nothing really there.
On the consumer side, you are seeing some normalization in the US, so losses coming up a little bit. And in the UK, we did see -- we do see an uptick. As you know, consumer lending and consumers obviously don't really affect us in the most part. It does on the margins affect some of our smaller loans, younger companies, where we tightened a little bit towards the end of last year and we continue to be prudent in that part of the market. But as I said, for the vast majority of our portfolio, we don't see much of an effect.
In terms of projected returns, these are projected returns that we put out quarterly. There's been no change in those. What these show is the net returns on our loans across each geography net of the projected bad debt rates below.
I think what is unique about small business lending and the product that we offer is that we have very high loss coverage on these loans. So if you look at markets like the UK, Netherlands, Germany, losses could treble; in the US, losses could double, more than double, and investors would still get a positive return.
And I think that is important because we will have movements in bad debt rates, small here or there and we constantly publish those, but those don't actually make that big a difference to the return number. And that is the number that investors on the platform really focus on. So it is a very resilient asset. I am not going to go through stress testing again, but we have stress tests. We feel pretty good about where we are positioned.
So in terms of strategy, at the IPO, we told you we had this Funding Circle 2020 three-year strategic plan. We continue to execute against that. And that has got four main pillars: driving a better borrower experience; investing in data, tech, and analytics; continue to diversify our funding sources; building this highly scalable global business. And I am going to talk through some -- where we are on those and how we continue to progress.
On the technology side, we continue to rebuild our platform into a global market -- into a global form. We put a global marketplace platform live in the US. We are currently rolling that out in Germany and the Netherlands. We have put live a global collection system, so all of our collectors globally are on the same system now benefiting from all the technology enhancements we are doing.
And we set out at the IPO, we have this important target for us of having 50% of loans automated by 2020. And we have over 150 engineers working on the global platform and that automation target. And we are feeling very good about the progress that we are making.
We launched proprietary bank account transaction models in the UK and US last year, looking at individual transactions, doing text mining. And as the largest online small business loan provider, we feel really good about our position in the market to be able to take account of new innovations like open banking in the UK, PSD2 in Europe.
Having bank account data is interesting, but having bank account data that you can match to years of loan performance and build proprietary models is very, very key to being able to use this. And we feel like we are one of the few, maybe even the only one that can actually really take that data and use it.
And we continue to focus on building the largest -- we call it data lake now; it used to be called databases -- but data lake of small business data across all our different geographies. And that is used for targeting, for marketing, for risk analytics. We added 1.2 billion data points into our data lake last year. And we continue we think be on the cutting-edge of analyzing small business data and definitely spending more time on this than I think anyone else.
We launched our -- in terms of driving a better borrower experience, one of our key focuses is to increase awareness and consideration. We launched our Captain Galactic advertising campaign in the UK and launched a few testing campaigns in other geographies. Captain Galactic going into the stratosphere. Hopefully you saw the ads; hopefully you like them. We have been focused mainly on TV and radio.
And we are seeing some early promising results in terms of improvements in unprompted awareness of borrowers. Definite improvement in consideration to take out a Funding Circle loan. Really, we are trying to build trust, awareness, really trying to get small businesses to stop thinking bank first and start thinking Funding Circle first.
And what we show here is weekly search volumes for business loans in the UK. We launched a smaller advertising campaign in 2017. That was a drummer and skipper; that is why we show some drums here; and Captain Galactic in 2018. We typically frontload these campaigns, so we spend a lot more at the beginning and then we go down and have a base level because that is basically what we have found to be the most effective and efficient.
But what you can see here which is quite interesting is that Funding Circle business search volume is now significantly larger than online search volume for business loans. We feel like we have really emerged as the category leader online. And as more businesses come online to take loans, as banks even try and move their customers online, we feel like we are really well positioned to take advantage of this trend.
Another interesting thing is that we saw this tail-off or dip towards the end of last year in business loan search volume with a little bit of uncertainty around Brexit. We feel like we were less affected by that, just given where we are in the market and our existing customer base. And we are able to continue to deliver all the guidance we talked about.
In terms of building a highly scalable global business, we set out at the IPO that having internationalized this business, we had aspirations to keep adding more markets. And whilst we remain very focused on our core markets, there is a huge addressable market there.
Really excited to announce that we will be launching in Canada in the second half of this year. Canada is a very attractive market. The businesses there are attractive from a risk perspective, but also share many of the characteristics in terms of data accessibility, in terms of being underserved by the banks, frankly.
It looks very similar to the UK and Netherlands from our perspective. Maybe you think Germany and US are more similar in terms of having lots of banks. UK, Netherlands, and Canada are a very concentrated banking system. We think we can make a big difference. The Canadian government has really been pushing getting alternatives into the market.
The fourth pillar: we had in the IPO, as we talked about, diversifying our funding sources. And if you look at the evolution of the Funding Circle marketplace, we started out with fractional loans. So this is where retail investors could buy parts of loans. A retail investor can't come and buy a GBP70,000 loan; we would divide it into lots of little chunks and we launched that across our geographies.
In 2013, we added whole loans. That was where institutions came to us and said I don't want loads of GBP20 loan parts. I want the whole loan and I want it to be separate from the retail platform. So we launched that. And in 2015, we launched the listed fund Funding Circle SME Income Fund. And really the rationale there was to give access to equity income investors, those that can't buy loans but can buy listed equities basically.
So we are really pleased to continue that expansion of our investor products. We will be launching a private fund in Continental Europe and a bond product in the US in 2019. And really, what these do is allow us to access a much wider universe of investors. We have projected that the future investor TAM or the future amount of money we can access increases 4x to GBP2.5 trillion. And really gives us access to these other types of investors, which we are excited about.
So I am just going to talk about some of the key highlights of these products and then Sean is going to walk you through some of the mechanics. And then we will finish with outlook and we will take some Q&A. But in the US, we will launch a securitization product, a bond product, in the first half of this year.
And this really provides access to investors that can't or don't want to purchase loans. Some investors say, look, I can purchase loans, but I don't want 2,000 loans on my system. I'd rather have one thing with a ticker that I can look at to actually access the income that we generate.
Over the next two years, we are targeting an additional more than $500 million for funding in the US from this product. There is a regulatory requirement in the US that we hold 5% of the bonds for up to two years, so we will comply with that. That really represents a very small part of the balance sheet.
And as we package these loans up, as we aggregate them for a few months, we do bear the credit risk on the loans while they get built up and then before they get sold. But typically that is the least risky part because borrowers can't actually default for three months. There is a small revenue and profit enhancement from this, so it will actually be accretive to the P&L. And Sean will talk through that.
In Continental Europe, what we have seen is a lot of investors are participating in these direct lending funds. So these are typically where these funds are lending to midsize corporates, typically 40 million, 50 million ticket sizes. And we've had a lot of demand from these type of investors -- insurers, pension funds -- to actually produce a product that can allow them to get access to smaller SMEs, which is what we do.
So again, we are providing access to investors that can't hold the individual loans but can invest in funds. Over the next three years we are targeting an additional EUR200 million of funding in Germany and Netherlands for this.
It's typically -- it's pretty standard for the platform or the manager to put in about up to 5% of the capital in these funds, which we will do. And again, a bit like the bond product, we will have some credit risk on our share of the loans in the fund for up to eight years as the fund does a three-year life and then starts to pay down. And again, there is a small revenue and profit enhancement from this activity.
So thanks. I will just hand over to Sean to talk about the rest of the presentation.
Sean Glithero, Funding Circle Holdings plc - CFO 
Thanks, Samir. So just going to take a few moments now to explain how these new products will actually work and how they will impact our financial statements. I have actually included a bit more detail in the appendix on the financial statement presentation for you to sort of get into how it models, etc.
But in terms of the mechanics of the bonds, if we start in the top left with the first issuance. So prior to creating the rated bonds for these investors to buy, we need to have sufficient loans need to be built up in the warehouse phase.
So loans originated on our platform will be funded by bank debt, which is shown in the light blue, and our own working capital, which is shown in the dark blue, in a ratio of about 3 to 1. So if we use an indicative warehouse size of GBP200 million, this would mean by at the end of the warehouse stage us having GBP200 million of investments in SME loans on our balance sheet, which would be funded in part by GBP150 million of debt.
Now whilst this debt will be consolidated onto our balance sheet, it will be held in a separate bankruptcy remote entity that will have limited recourse to the rest of the FC Group. So then at securitization, shown here in the dotted line, investors would buy 95% of the notes backed by these SME loans, with us retaining 5% for up to two years for regulatory reasons.
Now the cash from the sale of the notes would repay our working capital and the bank debt, and the investment in SME loans would cease to be recorded on our balance sheet at this point. Instead, we would be left with an investment in 5% of the bond notes, shown here in purple. And this investment then reduces as cash flows from the SME loans are used to repay principal as well as interest on the notes.
Then a second issuance would then follow the same pattern: originating loans in a warehouse until securitization, at which point we would keep 5% share of the bond notes. So there is no set rules on how long the warehouse phase should be, but a reasonable approach is five to seven months.
And then what the balance sheet will show at any reporting date would be very much a function of where we are in the phases. In this example, at the first year end, the warehouse is not yet complete. Whereas in the second year end, the balance sheet will show risk retention elements of two issuances and a partial warehouse build.
From a P&L perspective, the impact is small but welcome. Revenue is shown net of the cost to serve and fair value adjustments with most of the circa GBP3 million of revenue and circa GBP2 million of EBITDA being earned in the warehouse stage. But there is also worth remembering the primary reason for this new product is to diversify our funding and access a large investor TAM.
If we turn now to the private fund mechanics, once we are up and running, we will record our share of the private fund, which will typically be about 5%. Again, shown in purple. In the investment phase, our share will be quite static and we will be earning net returns, which will be shown as revenue, very much in line with the net returns of other developing market investors. Thereafter in the distribution phase, the investment will gradually reduce as principal repayments are made.
And then finally, turning to the outlook for 2019, our IPO medium-term plan, which for the avoidance of doubt was through to 2020, remains unchanged. The focus being one of pursuing growth over profitability.
Then if we think first of 2019, prior to the impact of these new investor products and the accounting change presented by IFRS 16, we are guiding revenue to be above GBP200 million with transaction yields remaining at 2018 exit levels, which will provide a year-on-year revenue benefit as we will be lapping lower average 2018 yields.
Segment margin, including the organic expansion to Canada, to approximately double, with marketing spend as a percentage of revenue remaining flat year on year. Then after central costs fall into 20%-plus of revenue, which includes the investment in product development and a full year of PLC-related expenditure, adjusted EBITDA losses are set to reduce from 2018 levels. Capitalized development spend, which is recorded as intangible fixed assets, to grow modestly.
Then there is the incremental impact of the new products and IFRS 16. New investor products are to add GBP2 million to GBP3 million to both revenue and adjusted EBITDA in the year. IFRS 16 is to add circa GBP5 million of both segment adjusted EBITDA and an overall Group adjusted EBITDA level, but have a minimal impact on loss before tax, which is similar to the pro forma 2018 impact I have outlined in the appendix. And then finally, we will report our first-quarter loans under management and origination figures on April 18 when we will put out our usual loan performance statistics.
Thank you very much for coming and for listening.