Half Year 2019 Funding Circle Holdings PLC Earnings Call
London Sep 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Funding Circle Holdings PLC earnings conference call or presentation Thursday, August 8, 2019 at 8:30:00am GMT
TEXT version of Transcript
* Samir Desai
Funding Circle Holdings plc - Co-founder, CEO & Director
* Sean Robert Glithero
Funding Circle Holdings plc - CFO & Director
Samir Desai, Funding Circle Holdings plc - Co-founder, CEO & Director 
Okay. Great. So we'll get going. So thank you for coming to Funding Circle for H1 2019 results. What we thought we do is I will talk a little bit about highlights, just talk about the Funding Circle story. I'll hand over to Sean to talk through the financials. And then we'll finish off with a bit of market analysis and the outlook.
Obviously, we put out an update on -- in Q2, in early July, on our outlook for the rest of the year. And we've recognized that by saying that we will grow revenues by around circa 20% in 2019. That's a change to the guidance that we put out previously at the beginning of the year. However, based on what we're seeing in the macroeconomic environment and proactive decisions we've taken to tighten credit and protect investor returns, we think that's in the long-term interest of the business and what we should be doing as a platform-based business.
So in 2019, we grew loans under management to a record GBP 3.54 billion. That's nearly GBP 1 billion more than what we've put into the IPO prospectus. Originations grew 14% to GBP 1.19 billion. And we were pleased to secure a number of new funding commitments in our European geographies, in particular, which have been more nascent, but really starting to show track record, and also launched 4 new funding products -- bond products in the U.K. and the U.S. and fund products in Europe and the U.K., which are really based around our strategic pillar of diversifying our funding sources.
Revenue growth was 29% to GBP 81.4 million in the first half. And importantly, 46% of revenue came from existing customers. And as you know, Funding Circle is very much a repeat-based business, like many platform businesses. And we make significantly higher margins of repeat customers because we don't have the associated acquisition costs. So it's a very important driver of our long-term profitability.
Our U.K. segment margin was flat at around 26%, despite the fact that we were increasing marketing investment and above-the-line advertising substantially, but our group segment adjusted EBITDA margin was around 1%, so lower than the 5% last year driven by higher losses in the U.S. and -- continent and our developing markets business, really, due to the investment that we're making there. And they represent very large markets that we're excited about for the future.
So I just want to spend a few minutes talking about why we set out Funding Circle and where we think we are today. So from a -- small business lending is a very small part of what banks do. On average, it only represents around 0.5% to 2% of their balance sheets. They have much more of their assets in corporate loans, mortgages, credit cards, personal loans. So it's really an area that they don't focus a lot on, don't care a lot about. But that's a big problem for society because small businesses represent around 50% of GDP, around 60% of employment, so there's a big disconnect between how much banks care about this type of activity and how much society cares about it. And we saw in the financial crisis that banks were really not delivering money into the real economy, delivering to small businesses. And we set up Funding Circle as a real viable alternative.
And we're really proud of all the impact we've been able to have. So Oxford Economics ran an annual data analytics exercise on our loans. They found that in 2018, there was an incremental GBP 6.5 billion of GDP added to the economies that we operate and 115,000 new jobs created. So the lending and the activity we do is making a really big difference in the economies we operate in.
And the addressable market is still very large. So we've estimated with OC&C that the addressable market is around GBP 470 billion in the sub 500,000 prime small business lending market. And whilst that's a small part of bank -- of what banks do, because banks are, as you know, very capital-heavy institutions, they tend to only do small business lending in one of their countries as opposed to -- in multiple markets. But for a capital-light platform business like us, it's a -- it's actually a very, very large and an attractive, addressable market. And you can see that we've taken share across all of our markets since the end of last year, now reaching around 3% market share in the U.K. and going over 0.5% market share for the first time in the U.S., which is clearly the largest of all the markets.
So Funding Circle, as you know, is a technology platform business. We have built a very sophisticated technology platform, aggregating huge amounts of data that allows us to attract in, credit assess and then service small business borrowers.
Our small businesses are not start-ups. They've, on average, been trading for about 10 years with GBP 1 million of revenue. And we connect them up with thousands of investors, 92,000 investors globally, around 5,000 joined in the first half of 2019, with a number of different sources, institutional investors, retail funds.
So what we've split out here is the repeat rate on loans, the average number of loans held by a small business customer in the U.K. by time. And we've done a couple of things differently in this chart. We've now split that out by quarter as opposed to just by year. And we've also extended it past 60 months, which we've not done before. And what you can see is that we get this very, very stable, predictable, repeat behavior from small businesses. Small businesses love what we do. We have Net Promoter Scores in the 80% to 90% range. And 82% of borrowers tell us they would always come back to Funding Circle first in the future rather than go to their bank. So repeat is really the way we're building our business. We're really trying to deliver a great customer experience to these small businesses and develop a long-term relationship with them.
On the investor side, we generate returns in the 5% to 8.5% range. And particularly, in a low interest rate environment with low yields, which is expected to continue, our asset offers a very attractive return relative to the duration that it lost. If you look at the weighted average duration of the cash that is actually outstanding, that's only about 21 months on average. So you're getting a 5% to 8% return on your money with a very short duration. That compares very favorably with other fixed income asset classes, and that's why we continue to have robust demand to invest in the loans that we do, which previously have been inaccessible.
As I said before though, we have a number of different sources. We have insurance companies, banks, asset management companies. Pleased to have launched our 2 new bond products. We believe that those will significantly increase the addressable market for investors. Number of investors prefer to invest in retail securities, listed securities on the bond side and that -- as opposed to loans, and that allows us to access that part of the market. Around 90,000 retail investors on the platform continuing to invest, continuing to get net inflows there. Supranational entities, like the British Business Bank, European Investment Capital are really lending with us because of their low-cost loans that we're providing small businesses.
And also on the lending -- on the fund side, we were pleased to launch 2 new funds, the Funding Circle European SME Lending Fund and the Direct Lending Fund in the U.K. lending fund. We have commitments from various insurance companies, pension funds to go into those funds. And those replaced our listed fund, which was the Funding Circle SME Income Fund, that we agreed to return cash to investors on -- in the first half of the year mainly because the associated cost of running a listed company, but also the hedging cost when taking pound sterling money and investing it in euros and dollars was not, we felt, the optimal way of investors accessing the asset class by funds. So we're very much focused now on private single currency funds, which we think of a more efficient way of accessing asset class, even though the Funding Circle Income Fund delivered returns of around 16.5% since inception.
So I'll just hand over to Sean to talk about the financials.
Sean Robert Glithero, Funding Circle Holdings plc - CFO & Director 
Loans under management grew 37% to over GBP 3.5 million, up nearly GBP 1 billion on a year previously, of all geos delivering good growth. The U.S. now has loans under management in excess of $1 billion, having now originated over $2 billion of loans for SMEs.
Originations of loans on our platform grew more modestly at 14%, reflecting the conscious tightening in the U.K. and U.S. and funding deals signed in later than expected in Europe that led to origination growth falling to 1% in that geo.
Growth figures for the geos exclude property loans and are shown in local currency. U.S. figures were again impacted by the policy change in April last year to require existing borrowers returning for another loan to roll over the remaining principle of their original loan to a new loan. Whilst revenue-neutral, this did impact U.S. originations by about 4 points of growth and group originations by about 2 points of growth.
If we move now to revenue. Revenue in the half was in excess of GBP 81 million and represented a growth of 29%. Geo growth rates were similar with the U.K. and U.S. growing well. And then on the right, we can see strong improvement in existing revenue, up 44%, mitigating some of the effect of tightening on new revenue, which grew 20%. Existing revenue includes servicing fee revenue as well as the transaction fee revenue on repeat borrowing.
Transaction yield was 0.4 percentage points higher at 5.2%, reflecting mix and optimization of pricing in the second half of 2018. Servicing yield was a touch lower, rounding to 0.9%, but was only down 5 points in the period, and this reflected some additional discount in the U.S. and elimination of some revenue from our new ABS program, where we cannot charge ourselves a fee.
The chart on the left shows the build of revenue growth, which was not just a function of the origination growth in the period. Origination growth drove 11 percentage points of the overall 29 points of growth, with the balance from servicing revenue that grew in line with loans under management, better transaction yield and then growth in other revenue that includes net investment income from our new investor bond products, which I'll talk to later. The policy change in the U.S., whereby a borrower's first loan is no longer automatically consolidated into repeat borrowing as well as some foreign exchange, changes half-on-half.
If we turn to segment profit on the right, we see segment adjusted EBITDA was GBP 1.2 million for the group, representing a margin of 1% and a full half-on-half, whilst for the U.K., adjusted EBITDA improved in line with revenue growth. Losses increased in both the U.S. and the developing markets.
For the U.K. and the U.S., a consequence of tightening is that the percentage of applications that convert to loans is reduced. This can offset the operational efficiency we gain from scaling as timing leads to marketing cost per new originated loan rising. And even rejected applications, you see the level of scrutiny and incur a cost to serve.
However in the U.S. and developing markets, where the opportunity remains huge, we continue to invest, particularly in marketing. Also in the U.S., we saw extra service fee discounts and additional loan repurchase costs that impacted profitability.
Loan repurchase costs, or where lenders pay us a fee to buy back defaulting loans on their portfolio for a specified period. But looking at our funding profile for the second half, I'm expecting loan repurchase cost to be below 50% of first half levels.
And then finally in the developing markets, originations lagged investment in the business as funding deals were delayed.
Looking in more detail at the U.K.. We see that existing customers now account for over half of revenue, with existing customer growth the driver of the overall 25% improvement in revenue. Compared to prior year, overall margins on the top right chart have stayed flat at 26% despite the increase in marketing spend to 41% of revenue, as shown below. This reflects net of tightening operational leverage and the benefit in the existing customer base. Whereas the margin on new customers has weakened from full year 2018 levels to negative 21%, existing customer margins have improved to a high of 68%.
In the U.S., the back book of borrowers is less mature than in the U.K.. Hence, growth of 37% was driven by a 42% improvement in new revenue. As you can see in the bottom left, this was in turn a function of marketing investment that rose to 50% of revenue. Overall margin of negative 31% was broadly flat with a margin impact of extra marketing spend and loan repurchase costs offset by operational efficiencies elsewhere in the cost base.
Existing customer margins were at full year 2018 levels, but new customer margin declined 60% due to credit tightening.
Finishing with the developing markets of both Germany and the Netherlands, funding delays impacted new borrower growth, such that most of the 27% growth in the period related to existing customers, which, in turn, led to revenue from existing customers rising to 37% of the business. An overall margin of negative 88% was weaker than in 2018 as marketing spend increased as a percentage of revenue. Some operational efficiency was also lost in sales conversion and the geo result, including some initial start-up costs in Canada. However, existing customer margin was positive for the first time at 11%. And just to reiterate our announcement in the July trading update, we have paused the launch of operations in Canada to focus on operations in our existing countries.
So moving back to the group view. The left-hand chart shows adjusted EBITDA, which has increased to GBP 19.7 million loss with a loss margin broadly flat at 24%. Segment profit of GBP 1.2 million was offset by GBP 14.3 million of product development cost that have been charged to the P&L and increased corporate spend that included operating as a POC post IPO. Together, these central costs remained at 26% of revenue as we continue to invest in data and technology.
On the right, to keep our free cash flow representative of the trade inflows of the business, we have slightly amended the definition to include the payment of lease liabilities and to exclude net investment in bonds and private funds.
Free cash flow in the half was GBP 28.1 million outflow and differed to adjusted EBITDA by GBP 5.9 million of capitalized development spend on tangible fixed assets. This was mainly investment in new technology platforms, including progress towards our automation goals; GBP 2.2 million on tangible fixed assets, mainly property fit-outs and IT hardware; and then GBP 0.3 million of working capital, including those property lease payments.
If we look at the statutory profit and loss format on the left and the items below adjusted EBITDA, we see the share-based payments charge fell to GBP 4.5 million as the related provision for national insurance payments reduced, very much a function of the change in share price. There was a rise in depreciation and amortization, reflecting both increased capitalization and development costs and recent property fit-outs. The increase in finance income reflected higher cash balances post IPO, and the income tax charge rose on R&D tax credits, which cannot be offset against past taxable losses.
Moving to the table on the right, you will see we have a new revenue stream net investment income. We explained at the March results how the launch of new investment products would generate income for us. This income is shown net with the cost of servicing debt offsetting the income on SME loans. More of that in a second.
But from a cost perspective, marketing spend rose to 43% of revenue from 39% in the prior period. And within the GBP 35 million of spend, above-the-line brand expense doubled to GBP 9 million. However, for the second half of this year, I expect that to be half of that at around GBP 4 million to GBP 5 million. Whilst the expenditure on marketing has proved successful, doubling awareness, given the current economic uncertainty, we are scaling back as we take the learnings from these campaigns.
So just recapping now on our disclosure in March, that we're launching these new products to diversify our funding and to access a much larger addressable market, particularly in the U.S. To date, we have launched 4 new investor products, a bond program in both the U.K. and U.S. as well as private funds, each of the U.K. and Europe. It's the bond programs that have generated the vast majority of the GBP 1 million net investment income in the first half.
Just going back to the mechanics of how these bond programs work, and they're very much operated as we expected. We are currently building up a stock of loans in 2 different segregated warehouses, one in the U.S. and one in the U.K. These short-term loan investments are financed through a combination of very specific bank debt that's purely attributable to these -- this purchase of SME loans, which is shown in the light blue here, and our own working capital shown in the dark blue. In the second half, we will securitize these bonds, selling to investors that want rated, tradable investments and not home loans. And in fact, we actually launched the start of our first securitization program for the U.S. yesterday. We will retain for up to 2 years only 5% of the bonds sold for regulatory reasons. And the cash from the sale of notes will repay our working capital and the bank debt, and then repay off the investment in SME loans, which will cease to be recorded in our balance sheet. We will then be free to use that working capital again to build up another levered warehouse.
So those SME loans in our bond program are shown within short-term investments in our balance sheet. So of the GBP 120 million of short-term investments in our balance sheet, GBP 177 million relates to this bond program, of which around 80% is debt financed. The balance of GBP 30 million is our working capital, but together with the GBP 270 million of cash at the end of the period represents our shorter-term available funds.
So if we bridge the starting cash of GBP 333 million at the end of December to the GBP 270 million of cash at the end of June, we see the free cash flow of GBP 28 million, combined with this GBP 30 million of working capital in our bond program. Then we have a further GBP 6 million of seed investment in our new private funds. And there is a small amount of other, which is essentially FX. So we have a balance sheet at the end of the period with an equity value of GBP 377 million.
Thank you very much. I hand back to Samir.
Samir Desai, Funding Circle Holdings plc - Co-founder, CEO & Director 
Great. So I'll just finish off with some market outlook data. So as you know, in our Q2 trading update that we've put out in July, we -- the net returns and bad debt rates on loans were stable, so we made no changes from previous levels. But as you know, since the second half of last year, we have brought down some of the U.K. return estimates. And that's what I wanted to spend a little bit of time talking about now.
So what the chart on the left here shows is indexed insolvency levels for companies and for consumers. And what you can see is that there's been a small uptick in company insolvencies mainly driven by start-ups, so younger companies. And on the consumer side, we have seen a large increase in insolvency levels since the middle of 2016.
If you look at the chart on the right, what this shows is the unit default rate of loans at 12 -- that we can read 12 months later, so 12 months on book. So for instance, in the H2 '17 number there, that would be what we could read at the end of H2 2018. And what you can see is that the vast majority of our portfolio, which is in the A+ to C risk bands, has been very, very stable in terms of performance. We haven't seen market changes there and that's because, as we've talked about many times, our portfolio is very much a prime solid portfolio, the kind of loans that the banks would do that we're competing against.
However, we have seen in our D&E risk bands an increase in unit default rates, which we've been able to read really more recently. And as a consequence of that, we have been tightening credit standards in the D&E risk bands, such that many of the loans, the vast majority of the loans that were in this category, we would no longer originate today.
Our belief, having looked at the data, is that, that has been driven by the degradation in the consumer environment. We can match those loans to companies where the directors have lower consumer scores. They tend to be younger companies. So we feel good about the performance of the portfolio and the loans we're originating or have been originating more recently.
And that's characterized in the return estimates that we've put out on the charts here. We -- and our July update, we are generating returns, we believe, in the 5% to 8.5% range across all of our different geographies. But most importantly, the loss coverage on our loans, which is the ratio of the interest rate to the bad debt rate, is very, very high. It ranges between 2 and 5x, depending on a different geography, which means that losses could double or, in some cases, got buybacks and investors would still get a positive return. So the high yields that we're generating, coupled with the low annual loss rates and the short duration of the assets, make this an attractive asset class, and that's why we continue to see strong demand for our loans.
So I just wanted to finish with the outlook. There are no changes from the guidance we put out in Q2 of the trading update. We expect revenue growth in 2019 to be circa 20% driven by the changes that we've done on the environment. We expect the adjusted EBIT loss -- EBITDA loss margin for 2019 to be better than 2018.
And our strategy remains the same. We're still very excited about the long-term opportunity for Funding Circle, the market share that we think we can get. We continue to focus on driving this better borrower experience, focusing on getting our customers to choose us as the point of the place they go to first for finance. We continue to invest in technology and data and analytics. We're pleased with the progress we've made so far on the automation efforts that we're doing. And we're very much on track to have 50% -- more than 50% of loans automated by the end of 2020, which is what we set out at the IPO. We continue to focus on diversifying our funding sources. And I think the new products that we've introduced are a testament to our ability to innovate and add new funding sources in this way. And we continue to focus on building this highly scalable global business, getting more and more efficient and trying to -- on the path to long-term profitability. We remain very confident of delivering our stated strategy and generating the long-term value for shareholders. And I and the team are very -- continue to be very excited by our mission and the big economic impact that we're delivering today.
Great. Well, thanks for coming. See you in 6 months.
Sean Robert Glithero, Funding Circle Holdings plc - CFO & Director 
Thank you very much.