Description

Funding Circle, a leading SME lending platform, operates primarily in the UK and the US. As of today, the company's net tangible assets (NTA) are approximately 65p per share, compared to a stock price of 80p. This valuation reflects a conservative estimate for a streamlined UK business that is nearing profitability on a pro-forma basis in the short term.

Originally launched as a UK fintech standout with an IPO price of 440p in 2018, Funding Circle's stock price plummeted to as low as 50p shortly thereafter. This decline highlighted a key realization in the fintech industry: to succeed, it's essential to integrate some traditional financial elements that weigh heavy on operational efficiency, such as human resources and traditional marketing. Additionally, the initial vision of engaging retail investors to fund SMEs (“P2P”) was abandoned and expanding globally was scaled back to focus on just two countries: the UK and the US.

In the UK, Funding Circle's operations include SME loans and a payments/credit service called FlexiPay, which is a BNPL for SMEs. While the UK SME loans are profitable, FlexiPay is currently not profitable, though it is growing rapidly and shows very good promise on a unit economics and recurring behavioural basis and has cross-sell synergies with UK loans. Conversely, the US loans business has been facing challenges for some time and has been in need of capital injections.

Funding Circle has been consistently trading at a significant negative to zero enterprise value in the last ~2 years, before which it surged on a what was a temporary spike on government backed funding schemes. The market seemed to imply that the company should be valued like a “broken biotech”, as it was experiencing continuous cash burn with no clear resolution in sight.

Funding Circle TEV in £m, source: CapitalIQ

However, the FY’23 results announcement on 7 March 2024 brought along a dramatic strategic shift across multiple dimensions:

• "Looking ahead, we will focus on our UK operations, comprising UK Loans and FlexiPay, to improve group cash flow and profits, thereby delivering greater shareholder value. While the US business holds long-term growth potential, it requires significant investment to expand the SBA proposition, which we currently do not see as the best strategy for the Group. We have received interest in the US business and will provide updates in due course."

• "Our forward-looking UK business is projected to be profit before tax (PBT) positive in the second half of 2024, with an attractive growth and profitability outlook for the medium term. We are excited to continue our mission to help more SMEs secure the funding they need to succeed in a large, underserved market."

• "We believe that the current share price significantly undervalues our business, and as such, we will be buying back up to GBP 25 million in shares."

The markets were likely taken aback by the fact that "shareholder value" via capital allocation was suddenly a focal point. Not surprisingly, this shift in strategy contributed to a significant rise in the stock price, which surged from 28p the day before the announcement to about 80p today. This increase reflects a renewed confidence in Funding Circle's strategic realignment and its future prospects.

The question is how long does it take to sell the US business, how much burn will there be and how does the market look at the pro forma UK businesses if “PBT flat” in H2 2024 is achieved, whilst FlexiPay is inflecting to profitability shortly thereafter. We think the guidance provided is a good forward point for the business and the stock price will grind higher once this unfolds.

UK LOANS

The UK Loans segment is the original, main, segment that sources SME loans from borrowers and place them with investors since 2010. Initially investors included retail, confirming with the “peer-2-peer” trend at the time until it evolved to a much more regulatory robust whole sale model to institutions. The “fintech” bit comes in through:

1. the underwriting which is superior to normal naïve credit scores that are widely available
2. the application time being 6 minutes, and
3. instant decisions being taken 80% of the time.

Roughly £1bn of loans got originated within the UK segment in each of 2022 and 2023.

Management likes to present “AEBITDA” but that clearly steps over the fact that a decent chunk (10-12%) of people costs (eating 2/3 of revenue, the biggest cost item) is being capitalised and then later expensed. A review shows that expensing and capitalisation over time is balancing out, hence our view is that PBT is the correct way to look at this business from a valuation/normalisation perspective.

The FY’24 guidance provided for this segment is as follows:

• “we see net income or net revenue growth of greater than 10% for the UK loans business with PBT margins improving to 8% to 12%, which are equivalent to EBITDA margins of 20% to 25%.”
  
  

Based on this guidance we see a FY’24 PBT for the UK Loans segment at £10.7-16.8m.

US LOANS

The US Loans business attempts to replicate the UK Loans business, but however has not been able to scale and become profitable. As said earlier management has now decided to sell this business, based on having “received early indications of interest” so that matters now is how long it takes for this business to be sold and at what price.

The US business sale has been given an essential positive catalyst on the 4^th of April with the SBA providing final license approval. This happened despite pressure of lobbying groups supporting a non-approval on spurious arguments. This article provides further background. In our view this makes it more likely that FCH will be able to sell their currently loss-making US business for a value that is greater than zero (rather than paying for it to get rid of it). On our final valuation we assume the US business gets sold at zero.

UK FlexiPay

This segment provides essentially a buy now pay later product for SMEs. Upon approval the SME can pay a bill or business cost on credit and pay back in 3 monthly instalments where each instalment caries a 1.5% fee, so a total fee of 4.5% for an annualised revenue rate of 18% on deployed capital. It functions like a rolling credit line, each payment carries its own 3 instalments, which are then aggregated and whenever an instalment is repaid it could be re-drawn for payment for repayment in 3 instalments again up to the maximum available amount. In H2 2023 an integrated, accompanying card was launched that allows payments now as well to be made outside the app and automatically provides the so available credit when required (i.e. able to switch from debit to credit card).

The transaction volume (i.e. all instalments with 1.5% of fees attached) has increased roughly 4x from £59.5m to £234.2m from FY 2022 to FY 2023. Guidance is for this to increase further by 3x over 2024. Current cohort analysis shows very favourable recurring transaction behaviour, implying strong unit economics.

Indeed, by examining the IFRS ECL breakdown in FY’23, it can be seen that the ECL for the 90+ days overdue balance of instalments had a movement of +£2.5m during the year. From a transaction volume of £234.3m, £7.9m was earned in instalment fees (it's unclear if this includes card fees as well as instalment fees). The average gross balance of instalments outstanding during the year was £36.5m, implying a net return of 14.8% on that balance. Funding Circle has entered a senior warehouse facility to fund the FlexiPay drawn balances with Citibank at a margin over SONIA that should provide flexibility to grow and leveraged returns to the net invested amount in this business, currently at £18m with senior debt of £54.7m. The warehouse has capacity to go up to £157.4m which implies that the 3x growth of income, if equating to transaction volume is achievable within the current warehouse.

Guidance related to FlexiPay is as follows:

• “For FlexiPay, we are targeting net income or net revenue growth of 3 times that of '23, as the product continues to scale and we expect to achieve this with similar levels of investment to those made during 2023. We are reaffirming our previous commitment that FlexiPay will be EBITDA positive in 2025.”

Valuation

The last piece of guidance provided is about the UK business as a whole:

• “The UK businesses (UK Loans and Flexipay) will be PBT positive from H2 2024”

The implication is that the US business will be the last “bleed” until we get the overall remaining UK business into profitability in short order, whilst the UK loans business on a stand alone business would already profitable throughout.

We ignore the current buyback progress in the table below but otherwise account for the latest balance sheet cash and investments to come up with an implied PBT multiple for the UK Loans business, ignoring the fact that FlexiPay will be inflecting to EBITDA profitability in 2025 and should have a positive EV number attributed to it.

On that basis we think that a ~4-6 implied multiple for UK loans is currently undemanding. So, whilst this provides downside protection currently, we can see that the UK Loans business + earnings power of FlexiPay from 2025 providing PBT of £25m, which should at least attract a 10x multiple. Which then, with a clean balance sheet should bring the stock price to 130-150p.

Catalyst

• Sale of US business
• Break-even of going forward UK business in H2 2024
• Continued growth of FlexiPay business into profitability
• Continued buyback of stock and other capital allocation measures