When I first moved to the US two years ago, it took me three visits and multiple hours to get set up with a local bank. It was a painful process. I haven’t set a foot into my local branch since and a few months ago, it was shut down permanently. This has got me thinking that there must be a better way to do banking; do you really need a physical branch? Why are banking apps so bad? Can I make do with just one bank account? In this article, I look at a publicly traded digital bank which I think has found an answer to those questions.
Retail Banking Today
I’m not the only one who has had the thought of taking all banks online. Digital banks, also commonly referred to as Neobanks, are taking the world by storm. The Neobanking industry is expected to reach a market size of $722bn by 2028, which is a CAGR (Compound Annual Growth Rate) of 47% from 2021. This demand is being driven by people, like me, who value the convenience of digital banking.
Despite this growth projection, retail banking is still dominated by the large incumbents (e.g. Chase, Wells Fargo, BOA etc.). In fact, 50% of us bank with the 10 largest incumbent banks (in the US).
Yet despite having such a large percentage of the market, incumbents are not doing everything right. Almost the same percentage (50%) hold more than one bank account and when asked why, 80% of these users cite inadequate one-stop shops as the reason for holding multiple bank accounts.
A One-stop Shop Bank
This resonates with me. I opened my first bank account in the US with the most popular retail bank (which was also a large incumbent). Over time, as I have wanted to trade stocks, take out a loan, set up a savings account, I have had to open more accounts with competing banks. I don’t think this is sustainable (and it’s a pain to manage logins, passwords and tax docs). The market and users would be much better off if there was a one stop shop for all banking needs.
My stock pick: Sofi
This is where Sofi comes in. Sofi is being taken public (via a merger with Special Purpose Acquisition Company, ‘IPOE’). The reason I like Sofi so much is because their entire business plan revolves around being a one-stop shop bank. In fact, they see the Fintech industry just like the market for food delivery, ride sharing, internet search or e-commerce. Just like Doordash, Uber, Google and Amazon, Sofi aims to be the ‘winner that take’s most’, in the Fintech market.
Sofi’s business model has three different segments; Lending, Technology Platform and Financial Services.
Sofi’s business strategy is focused on what they refer to as “FSPL” which is just a fancy way of saying that they try to get customers on their platform, offer them superior products and then keep customers using their services for all their banking needs. In order to do this effectively as a start-up, Sofi has had to be extremely innovative. Over the last couple years, we can see they have added a significant number of new products to keep in pace with user demand.
The virtuous cycle
I think this is very neat. Banks spend a lot of money trying to get new customers on their platforms (referred to as a “Cost of customer acquisition”). However, if Sofi can organically drive this growth by cross selling products to their existing members, Sofi can save these acquisition costs to then re-invest that into superior product offerings or cheaper products. Over time, this becomes a self-fulfilling cycle, as more users decide to stay on the platform in order to get better products, which means Sofi can invest in better products, which means more people stay on the platform…. you get the point.
We can see how effective this is by looking at one of Sofi’s case studies. If they were able to cross-sell a personal loan to an existing user with just a basic checkings account, this would result in an almost 80% improvement in the bottom line for Sofi, on that user (compared to selling both products to two different new customers). Not to mention that by cross selling products to members, Sofi can also focus on customers which it knows are credit worthy and have a built-up history with the bank.
Is this strategy working?
This strategy seems to be working for SoFi. Over the last couple years, Sofi has grown members rapidly, and a large share of these members have gone on to purchase more than one product. In fact, Sofi is expecting 75% growth in total users but 95% growth in multi-product members (users who hold more than one product) over the next 12 months.
What is truly remarkable to me is that 24% of Sofi’s product sales come from existing customers and for their more profitable segments, like Home Loans, this figure is even higher (69% of Home Loan sales come from cross sales).
This is having a real impact on Sofi’s bottom line. The company expects to post its first positive EBITDA in 2021. This is remarkable as most Neobanks struggle to make any money, particularly in their early years (and most remain loss making today).
Outside of cross selling, Sofi can also fall back on very strong margins for its core business.
(i) Lending: 58% Gross Margin
Sofi is 100% origination only for their lending business. This means that they do not buy outstanding debt obligations from other banks to turn a margin. Instead, they sell loans directly to end users, and then put these on their balance sheet before trying to sell these debt obligations to third parties (at a lower interest rate than they collect from their customer). This is the highest margin form of lending.
(ii) Technology Platform: 62% Gross Margin
Sofi also purchased Galileo, a leading fintech platform, for $1.2bn in 2020 and uses this to host not just its own tech infrastructure, but also outsources this to other Neobanks such as Robinhood, Chime, Moneylion and Revolut. This was a very smart move as this has effectively converted a traditional cost center for Sofi, into an income centre (the same way AWS has been for Amazon). Galileo de-risks Sofi as it captures the growth in the Neobanking industry. In 2020, Galileo was handling more than 90% of account creation amongst all Neobanks in the US.
(iii) Financial Services: Loss Making
The third and smallest part of Sofi’s current business (2% of total revenues) is their Financial Services Platform (which includes investing services for stocks, ETF’s and crypto). This is currently loss making but Sofi does expect this to start turning a profit and this is becoming increasingly likely as users transition away from apps such as Robinhood due to reputational issues.
Ultimately, this will allow Sofi to diversify its revenue base from primarily being a lender, to being diversified across these three segments which support high margins.
Is this a good time to BUY Sofi?
As mentioned above, Sofi is being taken public by SPAC. Investors in IPOE will get a 9.3% stake in the business.
Based on IPOE’s market capitalization as of the close on 5th Feb 2021, this implied the following valuation or Sofi:
40x Price/2025 Projected Earnings
6.8 Price/2025 Project Sales
Whilst this is by no means cheap, those ratios do not account for improvements to Sofi’s bottom line as a result a faster than expected transition to profitability in its Financial Services segment or Sofi obtaining a Banking Charter (which should add 25% to Sofi’s bottom line as it would allow it to borrow at cheaper rates).
Banking is an industry prone for disruption and I do fundamentally believe that this is a ‘winner takes most’ type of industry. The incumbents have failed to do this well and Sofi is pioneering the digitalization of one stop shop banking. They have a proven ability to cross sell, have a developed technology platform and have very defendable margins across two of their three key business segments. The stock is not cheap but with positive developments on the horizon, I will be looking to average in to my position at current prices.