Summary
SoFi Technologies announced that it is borrowing $1.1 billion via convertible notes.
Investors aggressively sold off the stock in a sign they didn't approve of the leverage and possible future dilution.
However, the offering is no surprise as SoFi needs to fund aggressive growth and meet liquidity requirements for its bank charter.
We view the offering as a critical step in the company's evolution and as an enormously positive development.
Introduction
SoFi Technologies (SOFI) announced last week that it would be raising nearly $1.1 billion via private convertible senior notes due in 2026. The market did not take it well. SoFi stock sold off over 6% in a single day, breaking a steady rally of 17% gains over the last two weeks alone. Two steps forward, one step back. However, we see this offering as good news and something all long-term investors with a 12-month outlook or more should welcome.
The company's stated objective is to become a one-stop-shop for helping people reach financial independence by offering full digital banking and brokerage services and providing the core back-end technology for all-new fin-tech banks with its Galileo platform. SoFi has a broad set of stated initiatives requiring enormous capital beyond what even last week's offering gives the company. The Financial Services and the Galileo Technology platform businesses will need significant investments, but capital is especially important for the Lending business. The Lending business is currently the company's largest segment. It accounts for roughly 75% of revenue and has generated $677 million in the last 12 months on approximately $10 billion in loan originations. However, the company expects to eventually generate several billions of dollars in revenue from loans worth hundreds of billions of dollars. The company may also want to own many loans themselves rather than sell them off to other institutions.
It is All About the Bank Charter
However, to grow the lending business, SoFi needs a bank charter. A bank charter will enable the company to take member deposits and use those to make loans, which vastly expands their profit margins and increases the number and kinds of products they can offer. It will enable the company to execute its mission and remain in a profitable hyper-growth mode for many years to come. In short, the bank charter is a game-changer for SoFi.
To receive a US bank charter, SoFi must meet specific liquidity requirements set by the Office of the Comptroller of the Currency. SoFi has made this hurdle quite clear in all their communication since purchasing Golden Pacific Bank last year. The offering announced this week secures more than enough cash to meet these requirements and is a crucial milestone that had to happen for the company to move forward with the bank charter and realize its big future vision. As we said, long-term investors should look beyond any possible dilution (which we will address below) and focus on the big picture.
The Offering Explained
Yes, the offering is technically dilutive and most likely the reason why some investors sold on the news. However, the offering is a thoughtful approach for expanding the company's capital and setting it on a path of continued hypergrowth. The terms are quite favorable for SoFi and give the company lots of options at the time of repayment. There is possible dilution, but it is minimal and it is so far in the future that it has little impact in the grand scheme of things. There are several key things to understand about the notes offering.
The first is that SoFi is simply borrowing $1.078B interest-free with repayment scheduled in October 2026. If the stock price goes above $22.41, the loan can convert to common equity (44.61 shares for every $1000). What this means is if the shares price rises 40% from today's level in the next five years, the company can (and likely will) issue an additional 48.1M shares (calculated as $1,078,000,000 in new money, divided by $22.41 = 48,103,525 shares) to bondholders who will convert their loan to common equity.
These 48.1 million new shares would be equivalent to 5.6% dilution (calculated as 800M current shares divided by 848.1M shares upon conversion). The shares would be issued five years from now, which seems like a pretty good deal given that the cash the company will receive ($1.078B) represents 8.5% of the current market cap. The ability to expand the value of the company's capital by 8.5% today in exchange for 5.6% dilution later is a net positive. Additionally, the company gets to put that money to work and generate a return for five years. At a 12% return on equity (a reasonably conservative metric that they will likely exceed), $1.1B today would be the equivalent of the company getting almost $2B in 2026. Well done, SoFi. We would take this deal any day of the week... and twice on Sunday.
However, it gets slightly better. SoFi will use $104.3 million of the net proceeds to buy capped calls on the number of shares of SoFi's common stock underlying the convertible notes. The cap price of the capped call transactions will initially be $32.02 per share and will result in an effective note conversion price (from SoFi's perspective) of $32.02. That means that the dilution in 2026 would be closer to 4% (calculated as $1.078B in new money divided by $32.02 = 33,666,458 shares; 800,000,000 current shares divided by 833,666,458 = 0.96; 1 - 0.96 = 4%).
Also, starting in 2024, if the share price is at least 130% above the conversion price of $22.41 (or around $29/share), the company has the option to pay the loan back in cash. Should they have the cash available, this may be easy to do then. However, if it doesn't have the cash or wants to use cash for other purposes five years from now, SoFi could easily issue new shares at a higher share price, something we'd like to see CFO Chris LaPointe do if the share price makes it possible. For instance, imagine that the share price in 2024 is $40/share. Rather than issuing 48 million new shares in 2026 to convert the notes or issuing ~34 million shares if you consider the impact of the capped calls, SoFi could do a secondary equity offering for 27.5 million shares at $40 (calculated as 27.5 million new shares times $40 = $1.1 billion), a dilution of 3.3%. At any share price materially above $32.02, the option to do a secondary and repay the notes would make sense and is an excellent option for SoFi to have.
The offering initially looked to raise $750 Million, but it was oversubscribed within 24 hours and the company increased the amount to $1.1 Billion. This is a sign of strength, with institutional investors showing confidence in the future stock price.
A lot can happen between now and 2026. SoFi as the disruptor could itself be disrupted, the company could fail to execute, or more significant macroeconomic or company-specific issues we don't know about today could derail the company. However, with everything we know about the industry and the company today, SoFi will probably be many times bigger in 2026 than it is today. Even if there is some multiple compression and the share price does not increase in lockstep with the business, the stock price will likely be materially higher than today (see the section on valuation below). As such, anyone selling because of 4% dilution (or less) 5 years from now is missing the bigger picture. Any future dilution of the stock in 2026 will be more than offset by the expanded margins from the bank charter and the likely share price increase from the business growth.
Growing Fast with Competitive Advantages
Much of the capital raised in the offering is predicated on SoFi's opportunity to grow the business at current rates or better. With 30% revenue growth this year and projected 50% next year, that is a tall order. However, SoFi operates in an industry that has significant tailwinds and has several competitive advantages that should allow it to grow well above the industry assuming the company is willing to make ongoing investments in those areas of the business. According to Allied Market Research, the digital banking market is set to rise by almost 14% a year through 2027, while the global digital lending market is expected to grow 24.0% annually between now and 2028, according to Grand View Research.
Per the company's corporate investor presentation, Americans use at least two banks for their financial services because one bank doesn't provide all their intermediate needs. SoFi has found a niche here by providing an all-in-one, comprehensive service available for their members in one bank. There is significant competition from traditional banks as well as new digital banks (neo banks), but SoFi has a first-mover advantage over traditional banks which still carry significant overhead costs with their physical branches, and the bank charter (if they get it) is a high bar that sets them apart from the other neo banks. Last year SoFi acquired Galileowhich provides a Banking as a Service (BaaS) ecosystem. Similar to the Cloud and SaaS services Amazon Web Services (AWS) offers, BaaS aims to provide an easy platform that reduces the technology requirements and capabilities to offer financial products such as maintaining account ledgers for different customer accounts that are required of a traditional bank. BaaS provides significant cost savings and few companies will build their own infrastructure from scratch when platforms like Galileo give them a significant headstart and ongoing cost savings. There are other BaaS platforms available, but each focuses on a narrow set of features and use cases and today Galileo offers some of the broadest set of capabilities, and with the capital raised, the company will continue to invest aggressively in Galileo to maintain its current advantage. SoFi acquired Galileo in 2020, and CEO Anthony Noto remarked that he views Galileo similar to Google's acquisition of YouTube or eBay's acquisition of PayPal. He doesn't mean that Galileo will necessarily be the same size as those businesses, but that it's a smaller well-timed acquisition that will eventually become the biggest business in the company.
Valuation
SoFi is a blend between a new-age digital lender like Upstart (UPST) and a pure FinTech infrastructure company like Marqeta (MQ) and has a flavor of both Square (SQ) and PayPal (PYPL). We are confident that SoFi will be worth many times more than today's values 4-5 years from now, but we also have reasonable confidence in the shorter-term risk-reward with as much as 50% upside in the next year. Cross-referencing the valuation from the EV/Sales multiple comparisons to the company's peers and from a discounted free cash flow analysis gives us about 50% upside from today's levels.
Peer Comparison (EV/Sales Multiple): $20.28 (12-month Upside: 33%)
When comparing SoFi to its peers, it's clear the company is getting big fast. In its IPO filings with the SEC, the company is projecting to grow at a 5-year compound annual growth rate of 43% compared to an average of 26% for its peers. So far those projections look accurate, and some valuation premium is justified. SoFi's gross margins are also higher than the others at 67% compared to 44% on average, and this is likely to grow if/when SoFi receives its banking charter. The company currently trades at a discounted 8.3x Sales relative to an average of 14x for its peers. We would conservatively expect the multiple expansion to be in line, if not directly with some pure FinTechs like Marqeta and Upstart, at least with the broader peer universe. Even at a slightly discounted multiple of 12x Sales, we get a share price of ~$20.
Source: Crystal Waters Capital analysis, 2021; SoFi Technologies' SEC filings
Discounted Free Cash Flow: $27.42 (12-month Upside: 80%)
From its torrid growth pace of 30% this year, projected analyst consensus growth of 50% next year, and 40% in 2023, we conservatively assume significant moderation in growth and a 10-year CAGR of 16%. Assuming the company's bank charter is approved, margins will begin to expand, but we believe EBITDA will plateau at close to 30% of revenue, which is somewhat lower than other analysts' projections. Capital expenditures will continue to grow, but the majority of the technology investment is in place, and variable costs will become smaller and smaller. Using a weighted average cost of capital of 7.5%, we get a price per share just north of $27, or almost 80% from current levels.
Source: Crystal Waters Capital analysis, 2021; SoFi Technologies' SEC filings
If we take the midpoint of these two approaches, we get a share price of around $23.85. This is a level the price has been at previously this year and given that this is a target price for 12 months out, we think this is well within reach again and could prove to be on the conservative end of the spectrum.
Source: Crystal Waters Capital analysis, 2021; SoFi Technologies' SEC filings
Risks
The bank charter is a game-changer for SoFi, and should they not get it, the business will face constraints on both capital that it can lend out and margin expansion. We don't see a clear and obvious reason for denying the company the bank charter, but until it happens, this is a risk and an overhang on the stock.
SoFi has built a large business quickly and has enjoyed a period of time with relatively little competition. However, larger traditional banks with more resources and more brand recognition are surely taking notice and will soon begin offering their own digital services. It seems like every week there is also a new digital bank emerging, and competition is likely going to be fierce from here, which may slow growth, increase user acquisition cost, and compress margins.
Key Takeaway for Investors
Borrowing over $1 billion is a lot of money for a company of SoFi's size, and is usually done in times of distress with punitive terms from lenders that hurt the company in the long run. However, this is not the case for SoFi. The company is financially strong and the loan has highly favorable terms. This capital provides the company with optionality and fuel for further growth at a time when it is rapidly increasing headcount and building out an ambitious line of products.
However, the more important point for investors to understand is that the majority of this capital is earmarked for meeting the liquidity requirements for the company's pending bank charter. Much of the long-term value for SoFi is tied to the pending bank charter which allows the company to lend money using member deposits. The charter will significantly lower the cost of capital and expand the lending business, not only in volume but also in the kinds of products it offers.
SoFi's business is healthy with accelerating growth, and the most realistic scenario is that in five years when the loan has to either be paid back or converted to common shares, the company will have many options available. Should the company choose to convert the loan at the conversion price, the dilution will be around 4%. With fair market value almost 50% higher than today's value and a fast-growing business that is likely to continue to drive the stock price higher, we see the offering as a big positive step forward and the possibility of a 4% dilution five years from now as a non-event.