SoFi Stock: Breaking Down The Bear Case (NASDAQ:SOFI)

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SoFi Technologies (NASDAQ:SOFI) stock is down over 70% from hitting its highs in November, and has hit a new all-time low 11 of the last 13 trading days. I rated it a strong buy in November and I reaffirm that rating here. The fundamentals of the company continue to improve even as the share price deteriorates.

SoFi the company continues to move from strength to strength as SOFI the stock languishes below its IPO price. I consider that a buying opportunity. However, there are some legitimate concerns about the company and stock. I will attempt to accurately represent the bear case and systematically describe why I think SoFi will overcome those issues to prove a good investment.

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Before I get started, I need to establish that I do not buy and sell stocks, I invest in companies. Benjamin Graham put it best when he said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The fact that SOFI has lost so much value is frustrating and can make you question your decision making. It is good to question your investment thesis to find out if you truly think the company is a winner long term. A big drop in share price does not, however, mean that the company is going broke or that you should not have invested in it.

As Peter Lynch said in One Up On Wall Street, “To my mind, the stock price is the least useful information you can track, and it’s the most widely tracked.” The market certainly has voted against SoFi and the fintech space broadly for the past six months. Valuations have compressed across the markets, but especially in growth companies. However, if a company performs well over years, the stock will follow suit. I will try to outline how I think SoFi will weigh in.

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The Bear Case

Because of my interest in the company and the stock, I read a lot of what is written about SoFi. Those who do not believe it is a worthy investment usually fall into one or more of four categories, whom I’ll refer to as dilutionists, loaners, profiteers, and moaters.

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Dilutionists argue that dilution, whether through acquisitions, stock-based compensation (SBC), or other means is too high. The loaners will say that SoFi is reliant on student loans, and continued extensions to the student loan moratorium or any student loan forgiveness will derail the company’s revenues and profits. Profiteers are hyper-focused on EPS and contend that SoFi is not a profitable company and that they have a large amount of debt. The combination of these two factors will keep the stock price low and puts the company in danger. Finally, moaters believe that SoFi has no defensible moat, that everything they do can be replicated, and that they will therefore not outperform their competition.

Tackling all four of these in one article is probably too big of an undertaking, so I’ll go through the biggest and most cited one here: dilution.

Dilutionists

The loudest bears typically harp on dilution the most. They are also known to roam Twitter and respond to every tweet by CEO Anthony Noto by asking him about dilution and SBC. The extreme case of the dilutionist theory is that SoFi is becoming the next Palantir Technologies (PLTR), a company whose investors have been subject to large dilution, cutting into the returns that they expected along the way.

Dilution happens when a company issues more shares, causing its total shares outstanding to rise. For example, if company X was worth $100 (its market cap) and had 40 shares, each share would be worth $2.50. If company X now releases 10 new shares out onto the market, and the company is still worth only $100, then each share is now only worth $2, and the existing shareholders just lost 20% of the value of their investment. Dilution on its own is not a good thing, but if the growth of market cap outpaces the dilution, investors can still profit.

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To use Palantir as an example, the chart below shows the percentage increase in share price (dark orange) and percentage change in market cap (light orange) since its IPO in September of 2020.

chart of PLTR price and market cap

PLTR Price and market cap percentage increase since IPO (Seeking Alpha)

If you had invested in PLTR at IPO prices, you would have made a 25.89% return. That is a fine return, but its market cap over that same timeframe has grown 54.92%. So, over half the gains in the value of the company have been lost because of additional shares that have been issued. In the case of Palantir, most of those shares have been due to SBC, which is when employees are given shares of the company as part of their compensation package. Dilution can happen in many ways, but the two elephants in SoFi’s dilution room are SBC and Mergers & Acquisitions (M&A).

Stock-Based Compensation

Is SoFi the next Palantir?

I understand that most people who make the argument that SoFi is becoming the next Palantir are making a generalized statement about SBC, but let’s cut to the chase here. SoFi’s SBC has been nowhere near Palantir’s and will not approach that level.

Comparison of PLTR and SOFI Revenues, SBC, and SBC as a percentage of revenue

Comparison of PLTR and SOFI Revenues, SBC, and SBC as a percentage of revenue (Author)

Palantir’s $847M of SBC in 3Q20 alone is more than double SoFi’s SBC for the entire three years of 2019-2021 combined. It is true that Palantir’s revenue is higher than SoFi, but even if you look at SBC by percentage of revenue (the gray and green lines on the graph), PLTR takes the cake for dilution. If you look at SBC as a percentage of revenue, SoFi’s peak was 4Q21 at 27.5%. By way of comparison, PLTR’s SBC as a percentage of revenue was above 27% for 10 of the 11 quarters shown above. People should cool the talk about SoFi becoming the next Palantir. It completely misses the mark.

Legitimate SBC Red Flags

Let’s not pat SoFi on the back quite yet though. After all, being better than the poster child of dilution is nothing to write home about. The dilution argument is completely legitimate, and SoFi’s SBC is high. SBC also counts as a noncash expense, so every dollar they give in SBC is a dollar subtracted from the bottom line. This delays the time to profitability in addition to diluting shareholders. It is a legitimate drain on investors in both ways.

There are two pieces of SoFi SBC data in particular that are absolutely red flags. First, in the final slide from their investor presentation from January 2021, SoFi established yearly guidance for SBC. Actual SBC has been significantly higher than the guidance:

2020

2021

2022

SBC Guidance*

$94M

$117M

$118M

SBC Actual**

$101M

$239M

$340M

Doubling your guidance for 2021 and nearly tripling it for 2022 is bad. I think it is unacceptable that they have gone so far beyond their guidance without having made a statement to shareholders. It is just as unacceptable that the professional analysts let them off the hook without having to address it in the earnings call. As soon as the earnings were released, there were two things I immediately had questions about. The EBITDA guidance was addressed in the call, but they never asked about SBC. Management needs to officially address this in some way.

The second red flag is that that SoFi’s SBC is much higher than their peers in their industry. As my colleagues at Business Quant covered in their SoFi article, SoFi’s stock compensation as a percentage of revenue, estimated at 24.3%, dwarfs others in the Credit Services industry. Their next closest peers are Upstart (UPST) at 8.6%, LendingClub (LC) at 8.2%, Senmiao Technology (AIHS) at 6.4%, and PayPal (PYPL) at 5.4%. This is not a category where you want to be beating your closest competitors by a wide margin.

How Much Will Investors Be Diluted?

So, why am I still rating SoFi as a strong buy with the SBC issues highlighted above? Once you do the math, the dilution is not really that scary, especially in light of the results they are paying for. Dilution does not happen in a vacuum. As a business, you hire people with the idea that they will add more value to the business than you are paying them in salary, SBC, or otherwise. I will discuss what the SBC is buying below.

The amount of dilution depends on the stock price when the shares are issued. The table below shows dilution assuming a given average price for 2022.

Share Price

Dilution

$5.27 (4Q21 Book Value)

7.09%

$10.00 (Lowest Price Target)

3.74%

$14.86 (Average Price Target)

2.51%

$22.00 (Highest Price Target)

1.70%

So even if SoFi trades at book value all year long, dilution would be about 7% for the year. It goes down from there as the stock price improves. According to their recent guidance adjustment after the extension of the student loan payment moratorium:

[N]ew full year 2022 financial guidance represents approximately 45% year-over-year Adjusted Net Revenue growth to $1.47 billion, a tripling of Adjusted EBITDA to $100 million, and a doubling of margins.

As an investor, I am more than willing to allow 2-7% of the company’s equity to be awarded to employees who drove 63% revenue growth in 2021, have beaten revenue and EBITDA guidance for three straight quarters since coming public, and will drive 45% revenue growth for 2022. To make an analogy, I would gladly take out a small business loan at a variable rate between 2%-8% if I knew I could use that money to grow my business revenues by 45%.

The fiscal results more than make up for the dilution, and that growth and execution is in spite of their previous hero product (student loans) being neutered for over two years through no fault of their own. SBC also gives the employees a vested interest in making sure the company and stock continue to perform in the future and allows the company to recruit and retain top talent. Every last one of them now has a vested interest in adding value to company, because a good portion of their own wealth is tied to the stock’s performance. SBC is a concern, and one to keep an eye out, but SoFi’s growth far outpaces their dilution.

A Light at the end of the SBC Tunnel

Brad Freeman reached out to CFO Chris Lapointe about the SBC issue after the Q421 earnings call. Here was Chris Lapointe’s comments, according the article:

Quote from SoFi CFO Chris Lapointe about SBC

Quote from Chris Lapointe (Brad Freeman)

This quote does leave a lot open to interpretation, and a more exact time frame than “longer term” would have been helpful. However, hopefully this points to the SBC reaching a peak soon and coming down over time. The SBC is a legitimate bear argument and it is something that I will be keeping a close eye on. However, ~5% dilution given to employees for a company that is growing revenues at 45%, tripling their EBITDA, and doubling their margins sounds more than reasonable to me.

Mergers & Acquisitions

Technisys

The second source of dilution is from M&A. Specifically, SoFi acquired Technisys in an all-stock deal in February. The initial press release in February stated that the deal would be for “approximately 84 million shares of SoFi common stock.” The final count ended up being 81,856,112 shares issued, which was approximately 10% dilution and brought SOFI shares outstanding to approximately 910M. At the time, that put the valuation for Technisys at around $1.1B. Because of the continued selloff since February, those shares are now only worth about $530M.

The question again becomes whether the addition of Technisys is worth 10% dilution of investors. Technisys’ 2021 revenue was somewhere around $70M, so SoFi is paying for the company at about a P/S of 15 for the acquisition. Considering SoFi is currently valued at a price to sales multiple of 4, it is easy to argue that they paid a high premium for the acquisition, and if you look at other fintech multiples right now, they probably did.

However, if you look at fintech multiples from last August, Technisys looks like a steal. At that point, Upstart (UPST), Robinhood (HOOD), Marqeta (MQ), and Affirm (AFRM) were trading at P/S ratios of 33, 29, 32, and 23, respectively. Keep in mind that those multiples got even larger between August and the peak of growth stocks in November (Upstart doubled from those levels and Affirm tripled, as each got to P/S ratios above 60). Those same companies’ trailing P/S ratios right now are 7.9, 6.2, 10.2, and 8.2.

The above numbers show both how fickle valuations can be, and why using a single multiple, like P/S, is not a very comprehensive way to determine whether an acquisition is worth its price tag. More important from an investor perspective is this: will that 10% of dilution in the number of shares outstanding result in a greater than 10% increase in the value of company in the long term?

SoFi has targeted $500M-$800M in additional revenue through 2025 as a result of the acquisition. If you extrapolate from those numbers, that means an average of $166M-$266M per year of revenue, which would make its simple payback 4.1-6.6 years. It remains to be seen what margins SoFi will see from this new revenue, but SoFi describes it as “high incremental margins.”

In addition to the revenue, they have estimated an additional $75M-$85M in cost savings by 2025, with an annual savings of $60-$70M annually every single year thereafter. This cost savings should go straight to the bottom line. Assuming that SoFi hits these revenue and cost savings targets outlined in their Technisys investor presentation, this looks to be an acquisition that will pay off sooner rather than later.

However, bringing Technisys in house could easily result in the whole of SoFi being worth much more than the sum of its parts. I plan on going much further in depth on this point in a future article about SoFi’s moat, but the combination of Galileo, Technisys, and the bank charter gives SoFi a unique and unrivaled product offering that is unmatched in the financial space. Technisys has “approximately 60 customers in 16 countries servicing more than 150 million end users, or banking customers,” according to their website. Galileo, meanwhile, has 100+ partners and over 100 million enabled accounts.

Every single Technisys banking customer needs a payment processor like Galileo, every single Galileo account needs to have access to banking core technology like Technisys, and every single one of those accounts in the United States needs a chartered bank to sweep their deposits into. Similar to how SoFi is committed to have each of their consumer-facing banking products work better together, their B2B offerings will also have significant synergies and cross-selling opportunities. This could, and should, be a case where 1+1+1=5, making the Technisys acquisition even more valuable than it seems on first viewing.

Future Acquisitions

While I do think that SoFi will probably sit tight for a while on the M&A front in the current market, I do not believe they are completely done. SoFi believes that a key differentiator for them is to achieve the best unit economics on all their products (meaning their cost to achieve their revenue). Chris Lapointe said, “One of the keys to having the best unit economics for us has been vertical integration […] So if every single one of our products is vertically integrated, we’re going to have the best unit economics.”

One of the key reasons for the Galileo acquisition was so to vertically integrate SoFi Money. Similarly, on the call to discuss the Technisys acquisition, they stated that:

With Technisys we can further vertically integrate into checking and savings, but also credit cards and other future products. Importantly, all in the same stack versus today, where we have different cores for each product, which is cumbersome, inefficient and costly.

Similarly, in their lending business, they “built an end-to-end process that allows us to offer the best experience, the fastest place to fund a loan. It also allows us to give very competitive interest rates to have the best unit economics per loan.”

Between in-house solutions, Galileo, and Technisys, Sofi has vertically integrated its banking, credit card, and lending products. That leaves their SoFi Invest product as the odd one out. Vertically integrating Invest requires them to build or acquire a clearinghouse. This should not come as a surprise, as SoFi made a play to acquire Apex Clearing in February of 2019. If the right acquisition target becomes available, I would absolutely expect them to jump on that opportunity and that they would use stock to fund the deal, as it is their most obvious source to raise capital.

Whether any future acquisitions will be worth the dilution they bring comes down to whether you trust management to identify the right target, not overpay for the acquisition, and execute on their vision for folding their newly acquired technology into their existing products. I firmly believe they have an exact vision for what they are looking for, and any acquisitions they make will be in line with the long-term strategy they have outlined to build best-of-breed products, drive superior economics in each product, and build the AWS of fintech. Their acquisition of Galileo is the only one with a track record long enough to judge whether the results were worth the expense, and it has proven to be a masterstroke. Based on my own research, I expect Technisys to follow suit. I trust management to only acquire companies that make strategic sense and add more value than cost.

If Dilution is Really the Problem, Upstart Should Have Been the Solution

If dilution were truly the reason for the drop in the SoFi share price, we should be able to test that hypothesis if we can find a company in the same industry who has significantly less dilution, or, even better, a share buyback program. Fortunately, Upstart is the perfect comparison. They are a fintech company whose primary revenue comes from lending. Upstart does not originate loans or hold them on the books like SoFi, but instead gets referral fees by using their AI and machine-learning algorithms to connect loan applicants to lenders who will finance their loans. However, Upstart should provide the perfect foil to the dilutionary SoFi.

SoFi announced their guidance for $340M SBC for 2022 on March 1 on their 4Q21 earnings call. Two weeks earlier, Upstart announced a share repurchase program on their 4Q21 earnings call with authorization to buy back up to $400M of common stock. Here is a comparison of the performance of Upstart and SOFI stock since. I intentionally chose to start the chart on November 4, since that is the highest closing day SoFi had in November, so this chart should paint SOFI in the worst possible light.

Comparison of SOFI and UPST price performance

Comparison of SOFI and UPST price performance (Seeking Alpha)

It is absolutely true that since their 4Q21 earnings calls, the gap between SOFI and UPST has decreased. However, UPST has also touched 52-week lows in the last week. If dilution were the reason for SoFi’s poor stock performance, then repurchasing shares should be the panacea. Upstart, however, has exhibited the exact same weakness in stock price as SoFi, which suggests that macro forces have outweighed any other factor over this time period.

Dilution Will Not Derail SoFi’s Long-Term Gains

SoFi stock has never been worth less than it is today as I write this. That trend can easily continue. While book value could provide a strong support, companies can and do trade below book value, and SoFi could easily do the same.

I am not smart enough to time the market and I do not try to do so. However, I think these prices are an absolute gift for any investor who is willing to hold through the volatility and make an long-term investment in the company. I have been adding to my position and will continue to do so as long as the company continues to improve.

SoFi has faced every headwind with aplomb and has continued its exceptional growth in members, products, revenue, EBITDA, and margins. Dilution is often cited by detractors as a reason not to invest in the stock. However, in the case of SBC and M&A, the return should outweigh the dilution. As long as SoFi the company continues its exemplary execution, SOFI the stock will remain one of my top investment picks.



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