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2019-08-14 22:17:48

Thesis

GreenSky (GSKY) is out of favor on Wall Street. The company posted Q2 results that slightly missed expectations for revenue and EPS yet the stock plummeted over 35%. While the quarter wasn't great, the stock is cheap.

Data by YCharts

I believe much of the reason behind the stock's decline is the market is fixated on the wrong metrics. When we analyze just how GreenSky derives its revenue, we will see the true nature that Wall Street is missing.

In light of the complexity of the company's operating model, we do not believe that the company's current market value is reflective of the company's strong record of cash flow generation and intrinsic value.

-GreenSky CEO David Zalik

David Zalik issued this statement in defense of his company. This is not the first time Zalik has responded to a negative price action for GreenSky shares. GreenSky sold-off on news that Region's Financial (RF) would no longer serve as a Bank Partner to GreenSky. Before Zalik initially commented, I wrote an article defending the company, titled GreenSky's Irrational Sell-Off. My thesis was that the Regions exited was for strategic reasons that were unrelated to GreenSky.

In my previous article, I noted that Region's was also exiting the indirect auto-lending business due to competition based margin compression. For this reason, I concluded, GreenSky loans were in demand. With revenue growing north of 30% demand for partners to finance these loans appeared strong. Zalik called the exit of Region's hardly noteworthy as GreenSky still had ample funding to service loans.

Following the post-earnings sell-off it appears Wall Street has viewed the quest to seek strategic alternatives as a negative, but I don't believe that to be the case.

GreenSky's Two Businesses

GreenSky derives its revenue from two primary sources. The market is looking into the smaller business much more closely. 85% of the company's revenue comes from transaction fees, while 15% comes from loan servicing.

The transaction fee business is quite simple. GreenSky provides merchants with a platform to offer consumers promotional credit on behalf of its Bank Partners. Every time a merchant finances a purchase through the GreenSky platform, the company receives a fee. There are numerous benefits to this reoccurring revenue model that enables GreenSky to generate enormous revenues with low operating expenses. I will touch on this later.

The servicing business is more complicated. The company collects a fee from its Bank Partners each month that is a percentage of the loan servicing portfolio. But, the company is obligated to perform a Financial Charge Reversal to the Bank Partners when loans are paid off in full prior to the interest-free period concluding. This is paradoxical in a sense, because the higher the FCR liability, the better consumers are at paying off the loan during the promotional period. Overall this is a greater positive, representative of the quality of the loan portfolio.

Source: Seeking Alpha

FICO scores of borrowers remain strong. Delinquencies are up slightly, but GreenSky mentioned previous delinquency levels were unusually low on the call.

Deferred interest loan products, which historically have represented a substantial portion of our transaction volume, have a feature whereby the consumer borrower is provided a promotional period to repay the loan principal balance in full without incurring finance charges. We bill interest each month to the consumer throughout the promotional period and, if the loan is repaid in full before the end of the promotional period, the interest billed to the consumer is reversed. Under the terms of our contracts with our Bank Partners, we are obligated to remit this reversed billed interest to the Bank Partners.

-GreenSky 10-K

Essentially, the company must pay the bank partners for interest collected, but it did not charge consumers because of the promotional nature of the loans. This makes quarterly earnings messy as the company estimates the FCR liability and subtracts it as a cost or revenue. It's very fuzzy and difficult to account for, since GreenSky uses its own sophisticated modeling to account for what it expects this liability to be. Part of GreenSky evaluating strategic alternatives is reevaluating the entire process of the FCR liability.

No, recall the transaction fee is paid by the merchant. This would have no impact whatsoever on the transaction fee. But there would be a premium or a discount realized when we closed the transaction. That would be in place of the FCR liability and/or performance fee realized today under our bank waterfall arrangement. So there's no deferred activity, if you will.

-GreenSky Vice Chairman and Chief Administrative Officer Gerry Benjamin

Essentially, GreenSky is pursuing a simplified strategy. But, remember this is only 15% of revenues. Throughout the earnings call, the analysts seemed transfixed on the strategic alternatives relating to loan servicing, that I can't emphasize enough, this is only 15% of the business. Even the quote above represents this point. The analyst questioned whether or not transaction fees would decline should this be implemented. That's not the case. 85% of GreenSky's business is strong and would be unchanged.

Qualitative Analysis

While analysts spent the entire earnings call questioning the company on the 15% of the business, let's look at the other 85%. GreenSky's reoccurring stream of transaction revenue is incredible because it combines various factors synonymous with competitive advantage, such as scale and network effects.

On an operational front, the company has significant scale. Operating expenses grew by 12% over 2018, trailing revenue which grew at a 27% rate. Neglecting the FCR liability, the company has quality cash-generating characteristics.

For instance, the company spent just 3.7 million on sales and marketing in 2018 to generate 415 million in revenue. GreenSky is a textbook example of scale. The company requires very little input in terms of operating expenses in order to generate additional revenue. If we normalize gross margins in Q2 of 2019 to 2018 levels, operating margins would have only decreased by 2 percentage points. Which, considering the relatively low marketing expenses, increases are going to appear larger in terms of percentage points.

This is due to the company's incredible network effects at the merchant level. Once a merchant enters the GreenSky ecosystem, the business benefits from every transaction. Since GreenSky financing is used on high dollar purchases such as home improvement, it is unlikely that merchants will see much incremental benefit from switching platforms. As the GreenSky ecosystem grows, the network improves.

The sell-off following the news of Region's Financial's exit was overdone, but not completely unwarranted. Fostering good relationships with banks, consumers, and merchants is key to success. GreenSky exploring strategic alternatives to include other financiers will only strengthen the ecosystem. But, as long as GreenSky has enough dry powder to back the loans its merchants are providing, there will be no material impact on the business. When thinking about the qualitative aspects of the business, it's difficult to conclude GreenSky's dramatic decline is a result of bad business. Any steps the company takes to simplify the servicing model should add clarity to the picture.

Value

At the end of the day fundamental investors, whether looking at high-flying growth stocks, or deep value, are concerned about cash. The fundamental belief is that a company is worth the sum of its future discounted cash flows. When I came across GreenSky, the metrics appeared to indicate there was value. The company grew revenue this latest quarter by 31%, not a mediocre number. Pressure on net income was driven by compression of gross margins. The company's FCR liability is what results in the volatility of gross margins.

The company pursuing a strategy that smooths the curves regarding revenue in relation to the FCR liability should be welcomed by the market. The FCR liability has two components, one of which has an impact on cash flow, and one that does not.

Source: GreenSky.com

While the company's operating model is indeed complicated as Zalik alluded too, understanding how cash enters and exits the business is crucial in seeing how cheap the business is. Initially, we see that operating cash flow has fallen by about 20 million dollars year over year. Much of this windfall can be traced to the 30 million dollar adjustment to loan receivables held for sale. I mentioned this in my first article covering GreenSky, and how the company planned to stop holding these loans. Even with that considered, much of the discrepancy year over year is in relation to the FCR liability.

With the effect of the FCR liability neutralized, the company performed better than last year in terms of net income and cash flow.

If we go back to read GreenSky coverage around the time of the IPO, we see the coverage largely centered around the positive qualitative aspects of the business along with the companies stunning growth. Now, the narrative has changed, but the business is the same. With those factors considered, management coming out to call shares cheap is quite obvious.

If we considered the business net of the FCR liability, things are looking pretty good. Thus, anyway the company can simplify the model should be lauded by investors.

It's difficult to place a definitive fair value on the stock because of the uncertainty surrounding future earnings. But, with the company's strong qualitative aspects and history of significant cash flow generation, I believe shares are trading at a significant discount at only about 10x forward earnings. I believe forecast clarity will be the first big catalyst to drive the stock higher. At that point, we will be able to use modeling techniques to more accurately assess fair value.

That uncertainty is far from making GreenSky a speculation. We've seen how the current model works, and a new strategy would only be an improvement. But, I believe that uncertainty, no matter how minor it is, causes selling.

Moving Forward

GreenSky has suspended its guidance as the company evaluates new strategies. Why the market would sell the stock while the company announces they are evaluating strategic alternatives is mind-blowing. As a shareholder in any business, one would hope the company is constantly evaluating its strategy with shareholder interests in focus.

Shares are down significantly since my previous articles. But, as always I caution investors to use discipline when entering positions. I have added to my position following the sell-off. My cost basis is $9.53, which I believe is still a significant discount to fair value, I remain very bullish on GreenSky.

Disclosure: I am/we are long GSKY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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