SoFi Stock Alert: Buy Dip on This Fintech Darling

If you wanted to build a profitable bank, how would you do it?

The founders of SoFi (NASDAQ:SOPHIE) certainly had the right idea. Instead of lending to businesses (which tend to chase the lowest possible interest rates), why not lend money to rich kids instead? Or at least the kids you Think that will become rich in the future.

It is a business that has worked. For the most part anyway. In January, the company reported that its net interest margin had widened to 5.94% after seeing deposits rise 46% in the quarter. And while SoFi is still losing money every quarter because of its significant marketing costs, analysts believe the bank could generate as much as $260 million in profits by 2025.

But there is a problem:

What happens if these depositors want their money back? And all at once?

The problem with bank runs

This difficult case has already brought down not one… but three different banks. On the 8th of March Silvergate capital (SNEEZE:SAY) announced that it would cease operations. Two days later, SVB Bank (NASDAQ:SIVB) would do the same. Signature bank (NASDAQ:SBNY) followed at the weekend.

The problem is, of course, that the banks often have a mismatch between deposits and debts. The money left by bank depositors can be called back on request. It’s as easy as going to the checkout and asking for your money back. Meanwhile, the liabilities (ie mortgages, commercial paper, bonds) are often less liquid and can take time to sell off. In finance, it’s called a maturity mismatch – which can also describe many failed first dates. Even very profitable banks can become insolvent if every depositor asks for their money back at the same time.

Now we might wonder why a company like Silvergate didn’t just put its deposits into liquid treasuries or money market accounts. 3-month Treasuries alone yield nearly 5% today, so a bank that “borrows” from customer deposits at 0% can technically receive 5% net interest on every dollar it withdraws.

But the banks are not always given a choice. Risk-free returns in 2020 were almost zero, and any firm looking to cover fixed costs would have needed to buy into mortgages and other illiquid loans. (There is also a profit motive that motivates risk-taking). These assets can then, annoyingly, remain on a bank’s balance sheet for decades.

The ‘Buy the Dip’ case for SoFi

SoFi also has many of these illiquid liabilities. As of December 31, 2022, the online bank had $8.5 billion in personal loans, $4.8 billion in student loans and $77 million in mortgages on its balance sheet. 84% of SoFi’s personal loan book matures between 1 and 5 years, while 84% of student loans mature after 5 years.

From this point of view, SoFi is even more risky than the average bank. Most diversified financial institutions focus on government bonds and government-guaranteed mortgages that can be bought and sold to other banks. Meanwhile, SoFi’s loan book has virtually no clear market.

But the online bank has an ace up its sleeve:

SoFi finances these riskier loans with “safer” deposits (ie bank deposits from private customers).

It’s a trick that other lenders use to reduce the overall risk. Banks know that retail deposits are stickier than business accounts, so many will use huge amount to entice these depositors. Some like Bank of America (SNEEZE:BAC), does so by building an extensive branch network. Others like Discover (SNEEZE:DFS) and SoFi cross-sell financial products to get hold. The end goal is the same:

“Sticky” deposits that cost virtually nothing to maintain.

This is important because SoFi need stable deposits. And that changes their risk profile completely.

The Mad Rush for Exits

Nevertheless, SoFi’s shares have fallen over fears of contagion. Investors know that the company’s assets are loud illiquid. And widespread panic among depositors could theoretically lead to a bank run.

SoFi is also relatively careful with the details of its deposits. Its annual filings do not report the number of accounts exceeding the $250,000 FDIC insurance limit or the nature of the depositors. In the past week, SoFi has lost nearly 20% of its stock value due to these concerns.

To be fair, most banks are similarly vague. Regulators had trouble disentangling the assets at Citigroup (SNEEZE:C) and AIG (SNEEZE:AIG) during the financial crisis, and even institutions such as Wells Fargo (SNEEZE:WFC) routinely don’t seem to know who their customers are. Signature Bank’s CEO promoted his company as a “well-diversified, full-service commercial bank” as little as four days before regulators took over.

SoFi may also see a further decline in the share price. Banks are notoriously opaque about the strength of their balance sheets, and investors have no problem punishing a bank stock if it’s performing on the edge.

Where will SoFi stock go from here?

Still, SoFi’s decline will most likely prove to be temporary. Banks today are far better capitalized than in 2008, and the Federal Reserve is far more cautious about letting large financial institutions fail.

SoFi’s unusual business model also puts it at far less risk of a bank run. It has largely ignored the easy deposits from commercial banks, opting for the more challenging route of retail deposits. And the interest rate problems that plague other regional banks are not as pronounced at SoFi. The start-up’s reliance on short-term personal loans gives its assets a shorter duration than most.

That means shares of SoFi likely retain their fair value of $10-$15, a 2x-3x upside. The company’s tangible book value is expected to grow around 9% in 2024 and 14% in 2025 as young depositors increase their savings, suggesting a book value premium is in order. (I hesitate to give a higher valuation, as return on equity is only expected to reach 3.2% by 2025).

It won’t be a straight trip to the top, of course. Lower stock prices generally do banking stocks less attractive, so a collapse to $3 will change my view of SoFi’s stock. But because SoFi’s risks are so different from those of Silicon Valley banks and others, it’s a risk speculators should be willing to take.

At the date of publication, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the author, with reservations InvestorPlace.com Guidelines for publication.