Morgan Stanley Downgrades On Deck, Which Is At 'The Mercy Of The Marketplace'

Morgan Stanley has downgraded On Deck Capital Inc ONDK to Equal-Weight from Overweight, citing erosion of near-term profitability from changes in funding mix.

"[W]e think fluctuations in institutional demand could limit origination growth potential beyond 2016 and push out any meaningful profitability until 2018," analyst Vasundhara Govil wrote in a note.

Quarterly Print

For the first quarter, On Deck's gain on sale premiums fell to 5.7 percent from 9 percent in the fourth quarter, despite its own loans having "thus far performed in line with expectations."

As a result, the analyst noted that marketplace funding is expected to drop to 15–25 percent of term loan origination in 2016 from 35–45 percent, thereby impacting near-term revenue and profits.

Related Link: Following Earnings Miss, BTIG Downgrades On Deck Capital

Increased reliance on balance sheet funding model deprives On Deck the benefits of high upfront revenues and margins from marketplace funding model, while the balance sheet funding results in deferred interest income and upfront provision expenses.

Rating, Expectations And Justification

Although the analyst acknowledged that risk premiums could stabilize, Govil thinks a reversal to 7–8 percent gain on sale premium for the company is "unlikely in the near-term as credit quality is more likely to worsen than improve from here."

Govil also warned that the company's origination growth will be lower due to its increased dependency on balance sheet funding and higher competitive pressures. On Deck lowered its 2016 origination growth expectations to 30–35 percent from prior guide of 45–50 percent and below Morgan Stanley's prior three-year CAGR expectation of 41 percent.

The analyst noted that changes in funding mix and its out-sized impact on profitability lowers the predictability of its future income streams, justifying a lower multiple.

Govil cut the 2016 gross revenue forecast by 13 percent to $282 million from $324 million and now expects adjusted EBITDA loss of $44 million versus a prior estimate of $13 million profit.

"Even though ONDK's forward growth rate is expected to be much faster than the compset, we think a premium is no longer justified given the variability in its future earnings stream," Govil added.

The analyst also cut the price target to $7 from $17 on On Deck shares, which fell 1.37 percent to $5.04.

Recently, BTIG's Mark Palmer also downgraded the rating on the company to Neutral from Buy, following the company's earnings miss and lowered guidance.