#29 Are Neobanks Overvalued

Looking at the Neobank space and contextualising their valuations

Hi all - This is the 29th edition of Frontier Fintech. A big thanks to my regular readers and subscribers. To those who are yet to subscribe, hit the subscribe button below and share with your colleagues and friends. 🚀

With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. - Warren Buffett

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.” - Warren Buffett

Globally, Neobanks have been on the up and up when it comes to valuations. Revolut recently confirmed an US$ 800 million fundraise at a valuation of US$ 33 billion. Nubank earlier in the year raised US$ 400 million and then six months later raised US$ 750 million at a US$ 45 billion valuation. The interesting thing here is that Berkshire Hathaway participated in the round. Recently, Chime raised US$ 750 million at a US$ 25 billion valuation. In Africa, Kuda Bank broke records when it announced a US$ 55 million series B valuing the company at US$ 500 million. The neobank bug has caught Africa particularly with Kuda Bank’s raise. India has not been far behind with Neobanks such as Jupiter and Novo both raising big rounds.

Initially, my article was meant to cover the African neobank space, but the more I researched this phenomenon the more I realised that some of the concepts applied at a global rather than local level. I wanted to understand whether the neobank fund raises are sustainable and whether real value is being created. In the course of my research, I figured out that there are both positive and negative arguments. Therefore, I will just lay them out.

For the sake of the article, Neobanks are defined as firms that offer financial services traditionally offered by banks exclusively through online or digital channels exclusively. Additionally, it may be useful for the sake of this article to define them as banks that are digitally native with technology defining their approaches to core banking tasks such as compliance, customer onboarding, KYC, credit scoring and most other tasks in the banking value chain.

The recent fundraise by Kuda Bank brought about angst and excitement in equal measure. A collective gasp could be heard throughout the continent as it was announced. On one hand, excitement that African Fintechs are getting global attention and that local founders can raise such rounds. On the other hand, there was concern that the space is overheating and if indeed a bubble bursts, the African fintech scene will take a long time to recover. This article by Maya Horgan Famodu best captures the concerns.

Comparisons to local banks such as GT Bank which has a valuation of US$ 2 billion were given as signs of exuberance. How can a bank that is barely 2 years old with significantly less revenue be valued at a quarter of the valuation of one of Nigeria’s most profitable banks? Across the continent, bank executives are scratching their heads at these valuations given that most banks are trading at less than 1.0x book value. Investors across Africa and globally are discounting any future earnings growth whilst stating that they don’t believe that bank books accurately reflect their stated value. 

I am not an Oracle and I won’t predict whether Neobanks are overvalued or undervalued, but I will state a few frameworks that I use to understand the value added brought about by Neobanks and their full economic promise. As stated at the beginning of this newsletter, in the long-term, the value of any company is defined solely by the cash flows it can bring to its investors over the long-term. Anything else is purely speculation or unique market factors that are difficult to replicate.

Manufacturing vs Distribution

This is one of the least covered elements when discussing Fintechs both in Africa and globally. There is a taxonomy when it comes to banking and financial services. On one hand there is the manufacturing of financial services which includes elements such as fractional reserve banking, maturity transformation, liquidity transformation and credit transformation. These are the core activities of a bank and are the heavily regulated elements that have societal implications. When a bank collapses, it is mostly because it has failed in its capacity to manufacture financial services. Additionally, manufacturing is capital intensive and benefits from scale economies. In the absence of scale economies, banks can execute their manufacturing services by focusing on serving specific niches very well. This can include banking a niche group such as military officers, large corporations or farmers.

Distribution on the other hand is concerned about how banks grow and serve their customers. This has been done traditionally through branches and ATMs. Recently, this has expanded into mobile apps and web browsers. The recent trend towards open banking is a regulator driven approach to disentangle manufacturing from distribution with the idea that improved distribution can lead to better client outcomes. Of course, banks that build powerful distribution mechanisms can use this to power their manufacturing business. The diagram below from GT Bank best captures this, the bank uses its retail distribution capabilities to grow liabilities which are then lent onwards to corporate customers.

Source:

GT Bank Annual Presentation - (Check retail deposits viz corporate loans)

A number of Fintech apps seem to be focusing on the less profitable distribution elements as opposed to manufacturing which traditionally are cost centres. The idea has been to offer customers products or services that are traditionally offered at the distribution phase such as low cost funds transfers, cheaper FX and account orchestration. Of course credit-led Neobanks such as Dave, Chime, Nubank and Tinkoff have built significant manufacturing businesses and that’s why they’re potentially further ahead on the path to profitability than their distribution heavy peers such as Revolut, Monzo and others. OakNorth and WeBank are other examples of Neobanks that have successfully mixed manufacturing and distribution. 

Of course, there is a potential business model where a Fintech or Neobank that has significant distribution capabilities helps a bank in the manufacturing element through origination. We have seen this happen successfully with M-Pesa and NCBA Bank with M-Shwari as well as Ant Financial with their partner regional banks. Jumo is another example of an African Fintech partnering with banks for credit origination.

It can be argued that some of the distribution heavy Neobanks such as Revolut are investing heavily in global distribution with a view of converting this into global manufacturing once scale has been achieved. If this is the case, then growth at all costs may be a useful though extremely risky strategy.

Market Failure vs Market Inefficiency

Market failure occurs when supply and demand don’t clear. This usually happens with public goods such as roads and security where the government has to step in to cater for this failure of the market. It can also exist in the market due to the inability of incumbents to offer a service to segments of the population. On the other hand, markets can be served but inefficiently. Neobanks are thus approaching markets based on the above dichotomy.

Nubank and Tinkoff have responded to market failure and offered a credit card to customers who were underserved by the traditional banking sector. Revolut, Monzo and Starling in my view are responding to market inefficiency where such services already exist but are distributed or packaged inefficiently. Stripe and Square responded to market failure by enabling merchant acquisition for groups (the long-tail) that were previously excluded.

Of course, with a great product, your initial customer base will grow from the previously excluded to the previously included who now want a better product. This has been the case with both Stripe and Nubank. 

Analogue examples can be given. Equity Bank in Kenya and GT Bank of Nigeria grew on the back of enabling people who were previously ignored by the banking system due to onerous KYC or minimum balance requirements. Nonetheless, as they grew, previously included became part of their clientele. These include large corporate customers who can now benefit from lower cost loans and cheaper FX generated from the retail base. 

I would venture to say market making Neobanks such as Dave, Nubank and Tinkoff have a brighter future than Neobanks that are responding to market inefficiency. In finance in particular, it’s more profitable to grow based on a new market as opposed to entering an existing market largely due to the inertia of account switching. Everyone complains about their existing bank but then does nothing about it.

Incumbents and the Innovation Stack

“We shape our homes and then our homes shape us” - Winston Churchill

The global banking revenue pools are predicted by McKinsey to reach between US$ 5.5 and 7 trillion based on a number of scenarios in a post-covid world. These are the revenue pools being targeted by Neobanks and in some cases, additional markets are being created that could drive these revenue pools higher. Arguably, as Neobanks achieve scale, there is a likelihood that the empire will strike back. This is a theme that is well articulated on this podcast of Invest Like the Best by Carl Kawaja. The idea is that as digital disruptors grow, traditional companies facing extinction will react and fight back for market share. Examples given are Walmart and Target building powerful e-commerce propositions in their quest to win back market share from Amazon.