Can the challenger banks survive the recession?

It’s not a secret that the financial sector tends to perform exceptionally bad during the times of recession, and this time isn’t any different. We’ve seen that the financials index has severely underperformed the broader market, and we think that this trend is here to stay.

Performance of US financial companies compared with the broader market

The banking businesses have been struggling like many others but on Wallstreet, some of the pain in retail services has been offset by record trading revenues due to the high market volatility. J.P. Morgan, Citigroup, Morgan Stanley, and Goldman Sachs all reported an increase of more than 70% in trading revenues. A more retail-focused bank like Wells-Fargo, which lacks a significant trading division, paints a clearer picture of the current landscape. Their revenues were down significantly, and they had to take an $8.4 billion loss provision, that heavily contributed to their net loss of $2.4 billion. In the UK, Metro Bank plc also reported a near 20% decline in revenues and a net loss, while Barclays fared quite well, in part due to its higher trading revenue.

In the other big market segment, Visa and Mastercard both reported similar results for the second quarter. Total transactions were down 10% compared to the same period last year — reflecting a weaker consumer sentiment, and cross-border transactions, which are the real profitability driver for the card providers, were down nearly 40% mainly due to the travel restrictions.

Adding salt to injury in the sector was Wirecard’s collapse in late June. The company fell into insolvency after a huge accounting scandal, and the shockwave of this event will definitely be felt for a long time to come. Not only did it wipe out billions of value for the investors, but it also suspended its services which were widely used in the fintech field. Some companies that operated on Wirecard’s platform are Curve, Pockit, McLear Ring, Payoneer, and others.

This matters a lot because it raises one very important question for investors:

“If that happened to Wirecard, can it happen to someone else?”

In the fintech field, the challenger banks are a serious cause for concern. They are unlikely to be engaged in fraud, but just like Wirecard — they are not shy on the valuation side.

UK’s most valuable fintech firm Revolut is valued at a staggering $5.5billion, despite having revenue of only $212 million, and a net loss of $139.6 million.

That puts the firm at a price-to-sales ratio of nearly 26, which, by many standards is considered highly overvalued. Sure, the revenue and the customer base have growth rates in the triple digits, but we must not forget that this is a highly competitive field, and the competition is growing as well. It’s not going to be long before the organic growth in the sector slows down, and the different players start fighting for customers.

Monzo, the second biggest player in the UK market had a revenue of £67.2 million and took a 40% decrease in valuation after the last funding round in February, it’s now valued at a more modest £1.24 billion. Which makes a price-to-sales ratio of 18. That leads us to believe that if Revolut runs out of cash, and are in need of another financing round in this environment, their valuation can also take a hit.

Online challenger banks users — Source: Finder.com

Even though Revolut has proved itself as the dominant player in the European market, having the biggest market share by a wide margin, there are still no signs of profitability. The same holds for the other challenger banks.

This leads to the question — is their business model sustainable long-term?

To understand this — we must first know how these companies actually make their money. Unfortunately, Revolut doesn’t issue public income statements, but we do have one from Monzo.

Monzo Income Statement

It looks like more than 50% of the total revenue comes from the “net fee and commission income”. The majority of this resembles the notorious “interchange fee”, paid from Mastercard to the issuing bank — Monzo in this case. This source of income is the bread and butter for all “neobanks”, and there’s a huge issue with that…

Regulation (EU) 2015/751 — the EU commission capped the interchange fee for debit cards to 0.2%. This directive greatly limits the chance that a company focused primarily on electronic payments will ever be profitable. As we see on the income statement, even if Monzo triples it’s customer base, the fees still won’t be enough to cover the costs of the platform.

What makes the situation even worse is that the neobanks are engaged in what is known as discretionary spending. It turns out that most of their customers are unfaithful — meaning that only around 20% of people use a challenger bank exclusively, while the majority of people use it as an add-on used to pay their friends for lunch.

That’s why all of the challenger banks are diversifying into different segments, Monzo focused on credit, Revolut on subscription revenue and trading fees, while Tide and Starling bank have mainly engaged in the more lucrative SME segment.

In Europe, all these firms are facing heavy headwinds, and with their current cash burn rates, if they don’t quickly diversify into more profitable segments, they’d be forced to raise capital at lower valuations.

All of the major companies operating in Europe, namely Revolut, Monzo, N26, and Monese have closed some of their offices and laid off staff since the start of the COVID-19 pandemic, that means that they are already strapped for cash, and if we witness a prolonged recession, a reduction in valuation might be the best outcome they can get.

The only place for hope in the current environment is in the Americas. The challenger banks there enjoy a more healthy interchange fee of 1.2%, which helps a lot to cover the costs of the platform. Chime the biggest online bank in the US has revenues of 200$ million despite having fewer customers than Revolut. It has significant competitive advantages compared to a normal checking account with a high street bank. Mainly it draws customers with the faster direct deposit on salaries and the automatic savings account. The biggest player in the Latin America region — Nubank is also expanding exponentially and managed to reach a revenue of $300 million for 2019 while growing its customer base at a rate of 40,000 per day.

In the short to mid-term, we expect the same trend to continue. The challenger banks will keep growing in the number of users, in the Americas they could even start turning a profit in a few years. However, in Europe, the regulatory environment is only exacerbating the already existing issues that the mobile app banks are facing.

I’m an asset manager focused on long term investing. My investment strategy is to buy assets with a discount to NPV and a high dividend yield.