I highlighted LendingClub Corp.’s (NYSE: LC) successful initial public offering in December, but warned investors that enthusiasm for the stock could wane after the first trading days.

#-ad_banner-#Despite triple-digit growth in sales and a healthy outlook, I put a buy-under price of $21 on the shares — 20% below where shares were trading at the time. After a rise to $28 in mid December, the shares fell and are currently hovering around my buy-price, and there could still be risk for further downside.

 

Even with risk, the growth potential of this market is too much to ignore.

 

The peer lending space is a fraction of the $3 trillion consumer credit market, even with growth averaging 100% annually since 2012 and nearly $6 billion in 2013 loan originations.

 

And companies like LendingClub have a leg up on big name lenders. Peer lending platforms have a cost advantage of up to 4% on traditional banks, and stricter banking regulations put limits on the amount of capital that traditional lenders can deploy.

 

Fortunately, another recent IPO in the peer lending space offers investors the opportunity to hedge the risks, but benefit from massive growth.

 

How Do Peer Lending Stocks Stack Up?

OnDeck Capital, Inc. (NYSE: ONDK) held its IPO last month to just as much fanfare as its larger competitor. The company is a short-term small business lender providing loans for three- to 24-months at rates between 18%-to-36%, but with an average APR of 54% on loans. Revenue grew 154% in 2013 to $65 million and 155% to $107 million over the first nine months of 2014.

 

LendingClub, the world’s largest peer lender, began by offering personal loans, but has since expanded to small business and education loans. The platform does not break apart rate data for product types, but reports an APR range between 6.8% and 28.7% for loans. LendingClub’s revenue grew 187% to $98.0 million in 2013 and 135% in the first six months of 2014.

 

Shares of both companies have plummeted since the post-IPO peaks.

  

LendingClub touched $27.90, but has recently dropped nearly a quarter to $22 per share. OnDeck Capital closed its first day at $27.98, but has since plunged 35% to $18.50 per share.

 

Even at current prices, the shares are expensive on a price-to-sales multiple. With 462.6 million shares outstanding on a fully-diluted basis and expectations for revenue of $309 million in 2015, LendingClub trades at a price of 33 times forward sales. With 89.6 million shares outstanding on a fully-diluted basis and expectations for revenue of $234 million in 2015, OnDeck trades at 7.0 times forward sales. 

 

On that relative valuation, you might think that OnDeck would make for the stronger play on the industry’s growth, but there are some serious risks to the company’s performance. Risks that might actually drive its share price down even further.

 

OnDeck is at greater risk from competitors because of its rates and business model. Other platforms are coming to market that offer small business loans at lower rates.

 

StreetShares may preview the biggest competitive threat to OnDeck with an auction-style investment model where investors bid down interest rates to win loan investments. Mark Rockefeller, CEO of StreetShares, told me recently that small business loans are being fully-funded in hours at rates under 20%. This kind of competition and lower rates could squeeze OnDeck out of the market considering its high-interest product.

 

The biggest risk to OnDeck appears to be its reliance on repeat borrowers. The company’s S-1 statement (a document filed to the SEC in order to become publicly traded) shows that 43% of 2013 originations were from repeat customers, a percentage that shoots up to 49% for the first nine months of 2014. While repeat customers are great for any other business, at an APR as high as 60% it may be more indicative of funding problems for client borrowers. If the economy slows, then it is quite possible that many of these customers would have problems paying their loans and a large percentage of OnDeck revenue could be in jeopardy.

 

OnDeck booked a provision for loan losses that was 47% of its interest income in the first nine months of 2014, up from 42% in 2013. Nearly half of the company’s interest income is at risk of loan losses. This could be a sign that growth is being supported through loosening credit standards.  

 

Beyond the competitive threat, any regulatory pressure could hit OnDeck harder than peers. While the 54% average APR on the platform is nowhere near the 400% seen on payday loans, it is still higher than most in the industry.

 

LendingClub does not report the percentage of originations that are from repeat borrowers, but since loan terms are for three-to-five years, the platform is less likely to see the same refinancing problem as OnDeck. LendingClub has an additional advantage in that its loan originations can be funded by non-accredited investors whereas only accredited investors can put money in OnDeck loans.

 

A Long-Short Strategy For Downside Protection And Upside Gain

I like the long-term upside on LendingClub and the peer lending industry, even if risk to investor sentiment sends the shares lower over the near-term. Estimates put the potential for the company to hit $1 billion in revenue by 2017 and the company has already been profitable though high marketing expenses drove a loss last year.

 

Even though LendingClub shares are priced more expensively than those of OnDeck Capital, the platform is the undisputed leader in the space with more than $4 billion in 2014 originations. That’s 2.5 times 2014 originations at the next largest peer lender, Prosper. OnDeck is expected to come in third with nearly $800 million in 2014 originations. LendingClub has less borrower risk than OnDeck, especially since its personal loan product may not be as susceptible to default on economic weakness compared to high-APR business loans.

 

The higher risk to OnDeck makes it a good candidate for a short position to hedge downside risks in LendingClub shares. I would maintain a short on shares of OnDeck Capital down to $14.50 per share and hold my one-year price target for LendingClub at $25 per share.

 

Risks To Consider: Both stocks of P2P lenders are trading at high multiples and could continue to drop if sentiment comes out of the industry. The long-term story remains intact but be ready for volatility along the way.

 

Action To Take –> Understand the difference in business models and competitive advantages among the publicly-traded peer lending platforms. Greater risk on OnDeck Capital makes it a good candidate to short against a long position on LendingClub.

 

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