Originally published on July 24, 2018
Disclaimer: I do not own NEXO right now and this is not investment advice. Invest at your own risk and do your own research.
Nexo is a platform for instant crypto-backed loans. It is linked to the founders of Credissimo, a European fintech in the online consumer lending space with a long and successful (10 years) track record in the industry. What gives Nexo credibility apart from its own execution track record is that Michael Arrington and Trevor Koverko from Polymath are on its board.
Nexo is a separate legal entity and is operating in the secured (via crypto) lending, which has its advantages over an unsecured lender. For example, Nexo would not have underwriting and impairment costs, as well as certain typical operating expenses, such as those related to collection, litigation, call center operations, etc. All that means that the net margins should be higher. The flip side of this argument is that due to the loans being collaterized by crypto, the effective interest rates that Nexo charges will not be as high as for an unsecured payday loan for example. They also would not be able to collect other fees which are typical in the traditional online lending business and which help out the bottom line.
The problems that Nexo solves are the same for any crypto lender: people with large holdings may need cash for other things, but don’t want to sell due to various reasons (price going up, taxation etc.) — this is a convenient way to have some cash while retaining ownership.
You can read all that on their website. What is interesting here is the native token (NEXO). Nexo successfully closed an ICO back in April and raised $52.5m for development of the platform by issuing 750m NEXO. Interestingly, 250m tokens were issued later as a so called Loan Funding Reserve, which have a 1 year vesting and should not dilute NEXO holders. In order to use these tokens to fund loans, Nexo will need to sell them at some point on the market, which should increase the circulating supply and dilute the original ICO participants (they claim here that this is not the case, but I don’t understand why not). The current price is ca. 35% below the ICO price in BTC terms and 30% in USD terms. That is not the interesting part however. The NEXO token is a dividend paying token, “the World’s First US SEC compliant Dividend-paying Asset-backed Security Token and is backed by the underlying assets of NEXO” to be precise.
Nexo’s plan is to pay token holders 30% of its net profits as dividends. Before we look at how to value the token, let’s first look at the stakeholders and their incentives.
- Borrowers: 1/ get a loan against crypto, 2/ hold nexo tokens to pay lower interest when using nexo as collateral or as repayment of a loan, 3/ hold nexo token to profit from an increase in value
- Lenders: 1/ get higher interest and lower risk vs competitor platforms, 2/ hold token as a passive investment based on dividend yield
- Nexo the company: 1/ grow loan book, 2/ grow the value of its own tokens. There is one scenario where the founders’ interest is not aligned with token holders’. If the founders incur artificial costs where the money goes directly to them as opposed to forming a net profit which is used for divs. This is a risk which exists pretty much with any company. Not to say it can’t happen (it happens regularly in the corporate world), however here it does not seem to make much sense because a) the accounts are audited by a Big 4 and b) the value increase in their own token stake can far outweigh the siphoning of funds
- Passive token holders: 1/ token value rises, 2/ receive dividends
How do we value the token?
As passive holder (investor):
- model the development of the company, margins and profits
- compare to the market price
- decide based on the resulting dividend yield
As borrower (user) only:
- estimate total interest quantum paid through the platform
- estimate % usage for the token (repayment and collateral)
- apply discount
- come to a resulting cash flow (implied saving) stream
- value via an NPV
As a borrower / investor:
- investing the saved amount on interest into NEXO and getting the dividends will reduce the effective interest rate paid
- when the dividend yield is higher than the effective interest rate, people could be incentivized to take out a loan only to reinvest into NEXO tokens (obviously ignoring price movements)
- The discount works similarly to the way some of the exchange tokens work, de facto a “bribe” to use NEXO vs. competitors like Salt or Unchained Capital. It is a clever way to attract and retain customers as well another competition lever in addition to its standard operating options (interest rates, funding costs, cost income ratio, management execution etc). The question is who is paying for the discount. It is not the lender, so it has to come out of Nexo’s PnL, meaning that it affects the bottom line, which is used for dividends. This is the big trade off here — effectively a dynamic marketing cost to attract and retain customers. It reduces the available dividend, but increases the profits and potentially the token usage and holdings. If exchange tokens like the Binance Coin are any indication, they have been used far more as a speculation asset as opposed to their utility aspect (reduced fees) so there’s that
- One always has to ask the question what the current token price prices in, i.e. when we input the price, what does that tell us about the level of the dividend yield. In other words, where should the company be in its development today to justify a given yield. Obviously, we need to make a few assumptions to get an idea, but, given standard inputs for a loan book, net interest margins and cost-income-ratio, we can derive a net profit from which to imply a div yield. Then we should compare this to our risk and similar cashflow options like dividend paying stocks or bonds. See below for more
- One important differentiation to make is between the value of the token as an investment and as a speculation. Even if it does not look that attractive as an investment based on one’s risk-reward, it may be a good speculation instrument if the price action of exchange tokens is any indication. Or this may not repeat again, of course
- There is a clear incentive to hold the token — getting dividends and holding it as collateral to get a discount on the interest payments. Intuitively, I believe the velocity on such an instrument will not be very high, as opposed on some exchange tokens for example, which also helps with value increases.
What is priced in?
For the founders
As expected, the ICO is a great deal for the founders — they raise $52m by promising 30% of net profits as dividends on a future successful business. If it works out well, they have 100% of the voting shares in a very valuable business, 70% (plus the tokens they hold) in its net profits, up to 225m NEXO tokens (1bn-250m reserve-525m ICO) worth $16m (at current price), but more and more as the token price increases as they will sell their own tokens over time. All this financed today. Not a bad deal!
For passive investors
The way to look at this is to take it into an extreme. Let’s assume one investor single-handily funds the whole $52.5m to receive 30% of net profits (ignoring the utility aspects of the token as well as its speculation potential). That would imply a net income of $175m for 100%. It seems the founders expect better net profit margins compared to their existing business — Credissimo, where they achieve ca. 35%.
Let’s do a back of the envelope calculation: assume Nexo achieves 35% net profit margin, translating into $500m in net interest income (revenues). For consumer lenders, the revenues are the difference between the interest they charge on the loans and the cost they pay on the funding base. Given the loans are secured, the margins tend to be much lower than the typical unsecured lending like payday or consumer electronics loans. Let’s assume conservatively a net interest margin of 2%. That implies that Nexo needs to process $25bn in loans to achieve this level of net profit ($175m). This is no small number! Remember, it will take time to achieve these numbers (if at all) and for the investor to get his initial money back (not counting opportunity costs). Only then the returns start to flow. If the investor ever gets there, she would be earning ca. 70% dividend yield based on the initial investment. Obviously excellent, but needs to be adjusted for risk and time.
So let’s look at the same calculation, but for some more foreseeable period. Nexo announced that they have demand for $1bn in loans. That is a big number. Let’s believe it and assume they reach it. Using the same assumptions from above (2% net interest margin (after discounts provided), 25% cost/income, 0.75% provisioning cost and 10% tax rate — by the way, I don’t know the actual numbers — these are only assumptions), would earn ca. $2m in dividends on $1bn loan portfolio. At current market price ($0.072) this implies a dividend yield of 2.8%. As a matter of sensitivity analysis, if the net interest margin happens to be 4%, the implied yield would be 8.4%.
A few interesting things to mention here: you need to compare this dividend yield to other earning opportunities like dividend paying stock ETFs or High-Yield bond ETFs. The global MSCI dividend yield is in the range of 2.2% and the HY give you 5%-ish. Hell, even the 2yr US Treasuries yield 2.65%! These are all assets that will pay you these today, not sometime in the future. One obvious difference is that if Nexo executes on their strategy, the token price will go up probably significantly more than any of the other assets can deliver. So, to be fair, this should be used as a reference because it is not apples to apples. Still, however, if looking at the yield aspect of the token only, one should probably want the implied dividend yield to be above 10% to account for the various risks and allow for fundamental (read: not speculative) token price appreciation.
Getting to a value (NPV) of the savings requires “just” a few assumptions. I say “just” not because they are obscure in any way, but because forecasting well the entire future of an ecosystem is bound to be a low probability exercise. The below are very simple: starting with $1bn in loans in 2019, growing 30% per year, all users use NEXO tokens for discounts, 10% interest paid on loans and 20% discount when paying (or collateralizing) with tokens. The cost of capital I used throughout is 8.4% for simplicity (the implied dividend yield).
To illustrate the logic, here is ONE of thousands possible futures:
The idea is not to prime anyone to these numbers, but to show that in this particular case, a user (user, not investor) should not pay more than $1.59 for one NEXO token today, because otherwise they are eating away their interest rate discounts. You can recreate the above very easily and modify the numbers at will, you’ll see how different they can be under different scenarios. The intent here is to show the value to one particular stakeholder group. Obviously, users holding the token will be less and less inclined to use it if the price appreciates quickly, but then the users stop being users and become speculators (quite logically so). If the price of NEXO starts to fall, the can revert back to being users.
How does Nexo get ahead? Its strategy ticks all the right boxes
- They know that to win you need to be (own) a bank. Buying a FDIC-insured deposit institution in the US to lower its funding cost is crucial. For example, one of Nexo’s competitors — Unchained Capital shows APRs between 12–18% on its website. These numbers are high and will go down with more competition entering this space.
- Prepare loans for securitization — a common strategy for traditional online lenders to expand their loan books and involve more institutional investors indirectly — again, this is complex and so knowing what to do and how is a big benefit
- The effect of crypto lenders on the velocity of BTC, ETH (and other coins used as collateral) is likely to be positive because instead of selling, people will simply move them and get the liquidity
- P2P lending will provide an indirect fiat-crypto on-ramp for institutional investors, which is also positive
- An interesting development is that these tokens will compete with other crypto passive income alternatives like staking yields, returns from work tokens or TCRs
- An obvious effect will be the opportunity for HODLers to leverage their holdings. In other words, the effective interest rate will act as a competitor to other funding alternatives involved with coin lending, margin rates etc