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UK Neobanks Growth vs Profit
UK Neobanks: Growth Stars or Valuation Traps?
We're often told that the UK needs to celebrate its entrepreneurial wins. Like the venture capital world says, "pessimists sound smart, optimists make money". In that spirit, let's shine a light on UK neobanks.
These much-touted UK fintechs – Revolut, Monzo, Starling, OakNorth, and Wise – have been on a strong run as of late. Yes, valuations have taken a hit, but revenue growth remains healthy, even accelerating in some cases. Furthermore, all but Monzo now boast profitability. A stark contrast to the Forbes 30 under 30 payments crowd across the Atlantic.
The Investor's Dilemma
However, there's a catch. If you're an investor, how do you cash out? IPOs are the usual route, but public investors demand transparency. Reporting accuracy hasn't always been a strength for all neobanks. Correcting details like your 2021 average headcount from 4,655 to 2,365, as Revolut did in its 2022 annual report, won't sit well with the scrutiny of stock investors and the financial press.
Mergers and acquisitions are another possibility, but differing strategic visions might complicate those deals. Does management aim to expand their lending operations (a profitable yet traditional route)? Or would they prefer a super-app story, attracting higher valuations but a model that's found real success only in China so far?
The core issue for neobanks is their desire to benchmark against tech growth stocks with similar profiles. The way they generate income, however, is more akin to the old-fashioned bank model.
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Lessons from Listed Peers
Let's turn to the listed sector for insights. Nu Holdings, owner of Brazil's Nubank, sets the benchmark. Backed by Warren Buffett, it went public on the NYSE in 2021; despite a sharp fluctuation, its stock now surpasses its initial IPO valuation of $40bn. Over the past two years, its customer base doubled to 90 million, mainly in Brazil. Q3 2023 revenues saw a 50% year-on-year increase, largely courtesy of interest income and gains on financial instruments. Interchange fees from card use saw a 20% year-on-year growth, making up only 20% of gross revenue. Net income now annualises at $1.4bn, resulting in a PE multiple of 29x.
Wise has followed a similar path, with a sharp sell-off post its 2021 direct listing, followed by a bounce back to its original £8-9bn valuation. Like Revolut, Wise operates as an electronic money institution in the UK, not a bank. Nearly 60% of its revenue stems from FX transactions, with interchange fees on cards adding less than 20%. Its current run-rate places Wise at 6x revenues and 25x net income.
The Key Difference
The key distinction from traditional banks is a heavier reliance on interchange fees from debit/credit card use and foreign exchange services. However, it's far from the annual-recurring-revenue model favoured by VCs.
Neobanks grow their customer numbers by 20-40% annually as cash usage declines. They'll eventually run out of new markets to enter, and an economic slowdown would highlight the cyclical nature of their income - vastly different from multi-year enterprise software deals or unique social networks.
Unlike Nubank, UK neobanks often aren't primary bank accounts, but even small sums held by millions of clients add up significantly. Revolut, for instance, has deposit sizes of a few hundred pounds from tens of millions of customers.
The Interest Rate Factor
Rising interest rates have fuelled their revenue growth acceleration of late, with neobanks passing very little along to their clients. Instead, customer deposits find their way to central banks, commercial banks, or short-term government bonds, now offering attractive yields. This creates an earnings stream with a low-valuation multiple given its inherent cyclicality, particularly in a rising interest rate environment. Bank investors usually factor in the likelihood of declining rates in the future, resulting in discounted net-interest margins.
Revolut's Remarkable Run
Revolut has reported another stellar year of growth in 2023, with claimed revenue up 75% to around $2bn. After years of struggling to achieve operational leverage, it's now targeting double-digit net profit margins. Subscription revenues remain a modest part of the mix, and crypto trading's impact is unpredictable, but there's definite progress.
However, we might not get Revolut's 2023 regulatory filing until later this year. It'll be fascinating to see how much of the growth is the mechanical effect of higher interest rates, which Revolut books as gross rather than net revenue. Questions remain – how profitable will they be once rates decline or if they need to offer some of this interest income to customers?
Monzo's Balancing Act
Monzo reported 130% revenue growth for the year ending March 2023, and finally achieved positive underlying profitability. However, it also took a sizeable provision for potential future loan losses, highlighting the tougher path of lending compared to simply parking cash at the Bank of England. Monzo now follows Starling and SME specialist OakNorth into the consumer lending market.
The Path to Public Listing
As these UK neobanks prepare for public listings, they mustn't assume recent growth or headline profitability will dictate valuation alone. Public market investors will ruthlessly scrutinize earnings quality.
Can neobanks diversify revenue beyond reliance on interest rates? Fee-based income through subscriptions, tailored financial products, or premium account offerings could be a route here. But it remains to be seen if the UK public, often more financially conservative than US counterparts, will embrace this shift.
Another issue is whether neobanks can transition from secondary accounts to becoming customers' primary bank. This brings higher deposit balances, boosting that interest income stream, and unlocks greater potential product cross-selling. Features like direct salary deposits, full overdraft services, and mortgages will be key to this evolution.
Lastly, there's the matter of scale. The UK market offers limited room for expansion. International growth is essential, but each country has its own regulatory complexities and varying levels of competition from both traditional banks and fintech newcomers. Wise's model of focusing on cross-border transactions has its advantages, but Revolut's aspiration for a broader super-app approach will require significant and sustained investment.
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Balancing Ambition With Fundamentals
The UK neobanks have undoubtedly shaken up the financial landscape. But for investors, their long-term appeal lies in proving sustainable profitability, not just growth at all costs.
The Customer Conundrum
For all the focus placed on investors and valuations, neobanks ultimately succeed or fail based on their ability to attract and retain loyal customers. Flashy app interfaces, low-friction onboarding, and clever marketing campaigns can bring them in; however, it's the underlying value proposition that determines whether they stay.
Creating an Edge
One major challenge UK neobanks face is trust. Traditional high street banks, despite their often-frustrating customer service, benefit from long-established reputations and familiarity. News headlines about neobank glitches, customer service snafus, or links to less-than-reputable crypto schemes erode consumer confidence. While the same issues can plague traditional banks, the public's perception tends to be more forgiving towards a brand with a long history.
Then there's the issue of features. Early on, neobanks differentiated themselves through budgeting tools, fee-free foreign exchange, and sleek user interfaces. However, established incumbents have been catching up. Most now offer near-identical app functionality, and their sheer size allows them to outspend neobanks on marketing and customer acquisition.
So, what's the edge? Customer loyalty often boils down to perceived value and a sense of belonging. Neobanks need to go beyond the basics to win customers over. One route is niche specialization: banks that cater particularly well to freelancers, travelers, or environmentally-conscious consumers cultivate a dedicated following. Others double down on the community aspect, fostering a sense of shared identity among their user base.
Furthermore, building trust means offering robust support channels and prioritizing security over breakneck feature releases. While neobanks might pride themselves on being tech-first, customers still expect a human touch when things go wrong or when navigating complex financial decisions. Balancing cutting-edge features with traditional service standards is essential.
Differentiating for the Long Haul
Can neobanks replicate the success of Nubank in Latin America, a region notorious for poor and expensive banking services? The UK public is less likely to view a neobank as their financial savior in the same way, meaning the differentiation strategy has to be more nuanced.
Some neobanks seem to bet heavily on the rise of cryptocurrencies and Web3 integration. Is it a passing fad or a fundamental shift in how we think of finance? It's too early to tell, and the volatility of crypto markets certainly adds an element of risk to the overall business model.
One potential growth avenue is the business banking sector, historically underserved by the large incumbents. Neobanks focusing on SME clients with streamlined invoicing, expense management, and simplified lending could find fertile ground. Yet, this also brings them into closer competition with established financial software providers like Xero and Quickbooks, requiring an even more tailored offering.
It Comes Down to Value
Ultimately, the longevity of UK neobanks depends on their ability to provide tangible value that goes beyond trendy features or fleeting sign-up bonuses. As interest rates normalize and the economic outlook potentially weakens, customers will scrutinize where they keep their money and how they spend it.
The Competition Heats Up
One cannot talk about neobanks without addressing the elephant in the room: established banks. The likes of HSBC, Barclays, Lloyds and NatWest have had ample time to observe the rise of the challengers. Initially dismissive, most now acknowledge the need for innovation, pouring resources into enhancing their digital offerings.
While they might not move as quickly as pure-bred fintechs, traditional banks have some inherent advantages. For one, they hold vast amounts of customer data, a treasure trove for developing personalized financial products. They also benefit from higher levels of public trust and often have interwoven relationships with customers, from mortgages to insurance policies.
Competitive Landscape
It would be unwise to underestimate incumbents' ability to copy the best aspects of the neobank model while leveraging their existing reach and resources. Witness the success of JP Morgan's Chase Bank in the UK. It launched with slick features and enticing sign-up incentives, quickly capturing a portion of the market, thanks in part to the familiarity of the parent brand.
The competitive scenario could evolve in a few different ways. One possibility is a gradual convergence. Traditional banks become more digitally savvy, while neobanks, particularly those seeking higher valuations, start to resemble 'proper' banks with a broader product range and even physical branches in some cases.
Another possibility is specialization. Some neobanks might double down on their niche appeal, attracting a passionate following rather than battling incumbents for mass-market dominance. Travelers, the ecologically conscious, or small business communities are all segments where tailor-made offerings could prove successful.
Then there's the potential for partnerships. Neobanks, especially those without a full banking license, may find it advantageous to team up with traditional players. This allows them to benefit from the underlying infrastructure and regulatory compliance while providing a front-end layer of enhanced customer experience and focused products.
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The Big Tech Angle
Another disruptive element to consider is Big Tech. Companies like Apple, Google, and Meta have been steadily encroaching upon the financial services area. Offerings like Apple Pay and Google Wallet are already ubiquitous, and further moves into lending, savings products, or even full-fledged banking accounts wouldn't be surprising.
Big Tech has a clear edge in sheer user bases and sophisticated data analytics. Their focus on seamless user experiences aligns perfectly with the demands of banking customers. However, they'd likely face regulatory pushback if perceived to be overstepping into territory traditionally held by licensed financial institutions.
The Future Isn't Set in Stone
The potential outcomes for the UK neobank scene are varied. Consolidation is likely, with some faltering and others being acquired, either by traditional banks looking to accelerate innovation or by overseas-based competitors seeking entry into the UK market.
Regardless of how it plays out, the disruption neobanks brought to the sector is undeniable. They forced complacent incumbents to improve, and customers will benefit in the long run. Whether UK neobanks turn into major success stories or cautionary tales of overzealous ambition, their legacy will be a more competitive and customer-centric banking landscape.
Lessons Learned and the Road Ahead
Beyond specific profit models and market strategies, the rise of neobanks highlights some broader shifts worth considering. Firstly, it demonstrates the increasing public demand for financial services delivered with both transparency and a customer-first approach. Traditional banking's reputation for opaque fees, outdated systems, and an air of indifference is no longer tolerated in an always-connected world.
Secondly, the neobank phenomenon shows that technology can be a powerful lever for change in even a highly regulated field like finance. While established banks often struggle to untangle decades-old legacy systems, neobanks start with a clean slate, building their infrastructure optimized for the digital age.
Thirdly, it's a reminder that competition is healthy. The arrival of neobanks has injected fresh energy into the UK's financial sector. Customers now have more choices, and pressure is on traditional players to offer better terms, greater convenience, and innovative products.
The road ahead for UK neobanks is undoubtedly filled with both opportunities and obstacles. Their ability to achieve sustainable profitability without becoming overly reliant on fickle market conditions will be crucial. Developing a loyal customer base that sees them as more than just a secondary spending account is another major challenge.
While the hype cycle might be cooling somewhat, the neobank movement's impact shouldn't be underestimated. They've shown that a different way of banking is possible, one that prioritizes user experience, agility, and a healthy dose of competition.
Key Takeaways
So, what are the main lessons we can draw from exploring the world of UK neobanks?
Investors must scrutinize earnings quality: Growth and headline profitability are important, but public markets demand transparency. Neobanks shouldn't rely on flattering accounting methods or temporary surges in interest income.
Customer trust is paramount: Flashy apps and initial sign-up bonuses won't cut it in the long run. Neobanks need to provide rock-solid security, reliable support, and compelling reasons for customers to see them as their main financial partner.
The competitive landscape is dynamic: Established banks are adapting, and new challengers like Big Tech firms might further shake things up. Neobanks must clearly define their niche and deliver exceptional value.
Sustainability matters: The UK public isn't likely to embrace a "grow at all costs" mentality. Focus on long-term viability, even if it comes at the expense of some immediate gains, will be critical in earning both investor and customer confidence.
The story of UK neobanks isn't over yet. Whether they become lasting titans of the financial sector or niche players with a devoted following, their contribution to the evolution of banking will continue to be felt for years to come.
