Part 2 — Nubank’s business model, profit margin and unit economics
Nubank’s business model
Nubank is a digital bank based in Brazil that provides a variety of financial products and services, such as credit cards, loans, savings accounts, investments, insurance, and crypto, all through a convenient and user-friendly mobile app. Like traditional banks, Nubank generates its revenue mostly from fees and interest. However, unlike traditional banks, Nubank does not have any physical branches and began by offering a credit card product rather than starting with deposit and loan offerings.
The credit card industry is relatively new, having been around for only about half a century, compared to deposit and loan services which have existed for at least 600 years or longer. Building a profitable credit card business is not easy, as delinquency ratios can be high if consumers do not pay back their unsecured loans. For example, Bank of America, the first bank to introduce credit cards in the US, initially lost so much money that it almost abandoned the credit card program. However, over time, it figured out how to make its credit card business successful. The three main sources of income for a credit card business are: (1) interchange fees charged by the issuing bank, (2) annual membership fees, and (3) interest charged on unpaid balances. Additionally, credit card business can increase customer loyalty and serve as a channel to sell other products. Historically, when delinquency rates are lower than 4%, banks can make decent returns from their credit card businesses.
In addition to credit cards, Nubank is also offering unsecured personal loans with a maturity of around 6 months. The company also has newer product lines in insurance, investment, and cryptocurrency, but these generate relatively little revenue.
How does a credit card work?
A credit card transaction typically involves five players: consumers, merchants, issuing banks, acquiring banks, and payment networks such as Visa or Mastercard. To illustrate how this works, let’s use a $100 transaction as an example.
- First, a customer uses their credit card to make a $100 purchase from a merchant.
- Next, the merchant submits the transaction to their acquiring bank, which acts as an intermediary between the merchant and the issuing bank.
- The acquiring bank then sends the transaction details to the issuing bank, which approves or declines the transaction based on the customer’s creditworthiness and available credit.
- If the transaction is approved, the issuing bank sends an authorization to the acquiring bank, and the acquiring bank sends the funds to the merchant, with a 1–2 day settlement period, minus the merchant discount rate (MDR). The MDR is the percentage of the transaction that the acquiring bank takes as a fee for processing the transaction. For example, if the MDR is 3%, the merchant would receive $97.
- The issuing bank then charges an interchange fee, for example, 1.5%, and sends the remaining funds to the payment network, such as Visa or Mastercard, which takes a small fee (around 0.3%) for facilitating the transaction and sends the remaining funds to the merchant’s bank.
- Lastly, the consumer pays $100 to the issuing bank in 30 days — the typical billing cycle.
In summary, for a $100 transaction, $1.5 goes to the issuing bank, $0.3 goes to the payment network, $1.2 goes to the acquiring bank, and $97 goes to the merchant. Since consumers typically pay back their credit card balance in 30 days, the issuing bank needs to fund the negative working capital. Additionally, the issuing bank is also assuming the credit risk of the consumers. In Brazil, domestically issued credit card transactions are typically funded on a D+30 schedule, which means that the funds are made available to the merchant 30 days after the day of the transaction. This creates a negative working capital benefit (i.e. interest-free float) for the issuing bank in Brazil. This small detail is significant, as it allows Nubank to fund its credit card balance through accounts payable, reducing the need to rely on external funding. In short, it strengthens Nubank’s self-funded nature.
Nubank’s credit card and loan businesses
The credit card industry is highly competitive and often resembles a commodity-based business, with the exception of banks being able to differentiate themselves through attractive rewards programs that can add to operating costs. To be successful in this type of business, it is essential to operate as a low-cost provider. Nubank’s competitive advantage comes from its position as a low-cost operator. It has no physical branches and employs only 7,000 people to serve over 70 million customers, compared to traditional banks that employ 100,000 people to serve a similar number of clients — 10 times more efficient than traditional banks. Nubank’s heavy use of algorithms to assess creditworthiness and data analytics to detect fraud has also helped to reduce fraudulent activity and better identify customers who are more likely to repay credit card loans, further reducing its operating costs. This allows Nubank to offer low prices, such as no fees for its credit card and higher interest rates on savings deposits, as well as personal loans at over 20% lower interest rates than competitors. This, in turn, attracts and retains good customers, as evidenced by Nubank’s low churn rate since its launch. Nubank’s growth in customers, from 6 million to 70 million within 4 years, has been driven by word-of-mouth recommendations, which has resulted in significant savings on acquisition costs — as Nubank disclosed, 80% of its new customers come from word of mouth. This creates a virtuous cycle where Nubank can continue to be a low-cost operator, grow its customer base, and expand into new markets such as Mexico and Columbia using the same playbook. To summarize, low-cost leads to low prices, which attracts more customers who bring in their family and friends. This further reduces cost, completing the virtuous cycle.
Nubank’s growth would be meaningless if it cannot produce reasonable profits. In its last quarterly report, the company’s bottom line finally turned positive, indicating a positive trend of continuing profitability despite macro headwinds and conservative accounting treatment front-loading the credit loss provision. Brazil’s consumers’ debt to disposable income ratio is at a record high and delinquency rates have edged higher each quarter, which is a major concern for all banks. However, Nubank has generally performed better with lower delinquency rates compared to peers. Its NPL (non-performing loan) ratio of 15–90 days was 3.7% for the last quarter, as compared to 5%+ for peers, according to the company’s latest presentation. This result is even more impressive when considering Nubank’s demographic concentration in lower-income cohorts. This demonstrates Nubank’s superior data analytical platform, which is capable of choosing better consumer cohorts with lower delinquency rates. Despite its growth, Nubank is currently earning less than its potential due to the upfront costs associated with entering new markets.
For a fast-growing loan book, credit loss provisioning can have a negative impact on margins in the short-term. Credit loss provisioning is the process of setting aside funds to cover expected losses from loan defaults or credit losses. This means that a portion of the revenue from loans must be set aside in a credit loss provision account, which reduces the funds available for other uses, such as paying expenses or generating profits. When a loan book is rapidly growing, credit loss provisioning can have a negative impact on margin due to the larger portion of revenue it consumes. This is because while credit loss provision is front-loaded at the inception of the loan, interest revenue is earned throughout the period. However, as growth stabilizes, the negative impact will become less severe. In the case of Nubank, gross margin is expected to reach 60% at the mature stage, compared to the low 30% reported in the last quarter. Its provision to balance ratio is currently at around 11%, more than double the reported delinquency rate. Recently, Nubank has intentionally slowed down the growth of its loan book, which demonstrates management’s flexibility when the environment changes. The goal is not to grow unprofitably, but rather to enlarge the price advantage and customer experience Nubank offers to customers.
Unit economics — ROA and ROE
The reader may wonder if Nubank has compromised standards in order to increase its market share. However, this is not the case. To demonstrate this, let’s take a closer look at the margins of Nubank’s two most important product lines: credit card and personal loans.
For a fast-growing technology company, it’s essential to focus on unit economics and return on capital for different product lines, excluding general corporate expenses and sales and marketing expenses.
- For example, Nubank’s personal loan balance of $2 billion (as of end of Q3 2022) generates a risk-adjusted (credit loss provision adjusted) net interest income of $300 million with an ROA of 14% and an ROE of over 100%.
- On the other hand, Nubank’s credit card balance of $8 billion (as of end of Q3 2022) generates a risk-adjusted net interest income of $500 million. Despite credit card’s lower loan rates, its margin is improved by its low funding cost — most of the balance is funded by account payable, which costs almost nothing, while personal loans are funded by relatively expensive deposits liability. Additionally, credit card has high-margin interchange fees, which are estimated to be $900 million — $1 billion per annum with low capital requirements. The ROA for credit card can be as high as 10% with an ROE of over 50%.
Furthermore, Nubank’s latest quarterly results (Q4 2022) have cemented its position as the Fintech industry’s fastest-growing and most profitable company. Its remarkable net interest margin (NIM) of over 10%, together with a 5% risk-adjusted NIM, and an exceptional 40% return on equity in Brazil, showcase its superior margin profile. In comparison, the five largest traditional banks in Brazil, which are arguably the most profitable banks globally, earn a 1–2% return on assets, compared to the US average of less than 1%. These banks produce only half the NIM that Nubank has reported, with a 5% NIM margin, and an ROE of 20%.
Unit economics — ARPU and LTV/CAC
To complete the unit economics analysis, let’s also look at the cohorts ARPU (average revenue per user). Since its launch, ARPU has been growing rapidly from $57 in 2018 to around $100 in the latest filings. More impressively, mature cohorts already reach $260 per year as more products are adopted by users. High-growth companies typically look at LTV/CAC (lifetime value to customer acquisition cost) to evaluate the efficiency of a company’s customer acquisition strategy as well as the profitability potential. A simple calculation indicates that Nubank is generating $100 x 40% (conservative gross margin) x 5 years lifetime (also very conservative as churn rate of 1% indicates a much longer lifetime) = $200 of LTV. As mentioned previously, Nubank’s current CAC is $5, which implies a 40x LTV/CAC ratio, a very high standard even in the fast-growing tech world.
To summarize, managers focus on unit economics and both credit card and personal loans are profitable for the company.
