Should we be worried about Kuda bank's financial performance?

Recently, an article published by TechCabal provided some insight into Kuda Bank’s alleged financial performance. The fintech raised $55 million to hit the half a billion ($500 million) valuation mark last year. The article was based on a financial report which flagged some concerns about the bank's performance.

The highlight of the now publicly available results was a 40x growth in 2021’s revenue of ₦3.2 billion, up from ₦72.7 million in 2020. 

Disclaimer: Kuda Bank is a private company, and the analysis here is based on the financial numbers published in this article, which the company has not publicly acknowledged.

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However, this revenue growth couldn’t cushion the 6x rise in the reported operating expenses of ₦7 billion from ₦0.94 billion in 2020. And so, its expenses, coupled with other costs, contributed to the neobank’s (bank without branches) ₦6.1 billion loss which was 6x higher than the ₦0.87 billion loss posted in 2020. 

The losses sounded bad. But the article also cited 69% non-performing loans (NPLs), way above the Central Bank of Nigeria’s (CBN) regulatory limit of 5% of all gross loans.

The reactions were expected. You see, some people believe Nigerian startups are overvalued, lack proper unit economics and are not backed by real fundamentals (i.e. large market for their products, low customer acquisition costs etc). With the current economic downturn and slowing VC funding, this financial performance fuelled a scepticism that has only been growing louder.

After all, the motive behind starting any business—VC or not—is to make a profit. Also, the main reason people trust financial institutions is that they can always get their deposited funds back when they need them.

Unsurprisingly then, Kuda’s alleged losses were worrying to traditional financial observers. Some analysts even compared Kuda’s performance with GTCO and Zenith—traditional financial institutions that have existed for over 30 years. 

However, as we will soon see, Kuda’s structure as a startup and its business model allows us to consider an alternative interpretation of the recent numbers. 

Kuda is, first of all, a startup

According to Paul Graham, one of the founders of Y Combinator, “a startup is a company designed to grow fast. Being newly founded does not in itself make a company a startup. Nor is it necessary for a startup to work on technology, take venture funding, or have some sort of ‘exit’. The only essential thing is growth. Everything else we associate with startups follows from growth”.

The key message here is that “growth” is the main focus for a startup and its investors, which means startups often have to forego profits in their early years to achieve this growth.

Industry giants like Uber (founded in 2009) and Airbnb (2008), which grew at record paces and raised billions of dollars in equity financing, are still not profitable businesses. The growth potential of a startup refers to how big its future market is and how quickly it can capture that market), which are what drive valuation estimates of startups during funding rounds rather than its current earnings. 

While there is no clear definition of what growth rate defines a startup, a good proxy, according to Graham, is to measure the growth rate of revenues, and the next best thing is to measure the growth rate of active users.

Now, let’s turn to Kuda.

Since its inception in 2018, Kuda has focused on growing its registered users. In 2020, this number stood at 300,000. By the end of 2021, the number of registered users grew to 1.4 million—over 3x growth and now over 3 million. Any seasoned startup operator today knows that registered users are top of the list for vanity metrics, as the better indicator of user engagement is active users. Nevertheless, the focus on user growth is undeniable.

As Kuda grows into a bigger company and begins to scale, accumulating a large customer base is expected to aid its path to profitability.

Similar to the number of registered users, Kuda witnessed a boost in transactions processed from $5.2 million in February 2020 to $500 million in November 2020 and then $2.2 billion in March 2021.

According to these numbers, average revenue per user (ARPU) rose 5x in 2021 to ₦1,603 versus ₦242 in 2020. This is a positive sign for investors, as it means the neobank can add customers without diluting the quality of their service offerings, i.e. generate revenue more effectively in the future.

Based on Paul Graham’s gauge, the growth rate of a good startup is about 5 - 7% a week, i.e. 1852% growth rate in a year. This doesn’t compare with Kuda’s 4000% revenue growth in a year.

It's a safe argument to make that these growth numbers form part of the justification for Kuda bank’s increased valuation from about $50 million in November 2020 to $500 million in August 2021. Startups, especially FinTechs, pursue aggressive growth mostly to meet targets ahead of future equity rounds.

But it doesn't end there for a startup. According to Graham, startups usually undergo three stages of growth in their lifetime. The first is the stage of little or no growth, where the startup is still figuring things out. Second, as the startup figures out how to create something of value and deliver it to people, it starts to see rapid growth (like Kuda). And lastly, when the startup becomes a big company, growth will peak partly because it's starting to bump up against the limits of the markets it serves.

The important thing here is that as loss-making startups move into the second stage and start seeing that rapid growth, the founders embrace a monetisation strategy to set the company on a profitability path. 

With the understanding of how startups are wired, let’s look at Kuda Bank’s digital microfinance feature, which distinguishes it from traditional banks, and allows us to consider a slightly different interpretation.

What is a digital microfinance bank?

Being a digital microfinance bank entails two parts that we must analyse separately. The first is being a digital bank (neobank or technology-based firm that services customers virtually) and then a microfinance bank (MFB).

This means that at its core, Kuda, which lacks a physical bank branch and offers all its services online, is different from traditional banks like GTCO. Examples of other digital banks in Nigeria include Vbank, ALAT by Wema and OneBank by Sterling.

Digital banking models are designed to operate cheaper than traditional banks. That is, the operational costs of managing physical branches (infrastructure, personnel) are minimal. The assumption is they shift these cost efficiencies to customers and deliver financial products and services at a cheaper price to a wider range of customers.

However, because the CBN (financial sector regulator) is yet to carve out a specific licence regime for digital banks, any company looking to play in this space must choose from three different licences: MFB licence, Payment Service Bank (PSB) and Finance company licences. Each with its own distinct features, limitations and advantages.

The MFB licence is the most popular because it is the most flexible of the three. It allows the holder to act as a sort of “lite bank” to receive deposits and grant loans (unlike the other two licences, which allow either one of both features). However, the licence prohibits the holders from purchasing or selling foreign currency or remitting funds internationally. 

As the name implies, an MFB is a much smaller version of a traditional bank—80% of the loans granted by MFBs must be below ₦500,000. In contrast, traditional banks have been financing loans of $490 million to a single entity since as far back as 2011.

Similarly, the capital required to obtain the MFB license ranges between ₦50 million to ₦5 billion versus ₦25 billion for a traditional bank.

This means that MFBs can’t operate on the same scale as traditional banks that cater mostly to large institutional clients. MFBs are designed to reach the low(er) income end of the economy, i.e. the retail segment (remember this, it will come in handy later); often ignored by traditional banks.

While we have established that Kuda is an MFB, we still can't compare it to traditional or legacy MFBs like Accion or Mutual Trust, some of Nigeria’s larger MFBs, because they also aren’t VC-backed start-ups chasing Silicon Valley-esque growth.

Besides, regulation limits the number of branches that MFBs can have and their reach regardless of the success of individual branches. Digital MFBs banks can reach anywhere.

Evidently, Accion MFB has just over 400,000 customers in the 16 years since its 2006 incorporation versus Kuda’s 1.4 million registered users in less than two years.

Therefore, the only other digital-MFB peers of Kuda bank are VBank, Sparkle, Rubies etc.

So now that we have successfully broken down what makes Kuda a digital bank let's look at its growth strategy and conclude if we should be worried about the bank's losses. 

Walk it as you talk it

Kuda bank talks a big game regarding its vision “to bank every African within and outside Africa”. 

But big ambitions cost big money and put some context to Kuda’s 2021 losses.

For Kuda to achieve its goal of banking every African within and outside Africa, the bank decided to start with the “Millenials” and “Gen Zs”, who are frustrated with traditional banking services.

So the neobank introduced free general banking services (all via a smartphone). This earned its title as the “bank of the free” as it does not charge its customers for transfers to other banks.

Instead of the ₦30 - ₦60 your typical bank charges you to transfer funds from your Zenith bank account to your GTCO account, Kuda doesn’t charge customers for their first 25 interbank transfers. Subsequent transactions cost ₦10 per transaction. 

Similarly, unlike traditional banks that charge between ₦1,000 - ₦2,000 to issue new debit cards to customers, Kuda bank issues cards for free to its customers.

These “free” service offerings and other aggressive pricing strategies adopted by the neobank cost billions of naira for Kuda to offer its customers.

Achieving these milestones in under four years requires significant advertising, marketing, and technology spending for Kuda bank. This informs the 6x jump in Kuda’s operating expenses (opex) to ₦7 billion in 2021 from ₦0.94 billion in 2020, according to TechCabal.

The article stated that personnel expenses (included in operating expenses) grew almost 5x to ₦1.3 billion (i.e. 19% of total opex) in 2021 versus ₦0.21 billion in 2020.

Following consecutive funding rounds, the neobank went on a hiring spree for top foreign talent (including former COO of Russian-based Tinkoff Bank as COO and ex-regional general manager at Revolut as CSO) to help fulfil its ambitions to expand outside Nigeria. Remember their mantra? “To bank every African within and outside Africa''.

Also, the article indicates that Kuda bank spent over $1 million (₦430 million) on marketing (billboards, YouTube ads, DSTV ads etc.) in Q1 2021 alone; annualised, that's about ₦1.7 billion ($4 million), i.e. 24% of total opex. For a bank that renders free services, it's little wonder they’re loss-making.

But let’s address the elephant in the room— the 69% NPL ratio. To do this, we would analyse a source of Kuda’s revenues. 

Lending in Nigeria is not for the fainthearted

Kuda’s entry strategy into the banking industry included a deliberate effort to create a simple lending product called “overdraft” that would become a household name among the youth.

During its early testing stage in 2021, the overdraft loans were extended to customers based on their transaction history with the bank, and qualified participants could borrow up to ₦50,000 at a daily interest rate of 0.3% of any amount they borrowed.

The problem is Kuda’s model didn’t account for the moral hazard of Nigerians. This directly explains the 69% NPL ratio and an impairment charge valued at ₦2.3 billion.

Remember the economy's retail segment (e.g. SMEs, farmers, and traders) that MFBs are designed to service? Lending to this category of borrowers is known as subprime lending because they have high default risk (i.e. low credit ratings), which results in high-interest rates on the loans to cover the risk.

However, some customers took advantage of the lack of laws punishing lenders for defaulting and the lack of cooperation between borrowers in sharing names of defaulters and often ended up defaulting on the loans.

Because eligibility was based on just a few transaction histories, some users simply needed to prop up some transactions on the app to qualify for the loans and then disappear. 

This led to Kuda’s high NPLs ratio and high impairment charges due to CBN regulation which mandates banks make provisioning in line with their NPLs. This tends to erode profitability and capital.

Evidently, Kuda’s reported impairment charges of ₦2.3 billion made up about 96% of its interest income, effectively wiping out 96% of interest received.

In summary, Kuda’s reported finances are just another reminder that Nigeria's lending business is very difficult to navigate. 

According to Adedeji Olowe, CEO of Lensqr, a cloud-based lending platform in Nigeria, “the lending game can be profitable once we can figure out how to weed out the bad lenders from the good ones”.  

In summary, depending on the lens you take to analyse Kuda's reported numbers, the company may be doing very badly or performing just as you would expect a loss-making VC-backed startup to do. Nevertheless, it remains true that the lending game in Nigeria (to retail investors) is a difficult nut to crack, so any attempt at making a business out of this market will require some renewed focus to squeeze a profit.