Description

We think QFIN is a solid way to play China re-opening/consumer revenge spend. There is 100% upside over the next 3 years.

Over the past 3 years, the business model and regulatory environment have significantly improved for QFIN. However, the business is still valued at a below historical average multiple and at liquidation value. Upside should come from beats to sell-side estimates in 2023/2024 as well as re-rating as investors better appreciate the transformed business and regulatory environment.

We explain the business below, the transformation, why it’s interesting now, and why this is the opposite of Upstart.

Quick business overview:

QFIN uses its marketing engine to acquire customers that are interested in unsecured consumption loans. Its underwriting software approves, underwrites, and originates loans. The loans have an average all-in APR of 22% and an average tenor of 11-12 months. The main customer profile is young professionals and adults who don’t have a long credit history. The loans can be originated on balance sheet, off balance sheet with a guarantee, or off balance sheet without a guarantee. For off balance sheet loans, QFIN earns a take rate and provisions against its guarantee obligations. For on balance sheet loans, it earns the interest income and provisions against credit losses.

QFIN is a significantly better business today than in 2019, yet trades at a significantly lower valuation. 2019 vs. now:

2019:

• High channel concentration: Most of traffic was from the 360 Group web properties (access to over 1 billion mobile devices). While it’s a related party, it still presents high customer acquisition channel concentration risk.
• Poor quality of funding: 20%+ of funding was still from P2P (even more in the preceding years). P2P funding is expensive, finicky, and not sticky. As we learned from studying UPST, SOFI and LC, lending models dependent on finicky and volatile P2P or ABS markets significantly increase the volatility of funding. Deposit rich banks (especially local banks) are the best source of funds.
• Large exposures to loans: 80% of loans were guaranteed by QFIN and 100% of loans were funded in a capital heavy model. QFIN provided a back-to-back guarantee with a guarantee company or guaranteed the loans itself. Under the guarantee model, QFIN had full credit risk. It must pay financial institution partners unpaid interest and principal in the case of default.
• No SaaS-like business:
• High leverage: Leverage (on balance sheet loans + off balance sheet loans that the company guaranteed) was 8.1x
• Many competitors: Ant and Webank’s lending businesses were growing unchecked and extremely fast. They could leverage their respective mobile and web ecosystems to cheaply source customers. There were also many public and private players trying to capture share.
• Usury-like rates which invited regulatory risk: many lenders were charging 30%+ APRs, which were above the generally accepted 24% line and close to the 36% red line.
• No regulation framework: The government was playing whack-a-mole without a consistent overarching framework and was always reactive (e.g. only when retail investors lost a lot of money to fraud in the P2P lending business did the regulators step in).
• No SME loan origination business

Today:

• More diversified acquisition channel: customer acquisition channels have expanded to include online media properties like Douyin, Kuaishou, WeChat moments, search, e-commerce and O2O platforms, banks, and offline.
• Cheap, stable funding: Almost 100% of funding is provided by regulated banks with large, sticky, low cost deposits
• Much smaller exposure to loans: <1/3 of loans will be guaranteed in 2023 and ~70% of originations will be funded through a capital light model under which QFIN bears no credit risk.
• QFIN is now offering its risk management solution to banks for internal use. For loans generated using QFIN’s software, QFIN gets a take rate (~1-2% vs. 6-7% for capital heavy loans) and has no credit exposure
• Lower leverage: Leverage is close to <3.5x this year.
• Fewer competitors: As explained below, regulatory barriers to entry and scale have increasingly significantly over the last 3 years.
  • It is impossible for startups to enter the online loan facilitation business.
  • Large internet non-BABA/Tencent platforms would rather partner with a licensed player than do it internally
  • Baba and Tencent will still grow consumer finance by monetizing their traffic but the aggressive growth days are over given regulatory scrutiny and leverage constraints on them.
  • Smaller, independent online loan facilitation players have either shut down or started focusing on other areas of growth (international for FINV and loyalty/virtual cards for LX) despite being at smaller scale vs. QFIN (QFIN’s consumer loan business is 2-3x bigger than that of LX and FINV and is still growing faster).
• All loans are below the 24% all-in IRR line: The latest average all-in loans were 22% in 3Q 2022. Regulators are okay with responsible lending under 24%.
• More mature regulatory framework: The fear in 2019-2021 was that regulation would effectively kill the online loan facilitation business model. Instead, the main regulatory guidelines introduced over the last 24 months have shown that regulators understand the need for this business model.
  • Clear guidance on max interest rate of 24%
  • More clear rules on what fees can be charged
  • Creation of credit reporting companies to handle PII information
  • Loan facilitation platforms must have one of the three licenses: bank, micro loan, consumer finance
  • Loan facilitation business models must be separate from securities, insurance, payment, joint-lending, and overuse of ABS leverage.
  • On Jan 8, CBIRC Chairman said that the regulatory overhaul of the fintech lending industry is basically done
• QFIN is growing its SME loan business, which unlocks significant new TAM

QFIN’s conservative underwriting enabled the company to perform very well through a 3 year pandemic-induced economic weakness in China

• QFIN is known in the industry as a very conservative underwriter. The numbers back this up. 90 day delinquencies are very low despite the fact that. For comparison, China Merchant Bank’s credit card (<18% APR) 90 day delinquencies were 1.14%, 1.27%, 1.14%, and 19% in 2019/2020/2021/9M 2022.
• 90 Day delinquency in Q4 2022, when everyone was sick from covid, was 2.03%, down significantly from Q2 and Q3

• Furthermore, it has generally underwritten better than its listed peers, not to mention all the private competitors.

Why now?

• Loan origination volumes will recover as the economy improves. The government is easing liquidity onshore and banks will want to earn a yield on that money. Consumer credit with APRs of 20-22% are very attractive, even on a risk-adjusted basis, vs. mortgages and credit card loans. Consensus is assuming 2023 loan growth of 10-15% when the company grew mid teens through several months of rolling lockdowns in 2022! With recovery and easy comp, we think the expectations are too low.
• Delinquency rates are at a cyclical high rate and will come down.

• Initial reopening fervor has died down a bit. Jan to Feb marketwide China reopening numbers have disappointed the market. This led to a sell-off in Chinese equities. We think it’s inevitable that things will get back to normal. Whether it’s earlier or later by a few months shouldn’t have an impact on the intrinsic value of the business.
• There is significant regulatory clarity now, especially given the Jan 8^th commentary

Valuation is near record lows

The company is valued at ~0.8x 2023 book value.

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30%+ book value growth plus multiple rerating should yield a double in 3 years.

Comparison with UPST: Thoughtful readers will read the above and think, this is UPST! Obviously, UPST has been a terrible stock and underlying business trends have been horrible. We think QFIN is quite different from a business and stock perspective.

 Starting valuation is completely different. UPST was valued at 15-28x revenue before the collapse. QFIN is 0.8x revenue and 1x BV.

• Funding structure is completely different.
  • UPST had a bad funding structure just when the funding market turned. Less than 20% of funding was from banks. The rest was from the ABS market and forward flow sales to institutional investors. Many of these buyers were also arbitraging between forward flow and the ABS markets. Whole loan buyers would purchase loans from UPST and immediately securitize for mid to HSD equity gains, which were juiced with cheap leverage. When ABS spreads widened and the pricing achieved was worse than that of forward flow, the gains turned into losses. Institutional investors thus stopped funding the loans. ~40% of UPST’s funding in late 2021 was playing this game, which effectively collapsed starting in early 2022. On top of this, the ABS market also turned unfriendly towards consumer credit.
  • QFIN has more than 100 different bank partners who provide funding and effectively all funding comes from banks. Deposit-based funding is low cost and sticky. Chinese banks are notorious for having bad ROEs so banks want high ROA loans like consumption loans to improve their financial performance.
• Growth profile is different in downturns: UPST may see loan origination decline ~50% this year even without a nationwide recession. QFIN grew loan volumes in the teens in Q2 and Q3 when lots of people were locked in their homes.

Catalyst

Earnings

China consumer recovery numbers