Description

This is a tough pitch we are hoping to get good feedback on.  It would not surprise us if this gets a low rating as this is a scary long (China + P2P lending + Technology + Bad GIFs / Cartoons = low rating on VIC) and people can view it in two distinct ways:

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To quote Baron Rothschild, "the time to buy is when there's blood in the streets."  Without getting too macabre the street where Chinese P2P lenders reside is dripping.   Just to show how hated this is here is a small collection of recent cartoons in Chinese media on the P2P space (wonder which way sentiment is):

Lexinfintech (LX) is a Chinese fintech company that provides reasonably priced (mid 20’s APR) installment purchase financing via its own ecommerce platform (11% of loan balance but an important customer acquisition tool) and unsecured consumer loans (89% of loan balances) to young educated adults, with loans funded by its P2P platform (1/3 as of last quarter) and institutions (2/3 as of last quarter).

Let’s not sugar coat this, LX is a scary long and here are obvious risks:

1.       Regulation: China announced has announced 108 new regulations on the Chinese peer to peer (P2P) lending industry to rein in rampant fraud which lead to bankruptcies of hundreds (if not thousands) of P2P platforms. The Chinese P2P industry was an orgy of Ponzi and get rich quick schemes that was out of control. The knock-on effect was significant as most of the public companies reported slowing growth and worsening credit quality.

2.       IPO wave: Prior to the regulatory overhaul, there was a wave of Chinese public online lending companies that went public most of them low quality, some of the potential fraudulent. They all had short business histories and insane growth rates. All of them have been at least cut in half from the highs (and many deservedly so).

3.       Competition: BABA and Tencent dominate payments in China, have massive user bases and considerably more resources than any of the fintech companies. They have been getting into this space.

4.       China: It is slowing and has gigantic amounts of debt.

5.       Short-term Capital Market Memories: ONDK and LC suck and burned many longs while shorts are hoping history repeats.

So now that we have laid out why this is a terrible long pitch let’s go through why that is a red-herring and LX is an interesting long and why now?

We believe LX is a legitimate and high-quality company with a good management team (who built TenPay while at Tencent) fitting a massive unmet need capable of compounding EPS at 20-30% rates for a very long-time trading for around 4x 2021 earnings. The baby has been thrown out with the bath water and their results and credit performance speak for themselves.

LX acquires customers through its e-commerce platform or via referral (about half each) with more than 80% of loan growth coming from its existing customer base. LX is mis-framed as a dodgy Chinese consumer credit provider while in reality it is dramatically different than its peers (more on that below). LX fills a massive unmet need for consumer credit from the 72% of the Chinese population that does not have a credit score (for comparison 8% of the US population does not have a credit score), with many of those without a credit history unable to access credit via traditional banks (super prime) or through Alipay / Tenpay (prime). In fact, legitimate lending to SMEs and individuals is encouraged by the government (https://www.forbes.com/sites/sarahsu/2017/06/01/inclusive-finance-china-opens-up-credit-to-more-people-but-risks-must-be-controlled/#87bac2e3489b), which they call “inclusive finance”. China’s consumer finance market is very underdeveloped, with per capita outstanding consumer finance loans excluding mortgages of just $614 in China compared to $7,647 in the US, providing a large and rapidly growing market. While the regulatory changes drove other public companies in the space to guide to flat to down loan originations this year (some have even halted new customer acquisition), LX will see 30% loan origination growth this year with steady credit performance, it grew acquired customers 35% QoQ in 3Q18 and has diversified its funding base (institutional funding is up to 65% in 3Q18).

This is a case of the data telling us one thing while the prevailing narrative (China is imploding, P2P lending is dumpster fire, regulations are going to kill the industry, etc.) is telling us another. Credit quality has improved, customer acquisition has accelerated, loan balances are growing significantly, and customer acquisition cost has remained low while the stock price has not reacted. The key barrier to entry that LX created is their ability to acquire customers at a low cost, while attracting institutional funding due to their low APRs and targeting a customer base that is difficult to lend to in China due to a lack of a credit score but has a growing ability to service their debts (targeting young, educated adults).

Customer acquisition: LX operates a breakeven ecommerce platform named Fenqile which serves as a low-cost customer acquisition engine and generates about half of their new customers. The other half come from referral codes. This is in contrast to peers who acquire customers through search engines and other competitive and expensive means which has led to some competitors shutting down their customer acquisition efforts. This differentiation has allowed LX to grow new customer by 35% QoQ in 3Q18.

This is not ONDK / LC: ONDK and LC spend 41% and 107% of revenue on OpEx compared to LX at 21%. For LC specifically (who focuses on individuals compared with ONDK which focuses on small businesses), they spend more on S&M then their annualized yield on customers. S&M, R&D and G&A as a % of revenue are all at least half for LX as compared to ONDK. In addition, LX grew their outstanding principle balance by 62% in 3Q18 compared to ONDK at 14%. Additionally, LX charges a mid-20’s APR compared to ONDK and LC in the mid to high 30’s but LX’s spending efficiency allows them to earn a 40% ROE in 3Q18 compared to 13% at ONDK (and negative at LC).  Simply put the Chinese market is not a mirror image of the US.

Target market: LX targets 20-35 year old young professionals that have trouble getting access to credit. While in the US this market would apply for a credit card, the lack of a credit scoring system in China locks them out of that market. While BABA and others provide payment or in some cases installment payment options, they will not provide credit to people with low or no incomes (even if they have good employment prospects). AJT (Alibaba, JD and Tencent) has entered this space but only in the prime space with 15-17% APRs. So if you are a 23 year old Chinese college graduate who needs credit to pay for a trip, dinner or other items, LX is your best option. LX has spent close to $100mm USD in R&D over the past 2.5 years on developing its risk management system (which they call Hawkeye) in order to quickly assess credit quality (more below).

Credit performance: LX has had stable to improving credit trends despite the government crackdown, with its 90+ delinquency rate stable at 1.39% and a vintage charge off rate of around 2%. This is in comparison to peers which have seen increased delinquencies and defaults. While their rapid growth helps to keep its delinquency rates down, the company does provide a vintage chart which has shown consistent performance. It remains to be seen how defaults will fair in a cycle but the recent stable performance during a time of slowing growth and market stress (in addition to a divergence from peers) indicates good underwriting. Former employees have told us that LX will generally extend a very small line of credit that grows as they repay and quickly blacklists anyone who does not repay. Additionally, they require uploading of government ID cards and other information which has led to a very low level of fraud.

Funding: While the majority of online lenders in China rely on P2P funding, LX has increasingly grown its institutional support. In 3Q18, around 2/3’s of its funding came from institutions which are a much more stable source of funding and allowed it to take market share when its competitors had to slow growth due to the P2P crackdown. Its low APRs allow it to attract institutional funding that peers cannot due to its compliance with regulations.

What do borrowers and former employees say?: We have spoken with more than a dozen borrowers and former employees which has generated consistent feedback. LX has better technology than peers which allows them to quickly assess credit, they are prudent in extending credit to new customers and growing it over time and they adhere to all regulations which has gotten them significant institutional support. Borrowers pay back on time to protect their credit rating and to avoid higher fees and that it is very hard to game the system as they black list non-paying customers and know if they are borrowing from other lenders so they are not able to pay back loans by taking out other loans.

Competition: ATJ are formidable competitors but do not extend credit to younger adults without a credit score as they focus more on the value to the platform. LX brings value by being able to risk price a demographic without a lot of data that is still likely repay given bright career prospects. ATJ mainly lend to prime borrowers and facilitate transactions for installment financings which has left non-prime / low data customers to platform partners such as LX. Given the relatively small size of LX and the regulatory risks the businesses face it would be logical for them to stay out of that market. We view LX as similar to CACC in the US, which has created tremendous amounts of value as a prudent non-prime lender.

Regulation: LX follows all guidelines laid out by the government. It has Guangzhou Development Bank as its custodian, it acquired a microcredit license in 2016 (only 20 or so have been given out) and has a financing guarantee sub, enabling the use of its own capital for loan issuance. Its loans have a mid-20’s APR, well below the recently imposed 35% cap. Further clampdowns may hurt the company but so far have had minimal impacts on its business outside of a 2Q18-3Q18 slowdown (regulations negatively impacted the entire P2P lending space with many other P2P companies going out of business), which caused LX to lower its full year origination guidance. September 2018 originations accounted for 40% of 3Q originations as the market has picked back up, demonstrating its resilience. LX has announced partnerships to give credit to new employees of Tencent and other companies which we see as an additional sign of strength. While some have viewed the regulatory crackdown as Beijing’s desire to get rid of the industry, we view this as similar to what happened in Macau in 2014 which was an effort to get rid of bad actors and clean up an area where bad actors were rampant, while at the same time being supportive of the longer-term growth trajectory of the industry. China needs companies like LX to succeed.

Management: LX was founded by the team that built Tenpay at Tencent and remains largely intact. They have done a great job of differentiating LX in terms of its customer acquisition, funding and underwriting ability, which has been demonstrated recently by their significant divergence from its peer’s performance.

What could we make: LX is trading at ~4x 2021 earnings while generating 40%+ ROEs and 20% sustainable growth. At 10x 2020 trailing earnings, LX would roughly be a 2.5x (See financials below). It is worth mentioning that the street is kind of irrelevant here as clearly investors aren't valuing this based on street consensus - given consensus shows a mid-teens topline grower, growing EBITDA at 50+% YoY (2019/2018 is 100%), with earnings growing at similar rates all trading for 4.7x 2020 street earnings. We show two sets of numbers below, first shows how very conservative assumptions still yield a very compelling valuation, second shows how with slightly more aggressive numbers (but still believable) the outcome can get silly. We think there is a high chance LX beats these numbers - but you don't need to believe that to earn very attractive returns. The other point worth pointing out is how overcapitalized LX will be and how large this dividend yield can grow.

Conservative Scenario:

More Aggressive Scenario:

Downside: In the case of a China recession or liquidity crisis LX would feel pain but a zero although is unlikely as LX is not responsible for the providing liquidity in the case of a loan not being repaid. In the case of accelerated competition, LX could see low returns as customer acquisition costs spiral. We get comfort from how controlled the Chinese economy and financial system are and how other financial systems have developed (10 years from now there is unlikely to only be 2-3 non-bank credit providers in China similar to how CACC, ADS, COF and others have carved out profitable niches in their respective areas).

To get an incredibly cheap stock it does not take heroic assumptions. We only assume active customers grow at low double digits (compared to 35% new customer growth in 3Q and historical 50%+ rates and a huge market), that loan balances grow at a HSD- MSD rate (historically they have grown close to 50%) and that credit costs and funding costs stay higher than historical levels while APRs stay lower while also gaining some additional scale on their fixed costs. It is worth noting that if they start to pay out 50% of earnings by 2021 LX would have a 13% dividend yield. If LX grows customers and loans balances in the mid-teens while having the same funding costs, credit costs and fixed cost ratios, LX is trading at less than 2x 2022 earnings (and less than 4x 2020).

As a sanity check, by 2021 their outstanding principle balance of loans in USD terms would be $8.5B and LX would have 4.6mm active customers, which is an absolute drop in the bucket for China (by comparison Capital One has $231B in outstanding balances, LC has $2.6B, and ONDK has $1.1B). The average loan balance per customer by 2021 would be $1,800.

Summary:

At the end of the day, China needs and wants individuals and small businesses to have more access to credit. Banks are not the answer. LX has shown themselves to be the most capable company with the best technology to lend in a responsible way to a growing and massive market. Should the leader in fintech lending in China only have a $1.5B market cap considering the size of the opportunity and the quality of their results in the face of massive regulatory and economic headwinds? If you can look past the noise and focus on the data and performance, we believe LX represents a great opportunity.  While scary we think this is a very interesting opportunity that has the potential for explosive outperformance over the next few years.   

We are hoping some folks can give us very harsh feedback and poke some holes in this ship! So to all VIC members - game on!

Catalyst

As the company proves to be "real" and isn't regulated out of existence the multiple will expand as revenue and profit growth materializes.