Description

Lufax - Scaled up fintech lender focused on the large Chinese SME credit market !

Disclaimer - We have been accumulating Lufax over the last 3 months and hence my views are biased. I am new to investing in China and hence this write-up is a way for me to receive feedback on the idea from better informed members on Lufax or the Chinese fintech space. 

Elevator Thesis - Well run fintech lender with solid unit economics available at 0.8X book and 4.7X earnings despite implied risk leverage of just 1.4X. Insiders & Ping An group own 78% of shares. 1 Bn USD of share buyback in execution ! 

Investment Note:

Lufax is a Chinese fintech firm that operates in two main business segments - SME Credit facilitation and Wealth Management. We will focus mostly on the former as the latter contributes to less than 10% of the overall value at present. The management does a very good job of explaining the investment thesis in this VIDEO and in this PRESENTATION. For better context, I would suggest readers to go through both of these before reading the rest of the thesis. 

At the core, Lufax is an unsecured business loan provider to small & medium sized Chinese businesses. Their secured loan portfolio is around 20% of their book and will continue to decrease in proportion going forward. Lufax has built a solid technology platform which combined with their feet on the street model provides a phygital solution for sourcing, underwriting and collecting unsecured business loans in a cost effective manner. The outstanding loan book facilitated by Lufax currently is around 101 billion USD. Their average loan size is around 25K USD with a 3 year tenor (behavourialized tenure is around 18 months because of early repayments). They have 51 banking and 6 trust partners that provide funding for these loans.

Lufax carries around 1/3rd of their overall loans on the firm’s balance sheet and the rest are off-balance sheet on trust vehicles. Even for the loans on their balance sheet, the firm has insurance partners who guarantee the credit performance. Hence, unlike other lenders that take a lot of underlying credit risks on their balance sheet, Lufax at present takes around 15-20% of the credit risk on the book and plans to increase it to 20-30% going forward in line with regulations. The remaining credit risk will be shared by the credit insurance and bank funding partners. This allows the firm to earn greater than 20% ROE even with very minimal risk leverage. 

The overall credit risk on the books currently is less than 20 billion USD compared with the firm’s equity capital base of 14.5 billion USD. Thus the implied risk leverage is less than 1.4X currently and even at 30% credit risk sharing, the implied risk leverage will be around 2.5X. When you compare this with traditional banks that have an implied risk leverage of 10-20x equity capital, it is clear that Lufax has tremendous balance sheet strength to navigate choppy economic conditions. 

I believe that Lufax ticks the 5 major boxes that I look for in an investment as seen below, 

1.) Large Opportunity Size that ensures multi year growth runway:

The total SME financing need in China is supposed to be 14 trillion USD and nearly 7.4 trillion USD of those needs are unmet. Lufax with a loan book size of 101 billion USD has a market share of roughly 2%-3% in terms of customer base or outstanding credit and hence they can continue to grow even if the market is stagnant for a few years by improving their market share. Even amongst the non-banking financial peers, Lufax’s market share of unsecured SME loans is just around 12% and hence there is scope for improvement. Similarly on the wealth management business, the firm has an AUM of 66 billion USD with a take rate of 30 bps and a consistent growth of 20%+. So even though both its business divisions are scaled up, they still are small players within a massive industry and have tremendous growth opportunities. 

Lufax operates at a loan ticket size and tenure in which pure online only models without any on ground collection teams will fail. Similarly, while borrowers are very sensitive about lower interest rates on larger ticket loans, Lufax operates within the medium sized unsecured loan segment in which the user experience and turnaround time are more important factors for the borrower. Lufax has perfected the phygital solution with a combination of a large on ground organisational strength combined with a smart AI backed underwriting system. 

Lufax is a scaled up business with over 90K full time employees. The firm uses a mix of direct sales force (64K full time employees), online & telemarketing team (4K full time employees) and Channel partners including the Ping An ecosystem to source unsecured business loans across 280 cities throughout China. Outstanding Loan Book to Disbursements multiple is just around 1X and hence Lufax needs to have a strong origination team to continuously replenish its loan book. Similarly the firm has over 10K tech enabled collection agents who help it to manage credit costs better than peers. As you can see from the image below, the value proposition and customer experience of Lufax is superior to traditional financial institutions and hence it will continue to take market share in this segment.  

2.) Credible & Skin-in-the-game Management Team:

Lufax was incubated within the Ping An insurance group in 2005 and has been a separate organisation over the last 7 years. Ping An group is generally regarded as a shareholder friendly organisation that has been able to attract and retain high quality talent. The insurance parent has compounded book value per share, earnings per share and shareholder wealth at 20% CAGR over the last two decades. It is currently the largest insurance group in Asia Pacific with a market cap of 135 billion USD and a total balance sheet size of 1.5 trillion USD. 

The group is at the forefront of technology investments with a total patent base of 36,835, which is the highest for any fintech firm globally. Lufax itself has around 1500 employees working on research & development. They have a total customer base of 225 million. More importantly, Ping An has an internet user base that is next only to the Alibaba and Tencent ecosystem. Unlike the other tech giants that haven’t been regulated until now, Ping An group has run large regulated businesses like insurance, banking etc as seen below and hence is better positioned to succeed in the evolving fintech space. 

The parentage of Lufax provides immense comfort for an investor like me who is an outsider to the Chinese investment world. The group has listed entities in the healthtech (good doctor), banking (ping an bank), car commerce (autohome), finance SaaS (one connect) and fintech (lufax) verticals. While there have been some recent concerns around the performance of these newly listed subsidiaries, the overall value creation of the group has been strong. Within the lending segments, the group firms such as Ping An Bank, Lufax and Ping An Consumer Finance firms have separate target segments and there is minimum overlap. 

Most interestingly, Lufax has the highest skin-in-the-game ownership amongst all the Ping An ecosystem firms. The top leadership at Lufax has been stable with both the firm’s Co-CEO’s being with it since inception and within the Ping An group for over 10 years. The shareholding structure is slightly complex as the promoter shares are held through a vehicle called Tun Kung company which owns 39% of Lufax. The shareholders of this vehicle are split as follows - Share incentive plans (7.5%), Tongjun Investment company (41%), Lanbang Investment company (37.4%) and others (14.2%). The Tongjun investment firm seems to be an employee trust that represents the economic interests of the top management team at Ping An group. I would think that the management ownership of shares in Lufax (2-3 billion USD even at today’s depressed valuation) is worth multiples more than their annual compensation and this should provide a strong ownership mentality within the organisation. 

So, it broadly looks like employees control 39% of the shareholding of Lufax and Ping An controls another 38.5% of shares directly and through its asset management arm. In addition to this, 0.81% of the firm is held by a former director and Ping An holds around 1 billion USD of equity convertibles which convert at 14.8 USD/ Share. Hence, there is enough skin-in-the-game for the Lufax’s management team and Ping An’s interests are well aligned with that of Lufax’s shareholders.

Once the share price started correcting this year, the management announced a 300 million USD of share buybacks. Once this was complete, they announced an additional 700 million USD of share buybacks. On top of this large 1 billion USD of buyback, the top management team also committed 5 million USD of personal funds to buy shares from the open market in May, 2021 when the trading price was 2X the current share price. There have been some recent insider sales from the Ping An employee trust and I couldn’t ascertain the reasons for the same. Need to watch the insider trades closely. 

3.) Strong & Scalable Unit Economics: 

Since the firm has a credit risk sharing mechanism coupled with an off-balance sheet asset model, it is easy to get distracted from the core unit economics while analysing financial statements. As with a normal financial business, I would expect the 3 key drivers of ROA to be spreads, credit losses and operating expenses. Lufax with its track record should be able to access cheaper partner funding and thus generate higher spreads than peers. Its data and the Ping An ecosystem advantage should help it to underwrite better. Its scale of operations combined with an efficient phygital model should help it to have better operational cost efficiency than peers. Hence, Lufax will be able to earn high ROA’s on a sustainable basis. 

As you can see in the image above, the firm’s net take rate is healthy at 3.5-4.5%. We need to understand that the credit guarantee insurance premium that the firm pays of 6.9% allows it to have a smooth earnings profile with very little volatility. Since the company takes only 20-30% of credit risks on its balance sheet, the real risk capital based metrics are even more attractive. For example, the business needs to only risk 20-30 USD of equity capital to generate 3.5 to 4.5 USD of profits, meaning the unlevered ROE (pre-tax) is as high as 15-20%. Therefore, theoretically, the levered ROE (at 15X) of this business can be as high as 175%-345% as can be seen from the image below. Hence, even with very minimal leverage Lufax can generate strong profits that will allow it to grow even while paying dividends and doing share buybacks (payout policy of 20-40% of profits). 

It is interesting to note that the real historical credit loss of Lufax’s portfolio is only around 4% on an IRR basis. Even the cumulative 36 month 90+ dpd delinquency is only around 6-7%. Out of the 6-7% credit guarantee insurance (CGI) premium charged by insurance companies, we estimate insurance companies earn a stable margin of 1.5-2%. Hence, the real take rate of Lufax should be higher by 1.5%-2% if the firm takes all credit risk on its balance sheet. 

Historically, over 70% to 90% of the credit risk ended up on Ping An’s balance sheet as they were the primary credit guarantee insurance partner for Lufax. From the segmental reporting of Ping An group, it is clear that their credit guarantee insurance business with a combined ratio of less than 90% is one of the most profitable business lines for the firm and hence Lufax will have some buffer to reduce their margins going forward. With some regulatory nudge, the Lufax management also believes that Ping An’s share of CGI premium with the firm will come down to 50%. 

4.) Clear edge to succeed in a competitive marketplace:

Lufax has very good operational and credit cost efficiency. The firm has over 46 million customers in its wealth management business and over 16 million customers in its SME lending business. Ping An ecosystem provides them originating leads for almost 40% of their loans for which Lufax pays a commercial fee. This scale not only helps them to spread their costs over a large base, but also provides them with a significant data advantage over peers. Lufax has 15 years of its own credit lending data to the SME segment that fuels its underwriting engine with continuous feedback on the performance of the underwritten loans.  

The company uses AI extensively across its lending operations. For example, every potential candidate is interviewed and an AI uses facial recognition and other pattern recognition tools to identify fraud risk. Similarly, for collections, the firm has early warning indicators and proper heat maps to manage its team efficiently. Every borrower whose loan has become delinquent by a day gets an AI based call and then the human intervention comes for longer delinquencies. It is difficult for traditional finance firms to develop these technology tools internally. Similarly, it is difficult for pure technology firms to develop the organisational capability, balance sheet strength, credit track record, and the funding/ insurance partnerships required to scale the SME lending business. 

The loan sourcing fee: post origination fee mix for Lufax is approximately 18: 82 and this clearly shows that the value of Lufax lies in managing the credit costs. The firm ranks its customers into 8 bands based on credit risks. Currently, G 1-3 which is the top 3 bands with low credit risks contribute to over 60% of the overall loan book. In the future, Lufax’s systems will be sophisticated enough to provide its partners the grade of borrowers they need and thereby price the funding costs and credit insurance guarantee according to their respective risk class just like how different tranches of securitized credit are currently available in the western markets.

There has been increased regulatory pressure on higher APR loans and hence the portfolio of Lufax will slowly shift towards lower APR loans. As you can see from the delinquency data below, it is clear that as Lufax goes down the risk curve with higher creditworthy borrowers (G1-3) and lower APR loans (22%), the firm will get meaningful benefits on lower credit guarantee costs and impairment expenses that should help it to manage margin pressures. More importantly, the volatility of the P&L statement would be lower even with a 30% credit risk sharing model on these higher quality loans. 

5.) Attractive Valuations providing asymmetric Risk-Reward: 

I have never invested in Chinese equities before and hence I started with a clean slate of looking into them when the China focused ADR’s started to correct this year. I looked at a lot of well discussed Chinese names, but Lufax attracted me the most primarily because of the asymmetric Risk-Reward. Like all Chinese equities, Lufax has also de-rated meaningfully over the last year. The stock is currently trading 64% below its IPO price in November, 2020. Also, compared with the current market cap of 12.3 billion USD, the firm had raised a private round in late 2018 at a valuation of 38 billion USD. This massive de-rating has enabled us to own the asset at a valuation that is cheap at 0.8X Price to Book and 4.8X Price to Earnings. 

I believe that if China is supposed to become the largest economy in the world with a GDP of 30 trillion USD, the biggest and the most efficient lender to the country’s SMEs should be a very valuable business to own. For a business that facilitates 100 billion USD of loans every year and has a 66 billion USD of wealth management AUM, any simple thumb rule will suggest that the current market cap of 12.3 billion USD is cheap. I don’t need to be accurate in estimating whether the net margin on loans is 2% or 3% or 5% when we are buying the business at book value. It is very clear that the business is extremely profitable and can continue to grow on a secular basis. 

The Lufax management during an interaction with me said that they expect to grow at a 15 to 20% CAGR over the next 3-5 years and reinvest capital at healthy rates. If they execute well, we should get both earnings growth and valuation re-rating going forward, leading to strong investor returns. As we have discussed before, the size of the opportunity, management’s ability to execute and valuations looked attractive enough for us to initiate a position. Unless, I am underestimating any China specific tail risk or Lufax is an outright fraud, it is difficult to justify the current valuation. We will look to slowly scale up our position as we get more comfortable with the management team and the China risk. 

I would like to discuss the 3 major risks that face Lufax and why we are comfortable underwriting them at the current valuations. 

1. ) China Risk - Macro & Stock Market related: 

The Chinese ADR market has had a very bad 2021. I don’t have much value to add around the commonly discussed Chinese risks such as the VIE structure, US-China trade war, Chinese real estate bubble, Technology regulations, Xi’s politics etc. I understand that these could be meaningful risks and would probably make China uninvestable to few investors. I don’t have any strong opinions on these issues and I believe that after a steep fall in Chinese ADRs and after these issues being discussed ad-nauseam across the investment community, a major part of these risks should already be in the current price. Anyways, we will manage the Chinese tail risk by ensuring that our overall Chinese portfolio exposure and Lufax position size is within our tolerance limits. 

2.) Regulatory Risks that creates uncertainty for future unit economics: 

Chinese regulators have changed a lot of rules across sectors and there are a few of them that directly impacts fintech firms like Lufax. Before I get into the details, I believe that the Chinese regulatory and political goals are well aligned with Lufax’s business business model as it provides a very valuable service by helping the country’s small enterprises access credit at reasonable rates. It also helps the state dominated banking system to lend to these vital segments of the economy for which they don’t have the necessary capabilities. 

The firm’s investor presentation linked above provides the necessary details on the ongoing regulatory changes and its impact on Lufax’s operations. I have also been reading certain sell side reports that speak about risks regarding financial guarantee licence, data sharing practises etc. To me, a lot of these regulatory changes look like additional friction which impacts the business on the margin and these are not really thesis killers. Lufax was one of the large players in the P2P wealth management business pre-2018. While several Chinese firms couldn’t navigate the changing regulations that killed the sector, Lufax’s management was smart enough to pivot their wealth management business and funding mechanism for their retail lending business during this phase. In general, Ping An group has a reasonably good compliance track record across their regulated businesses. 

The one major regulatory change that is impacting the financials of the business and creating a large uncertainty for future unit economics is the proposed change in on-balance sheet credit risk exposures. While Lufax took less than 5% of the credit exposure in 2020, it is expected to take 25%-30% of the credit risk exposure on its balance sheet by 2023. In fact, I believe that the transition to a on-balance sheet credit risk model should improve the competitiveness and unit economics of Lufax while introducing volatility to its earnings. You can see from the image below that Lufax will continue to be very profitable across different risk-sharing models. 

We have investments in Indian SME lenders who are moving away from a 100% on-balance sheet credit risk model to a 60% on-balance sheet model. As long as the core lending is profitable, we should not be too worried about the amount of credit risk that the firm takes on the balance sheet. If Lufax with Ping An’s support and the current equity buffer is not able to build the required balance sheet capacity to take increased risk, I am not sure which other fintech firm will. Even at 20%-30% on-balance sheet credit risk, the implied returns that we get on our equity is significant. 

Similarly, the regulators have also been pushing hard for interest rate caps at 24% APR and this is making Lufax go down the risk curve in terms of new loans. I don’t know anything about the Chinese regulators' thinking, but a 20-24% IRR for unsecured SME loans seems reasonable compared with global standards and hopefully the caps stay at current levels. Lufax has already adjusted its loan book below 24% IRR loans without any impact on its net take rate because of tailwinds on its funding, operational and credit insurance costs. 

Even in developed markets with much lower structural interest rates, we see credit card firms and other unsecured lenders charge similar or even higher APRs. I have seen from the interest rate cap experience in the Indian microfinance space that the regulators quickly realise that a very low interest cap will only push the higher risk borrowers from the organised lenders to the unorganised players. The competitive moat of larger players gets even more enhanced as it becomes difficult for smaller lenders to work with reduced margins. 

Lufax’s competition including listed players (majorly consumer lenders) such as QFIN, LEXIN, FINVOLUTION etc have only 10% of the balance sheet equity of Lufax. Some of these firms would also need to build debt raising capacity to scale up their loan book. A new peer would need to go through multiple credit cycles, build organisational capacity and prove themselves before markets trust them with a low enough funding or credit insurance costs.

3.) Credit Risks in Lufax’s unsecured portfolio:

I fully understand that It is extremely risky to hold an unsecured portfolio of small enterprise loans during an economic downturn. I am comforted with the fact that almost all the loans on Lufax’s books currently would mostly have been generated post the initial COVID crisis, as the average loan tenure is only 18 months. As per the filings, for any particular loan, Lufax generates around 67.5% of revenues in Year 1, 26.8% in Year 2 and the remaining 5.8% in Year 3 for a loan. Hence, the % of loans underwritten pre-2020 will be insignificant next year and it’s usually the long tenure loans that are underwritten during boom times that come to bite the lenders during a downturn. It is logical to expect management teams to have underwritten credit cautiously post the initial COVID wave. If there was any meaningful stress in the books, it would have shown up within a few quarters in credit metrics. 

As you can see from the image below, Lufax has been able to manage the stress on their loan book well until now and I don’t have any reason to believe that the NPA’s will suddenly shoot up going forward especially considering the fact that the firm has moved down the risk curve with higher quality borrowers and lower APR loans. My interaction with the management and reading of public filings show that there is no cross-guarantee or off-balance sheet liabilities on the loans and the risk transfer to partners is in its true economic sense. 

Lufax loans are granular and well diversified across geographies and end industry exposures. The current 90+dpd at 1.3% for an unsecured business loan portfolio during a phase of economic stress looks very good. On the company’s RHP, it can be seen that the expected credit loss provisioning for the firm is as follows - 1.75% on 0 dpd standard loans, 20% on 1-90 dpd loans, 55% on 90-180 dpd loans and complete write-off any loans above 180 dpd. The firm has been able to recover around 20% of the written off loans. These provisioning and expected loss norms look fair when compared with other SME lenders that I have researched globally. 

Unless Lufax’s underwriting has a specific governance issue, I believe that their credit costs will be indexed to the overall financial health of the SME ecosystem. Even at 30% credit risk sharing, the delinquency rates need to go up by 3X for Lufax to start making losses and deplete its book value. Of course, the funding and credit insurance premiums will go up for the front book and therefore Lufax will have reduced earnings power, but the credit risk on the back book would be manageable. 

If Lufax with an implied risk leverage of 1.4X starts making meaningful losses, I would believe that in such a stressed economic scenario, the majority of the Chinese lenders with a 10-20X equity leverage will be facing bankruptcy risk. I hope that the Chinese Central Bank will have the necessary tools to avoid a tail risk scenario like that. In other words, I believe that Lufax is over capitalised and has the necessary equity buffer and earnings power to survive a bad economic cycle.

Catalyst

Share Buybacks, Strong Earnings, Chinese sentiment turnaround