QFIN - FinVolution: A Valuation-Driven Buy Recommendation

2023-09-20 10:40:28 ET

Summary

• FinVolution is a leading online consumer finance company in China, facing competition from other fintech companies and banks.
• The company has not seen as fast of a loan-facilitated volume growth as its competitors in recent years.
• Despite challenges, FinVolution has opportunities for growth in the underserved Chinese market and through international expansion.

Introduction

FinVolution ( FINV ) is a leading online consumer finance company in China. It provides a variety of loan products to individuals and small businesses. FinVolution has a large customer base and a strong track record of growth. Although the company faces many challenges, including competition from other fintech companies and banks, as well as regulatory risks, I believe FinVolution is undervalued and its stock is a 'Buy'.

Competitive Landscape

FinVolution faces stiff competition from its peers Qifu Technology ( QFIN ) and LexinFintech Holdings ( LX ), who aim to reach underserved or unserved customers in China. In addition, other financial institutions such as banks and fintech supported by internet companies (Ant Group, for instance) also represent competitors fighting in the consumer finance industry. However, in China, there are roughly 225 million unbanked people , which indicates some areas for improvement in the banking industry to integrate a considerable part of the population. Moreover, most of FinVolution’s customers are young people who are not well-attended by banks and want to build credit scores through operations in the platform while demanding flexible and rapid loans in a completely online environment.

FinVolution hasn’t raised its loan-facilitated volume as fast as its competitors in the last five years in China. In fact, Qifu has been the fastest-growing company among the three since 2018, while LexinFintech came in second place, and FinVolution seems to have lagged:

However, regarding profitability, LexinFintech has had inconsistent operating margins in the last five years; Qifu Technology has outperformed FinVolution in the previous years. I think the latter is essential, as in 2019, the Chinese government forbade individual investors to provide funds to these fintech companies, so the latter were forced to establish relationships with financial institutions. Better profitability from Qifu may signal that this company adapted better to new regulations than FinVolution. Nevertheless, the ROA of FinVolution has decreased from 22.3% in 2018 to 11% in 2022, while the ROA of Qifu has decreased from 22.5% to 10.5%, and the ROA of LexinFintech passed from 14.2% to 3.6%.

I think lower profitability is due to stricter regulations and a more challenging economic environment, as credit growth in China has been slowing down, especially credits to households, as lenders are more cautious owing to fewer guarantees that the government will bail them out and slower economic growth. In addition, the wealth effect may decrease household consumption in the future.

A more challenging environment has driven these companies to invest more in marketing efforts in order to acquire new clients, who end up being highly valuable as more than 80% borrow constantly over the year. Furthermore, as companies incorporate more advanced AI in their technology, the risk of disruption increases. Thus, if a competitor develops a better credit assessment tool, it will get a competitive advantage that may be hard to match.

Furthermore, it’s difficult to predict whether margins and returns will compress further or if they will stabilize or even improve in the future. However, the competitive environment remains challenging, the economic conditions adverse, and the regulatory framework uncertain.

Lastly, I believe the barriers to entry are mid-to-high as fintech companies need to create a network among borrowers and financial institutions, develop technology resources that return accurate credit assessments, and comply with all the regulations.

Opportunities

On the one hand, there are 225 million adults in China without a banking account, of which only 24.4 million have used FinVolution, according to its last quarter report. Thus, a large market in China is still unattended by banks and fintech companies like FinVolution. Even though FinVolution has almost 150 million users registered in its app, in 2022, only 4.7 million users were unique borrowers, so there is plenty of room to keep growing. However, the business faces tough competition from other fintech, and China’s economy is not at its best moment; the former may create adverse competitive conditions with less consumption as Chinese people see their wealth decrease owing to a Real Estate crash, so current companies will have to compete harder among them to keep their revenue in a reduced industry. But, despite the current unfavorable conditions, iResearch estimates the credit-tech consumption market in China will grow at a CAGR of 9.2% until 2026, and the Small and Micro Enterprise ((SME)) credit-tech market in China will grow 35.9% annually. In my opinion, the growth will keep the level of rivalry in the industry stable, as companies can achieve high revenue growth rates without trying to take market share from competitors; however, lagging can significantly reduce the number of fund providers and borrowers in the company’s network, reducing the value of the service, as the latter relies on credit data and the availability of funds and clients.

On the other hand, there are plenty of opportunities internationally, as many developing countries suffer from large unbanked populations:

The company is already expanding its services in Indonesia and the Philippines, where sales have grown considerably faster than in China, as international sales now account for 16.3% of total revenue, and the growth is even accelerating as transaction volume and total sales grew 100% and 112.1%, respectively, in the last quarter. The company can keep expanding to other markets as soon as it completes its expansion in the Philippines and Indonesia. That way, it can lower the risk of doing business only in China and be less vulnerable to changing regulations, and at the same time, it will have access to a market similar in size to the Chinese market. Moreover, I believe being the first mover gives the firm some advantage. It can create strong relationships with financial institutions in the country and lock them in its network, making borrowers prefer the company as it has more funds to lend. The growth in funds provided by international institutions increased to 65.2% from 39% in 2022. However, as a Chinese company with sensitive data, it may face some restrictions in countries like India. In addition, growth in international markets is putting downward pressure on margins as marketing expenses and provision for loans receivable increased by 43.3% and 169.4% YoY, respectively. Thus, provisions in international markets tend to be larger than in China, and the company is investing heavily in acquiring new customers in global markets through marketing campaigns. Consequently, growth in international markets may not necessarily mean higher profits as these markets seem to be less profitable because of higher provisions for loans receivable.

Risks

Competition

Although I believe barriers to entry to be high enough to protect the incumbents from new entrants, the network effect may play against FinVolution as its peers grow faster and create a more extensive database, which leads them to offer a better service to fund providers, who could provide more loans to borrowers making the former have better credit conditions than they would have in FinVolution. Furthermore, other financial institutions elevate substitution threats inside the industry.

Governance

FinVolution has two types of shares with different voting rights, which gives all the decision power to the current executive directors (founders). It also has anti-takeover policies, which make it even harder to change the board or the business strategy. Nevertheless, as founders still hold a significant interest in the company, I think it could deter them from taking any decision that could reduce shareholders' value. Moreover, the management has shown the capacity to adapt faster to changes in the regulatory framework and achieve outstanding growth and profitability in the industry.

China Economy

China is facing adverse economic conditions owing to several factors, such as the burst of the Real Estate bubble, near-shoring tendencies, high young unemployment, and increased government indebtedness. The entire Chinese financial system may be at risk as Real Estate loans (mortgages and loans from developers) represent a significant proportion of banks’ assets. In addition, weak economic activity may increase young people's unemployment (which is not published anymore), which I think may decrease the volume of loans in the industry as young people won’t be able to repay the debt.

Furthermore, deteriorating economic conditions may lead to higher delinquency rates, which will raise operating expenses as FinVolution guarantees the repayment of the debt to financial institutions. Nevertheless, it’s impossible to predict what the economy will do tomorrow, but as FinVolution generates a more significant portion of its revenue outside China, this risk decreases.

Possible Crackdown

The Chinese government has taken and could take future actions against fintech, which may limit the ability of these types of companies to grow and be profitable. Furthermore, online consumer finance regulations have evolved in recent years, forcing the company to change its operations, regulating the interest rates charged and what entities can provide funds. Nonetheless, I believe the government needs these companies to develop to keep the economy growing and increase its influence in Asia.

Valuation

FinVolution’s average ROE in the last seven years is 30.1%; however, it’s been falling since 2016, along with the ROA and ROIC. The TTM ROE is 19.07%, but to be conservative enough, I will use a ROE of 15% to project the growth in EPS, a P/E of 5, and a dividend payout ratio of 14.73% so that the EPS will increase by 12.79% annually.

Final Thoughts

My recommendation on the stock is a ‘Buy,’ as the margin of safety is over 30%. I think my valuation is conservative as it uses a lower ROE and a low P/E for a company with double-digit growth and a favorable long-term industry outlook. However, uncertainty involving new regulations and adverse economic conditions may decrease even further the current returns. Moreover, even if the international markets continue growing, they may put more pressure on margins, and the growth may not turn into profits. Lastly, even if the cash reserve is significant, I’m concerned about why the company would keep that amount in cash instead of returning it to shareholders or investing in expanding to new markets.

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