LU - OneConnect: Recent Results And Future Prospects Justify A Valuation Discount

2023-03-17 12:09:30 ET

Summary

• OneConnect Financial Technology Co., Ltd. has much more work to do in terms of client diversification, as the company's reliance on its biggest customer, Ping An Group, hurt its Q4 2022 top line performance.
• On the bright side of things, OneConnect's net loss narrowed significantly in the recent quarter, as the company optimized research & development, selling & marketing, and general & administrative expenses.
• I maintain a Hold rating for OneConnect Financial, as I view its current valuations as fair in consideration of its results and outlook.

Elevator Pitch

I retain my Hold rating for OneConnect Financial Technology Co., Ltd. (OCFT) [6638:HK] shares.

With my prior January 1, 2023, write-up , I touched on OCFT's "strategic pivot focusing on a narrower product portfolio and larger clients." My attention turns to OneConnect Financial's Q4 2022 financial results released earlier this week on March 13, 2023, before the market opened.

OneConnect Financial registered a narrower net loss for Q4 2022, but it experienced its first quarterly sales decline since its public listing. Looking ahead, it is likely that OCFT will continue to experience slower top line expansion and continued losses which warrant a substantial valuation discount for its shares. I decide to keep my Hold rating for OCFT unchanged after evaluating its results, outlook, and valuations.

OCFT Saw Its First Quarterly Revenue Contraction Since Listing

Revenue for OneConnect Financial declined by -3% YoY from RMB1.28 billion in the fourth quarter of 2021 to RMB1.24 billion for the last quarter of the previous year. It is worthy of note that this is the first time that OCFT had failed to achieve positive quarterly top line growth since the company's NYSE IPO on December 13, 2019 . As a comparison, OneConnect Financial's revenue expanded by +51%, +39% and +19% in Q4 2019, Q4 2020, and Q4 2021, respectively, in YoY terms.

In my earlier article for the company published in January this year, I highlighted that OCFT is "targeting larger financial institutions as customers to reduce the reliance on its biggest clients." OneConnect Financial has made decent progress with respect to customer diversification, but it wasn't sufficient to allow OCFT to deliver positive revenue expansion in the most recent quarter.

OCFT's two largest customers are Ping An Group (the company's parent) and Lufax Holding Ltd ( LU ), which in aggregate accounted for 64% of the company's top line for Q4 2022. This represented an improvement, LU and Ping An Group contributed a relatively higher 67% of OCFT's Q3 2022 top line.

But OneConnect Financial can't afford to continue relying on its major clients to sustain its revenue growth. Sales generated from Ping An Group and Lufax decreased by -3% YoY and -31% YoY to RMB696 million and RMB105 million, respectively, in the fourth quarter of 2022.

At the company's Q4 2022 results call on March 13, 2023, OCFT mentioned that "digital transformation demands" drove a +9% growth in revenue contribution from Ping An Group in full year FY 2022. However, it is reasonable to assume that Ping An Group's pace of "digital transformation" (and need for OCFT's services) has slowed in recent quarters. Specifically, the YoY growth in revenue derived from Ping An Group had already moderated from +26% for Q1 2022 to +21% in Q2 2022. Sales contributed by Ping An Group were flat YoY in Q3 2022, and subsequently declined by -3% YoY for Q4 2022.

In summary, the decline in revenue contribution for the company's parent and largest client, Ping An (56% of Q4 2022 top line), in Q4 2022 was the main factor that led to OneConnect Financial reporting its first top line contraction since its late-2019 IPO.

OneConnect Financial's Net Loss Halved YoY In Q4

OCFT's net loss attributable to shareholders roughly halved from -RMB358 million for Q4 2021 to -RMB177 million in Q4 2022, despite the fact that it recorded lower revenue on a YoY basis for the recent quarter.

Normalized gross profit margin for OneConnect Financial expanded by +4.4 percentage points QoQ and +2.0 percentage points YoY to 42.8% in the final quarter of the prior year. The company's G&A (General & Administrative) and S&M (Selling & Marketing) costs as a proportion of sales decreased by -130 basis points and -490 basis points to 20.6% and 8.0%, respectively for Q4 2022. R&D (Research & Development) as a percentage of sales also went down from 32.7% in Q4 2021 to 31.8% for Q4 2022.

OCFT stressed at the company's most recent quarterly investor briefing in mid-March that "the ratio of all three expenses (G&A, S&M, R&D) will keep going down until we breakeven on the mid-term" as part of its "cost control policy."

Nevertheless, OneConnect Financial didn't commit to a specific time line for the company to achieve profitability. According to the market's consensus financial forecasts taken from S&P Capital IQ , OCFT is expected to only turn profitable in FY 2026. In my view, the reasonably long time (three years from now) needed for OneConnect Financial to turn profitable makes sense. In the near term, OCFT's bottom line will still be affected by slower revenue growth as the company continues to work on client diversification, notwithstanding expenses control efforts.

OCFT's Cheap Valuations Are Justified

OneConnect Financial is now valued by the market at an undemanding consensus forward price-to-sales multiple of 0.36 times . But I think that OCFT's cheap valuations are justified for multiple reasons.

Firstly, OCFT's revenue growth has slowed considerably from +42% and +25% for FY 2020 and FY 2021, respectively, to +8% in FY 2022. I expect that OneConnect Financial's top line expansion on an annual basis won't exceed +15% for the next three years considering its ongoing client diversification plans. A moderation in top line expansion warrants a valuation discount for OCFT.

Secondly, OneConnect Financial isn't going to turn profitable any time soon. As discussed in the preceding section, OCFT is likely to remain loss making in the short term. Unprofitable companies like OneConnect Financial will struggle to command a premium valuation multiple from investors in a tough market environment.

Thirdly, investor sentiment towards financial and technology companies in general is pretty weak following the recent fall of Silicon Valley Bank . Although OCFT has clarified at the Q4 2022 investor call that it has "no deposits in the Silicon Valley Bank," it is unavoidable that certain investors will be wary of OneConnect Financial's profile as a technology business serving financial institutions.

Concluding Thoughts

I have a Neutral opinion of OneConnect Financial Technology Co., Ltd. stock. OneConnect Financial's recent quarterly results were a mixed bag, considering both top line contraction and narrower losses. OCFT's shares seem pretty cheap based on the price-to-sales metric, but there are valid reasons which explain why the market has assigned a hefty valuation discount to the stock.

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