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  • Writer's pictureArbat Capital

Consumer Finance Report - August 2023

US consumer finance companies outperformed the broad market again in July 2023, for the 4th consecutive month, after quite weak dynamics in March, when median underperformance of our group of companies was -14.8% MoM.


EXECUTIVE SUMMARY


US consumer finance companies outperformed the broad market again in July 2023, for the 4th consecutive month, after quite weak dynamics in March, when median underperformance of our group of companies was -14.8% MoM. Thus, median growth of consumer finance companies on an absolute basis was +3.4% in July vs +3.1% MoM of SPX index. It was noticeably higher growth than average monthly performance over three previous years of -0.1% MoM. Despite a quite strong start of the year for consumer finance companies, which skyrocketed by 19.3% MoM in January, outperforming the broad market by 12.4%, the sector growth remained roughly in line with SPX index growth ytd as a result of quite weak dynamics in February and March because of the regional banking crisis. Recall that in two of the three previous years, the sector showed weaker growth than the broad market. Despite quite weak performance in February and March, just 4 out of 18 companies in our sample remained negative ytd (as of August 14, 2023). Thus, LC decreased by 17.7% ytd, while SLM lost 10.8% ytd. July dispersion of absolute monthly performance was again one of the highest one since the January 2021. Thus, the difference between the best and the worst performers was 105.8% in July.

Given the risks growth in the recent quarters, consumer finance companies continue trading with a significant discount both to historical averages and to S&P 500 index. The key question is how deep a recession will be, if at all. In case of a mild recession, which is our baseline scenario at the moment, majority of companies of the segment look cheap, even after their outperformance in recent months. Thus, median P/B of the sample was just 1.3x (as of the end of July) vs an average figure since 2014 year of 1.7x and current SPX’s P/B of 4.4x. Moreover, the current discount to SPX’s P/B is 70% while an average figure since 2014 year is just 47%. A similar pattern is observed with respect to other key multipliers. Thus, the current discount to SPX’s P/E is 60% while an average figure since 2014 year is 47%. Median P/E of the sample was just 8.7x (as of the end of July) vs an average figure since 2014 year of 10.7x. Median P/S of our sample was 1.1x (as of the end of July) vs an average figure since 2014 year of 1.7x. So, the current discount to SPX’s P/S is 58% while an average figure since 2014 year is just 21%. On the other hand, median EV/EBITDA of our sample was 11.5x as of the end of July while an average figure since 2014 year was just 7.7x. So, the current discount to SPX index of 23% is noticeably higher than an average since 2014 of 39%.

The US economy remains quite resilient even despite skyrocketing rates growth, which have already reached their multi-decade highs. Thus, real GDP increased by 2.4% qoq on an annualized basis in 2Q23 vs the consensus estimate of 1.8% and 1Q23 growth of 2.0%. The labor market remains quite tight, but there were more and more signs of gradual softening of the labor market in recent months. Thus, payrolls increased by 187K in July 2023 vs the consensus of 200K (and the revised down June figure of 185K). So, two-month net revision was equal to -49K while average payrolls for 7 months of 2023 were 262K, remaining well-above the average payrolls of the past cycle. Inflation also continues decelerating slightly faster than it was expected in recent months. To be fair, not all macro indicators were strong recently, especially in manufacturing. Nonetheless, economic sentiment improved significantly in 2Q23. So, more and more market participants think at the moment that a recession can be avoided. But the probability of a recession in the nearest 12 months is still estimated at 60%. However, GDP growth forecasts continue going up. Thus, it is expected that US GDP growth will be +1.5% yoy in 2023 and +0.6% yoy in 2024 (vs January 2023 forecasts of +0.5%/1.2%, respectively).

Nonetheless, soft landing scenario is just better than feared one rather than ‘it is all over’ one given more and more signs of gradual deterioration of US consumer financial health. At least, taking into account the current level of interest rates, most of which are at multi-decade highs, as well as still elevated inflation but tepid income growth, fundamentals of consumer finance companies will continue deteriorating in the near future even in case the US economy manages to avoid a recession. At least, 2Q23 earnings season wasn’t strong for the segment. Thus, just 10 out of 18 companies from our sample beat revenue estimates with a median surprise of 1.4%, while EPSs were better for 13 companies with a median surprise of 8.6%. Unsurprisingly, market perception of the results wasn’t strong, which is not surprising as forward guidance of many companies were weaker than expected. So, banks continued tightening lending standards for all major consumer credit categories in 2Q23, noting that standards, on net, were on the tighter ends of their historical ranges for all consumer loan categories, especially for subprime credit card and subprime auto loans. However, contrary to all challenges, loan growth of consumer loans remained resilient so far but decelerating very fast in the recent months. Thus, consumer loans increased by 5.9% yoy (as of July 26, 2023) vs +12.5% a year ago. Nonetheless, it was driven only by credit cards growth while other consumer loans were roughly flat yoy. In turn, auto loans were already negative both on ytd and yoy bases. Debt service ratios remain strong and low from the historical point of view, mainly due to active refinancing of mortgage loans during the period of ultra-low rates. So, credit quality indicators remain solid either, but the speed of deterioration of key metrics has accelerated recently, especially in cards. Thus, S&P/Experian bank card default index increased by 8 bps MoM, or +115 bps yoy, to 3.7% in June 2023 vs a median of the time series of 3.6% (since mid-2004) and 2.95% at the end of 2019. And credit quality indicators as well as loan growth will continue deteriorating across the board in the near future, especially taking into account further deceleration of economic activity as well as inevitable but not instant negative impact of the cancellation of student loan moratorium and resumption of student loan payments.

Consumer finance fundamentals remain resilient but deteriorating as a result of gradual deceleration of the economy, elevated inflation and quite high interest rates. Still high recession risks imply further deterioration of the fundamentals in the near term, but it seems that recession risks have mainly priced in, especially taking into account that the recession isn’t expected to be deep. Moreover, key multipliers still remain near multi-year lows. Nonetheless, to have more constructive view we need lower speed of deteriorating of key fundamentals, at least. Also, we don’t expect that any rally in the sector in the near future could be any long-lived when credit quality is deteriorating, loan growth is decelerating while margins are narrowing. So, we remain neutral on the sector as potential rewards are balanced by risks at the moment, from our point of view.


AC - Consumer Finance Report - Aug-2023
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