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  • Writer's pictureArbat Capital

Consumer Finance Report - January 2024

US consumer finance companies outperformed the broad market significantly in December 2023, for the second consecutive time after three months of underperformance. And it was the 7th month of outperformance in 2023. Despite meaningful decline in March, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies managed to outperform the broad market in 2023.



EXECUTIVE SUMMARY


US consumer finance companies outperformed the broad market significantly in December 2023, for the second consecutive time after three months of underperformance. And it was the 7th month of outperformance in 2023. Despite meaningful decline in March, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies managed to outperform the broad market in 2023. Median growth of consumer finance companies on an absolute basis was +18% MoM in December vs +4.4% MoM of SPX index and average monthly decline over three previous years of -0.1% MoM. So, consumer finance companies increased by 39.6% yoy (as of December 29, 2023) vs +24.2% yoy of SPX index. Recall that in two of the three previous years, the sector showed weaker growth than the broad market. Nonetheless, the segment remains quite volatile with median price change ytd ranged from -5% in early May to more than +30% in December. Moreover, a difference between the best and the worst performers was 67% in December vs 89% in November and 105.8% in July. It was mainly driven by TREE, which skyrocketed by 71.3% MoM in December. In turn, ACT increased just by 4.3% MoM in December, underperforming the sector for the second consecutive month. However, despite quite weak performance in March, August and October, just 2 out of 18 companies in our sample ended 2023 in the red.

Given growth of risks in the recent quarters, consumer finance companies continue trading with a discount both to historical averages and to S&P 500 index, but it narrowed notably in recent months. The key question is how deep a recession will be, if at all. In case of a mild recession, which is our baseline scenario, CF companies already look slightly expensive, in our opinion, after significant outperformance in November and December. Thus, median P/B of the sample was 1.62x (as of December 29, 2023) vs an average figure since 2014 year of 1.7x and current SPX’s P/B of 4.5x. Moreover, the current discount to SPX’s P/B is 64% while an average figure since 2014 year is just 48%. A similar pattern is observed with respect to other key multipliers. Thus, the current discount to SPX’s P/E is around 56% while an average figure since 2014 year is 48%. Median P/E of the sample was 10.0x (as of December 29, 2023) vs an average figure since 2014 year of 10.6x. Median P/S of our sample was 1.2x (as of December 29, 2023) vs an average figure since 2014 year of 1.6x. So, the current discount to SPX’s P/S is 54% while an average figure since 2014 year is just 23%. On the other hand, median EV/EBITDA of our sample was 11.7x as of December 29, 2023 while an average figure since 2014 year was just 7.9x. So, the current discount to SPX index of 21% is noticeably lower than an average since 2014 of 38%.

The US economy continued growing well above expectations but it would inevitably decelerate noticeably in the flowing quarters after very strong growth in 3Q23. Thus, US macro indicators revealed in November and early December weren’t strong but GDP growth forecasts continued going up. Hence, it is most likely that US GDP growth will remain positive in the nearest quarters, and the probability of “soft landing” scenario continues going up. Nonetheless, according to consensus expectations, it is still predicted that a recession in the next 12 months will occur with a probability around 50%. At least, the Fed continues to adhere to the data-dependent paradigm, emphasizing at each meeting that risks are tilted to the downside and that inflation still remains unacceptably high, even despite both economic activity and inflation were notably better than expectations in recent months. However, the dovish Fed’s meeting in November and December accompanied by lower CPI/PPI data allows us to hope that rates will not be so high for longer as it has been implied more recently. So, rate expectations for the nearest years moved notably down in 4Q23, implying possible easing of the pressure on the financial health of the US consumer. Definitely, the lags with which monetary policy affects economic activity and inflation might still be unpleasantly surprising. Nonetheless, inflation was moving in the right direction in 2H23 albeit the battle still is far from the Fed’s outright victory although GDP growth remains above expectations. On the other hand, there are more and more signs of gradual softening of the labor market in recent months, implying inevitable growth of unemployment from the current very low levels, which will affect negatively the financial health of the US consumer, especially low-end customers, which excess savings have already vanished due to high inflation and elevated interest rates.

FY24 outlooks will be much more important than 4Q23 figures during the earnings season after strong rally in the last quarter of 2023 and less compelling valuations. Moreover, the start of the 4Q23 earnings season of CF companies was relatively weak. Thus, 4Q23 DFS’s EPS missed expectations considerably, driven by much higher provision for loan losses, $1.54 vs the consensus of $2.52. The growth of provision was caused by reserve build due to less optimistic credit outlook although NCOs were roughly in-line with expectations in 4Q23. In turn, DFS expect that average 2024 NCO ratio will be 4.9%-5.3% vs 3.42% in 2023. Hence, market perception of results was quite negative, which is not surprising after the strong rally in 4Q23. Moreover, we believe that ‘soft landing’, the increase in the probability of which was the main reason for the rally, isn’t a blue sky scenario for the segment, given relatively fast deterioration of the US consumer financial health so far, driven by still elevated inflation, high interest rates as well as deceleration of employment growth. Indeed, CF fundamentals prospect rather looks challenging in the near term, even despite significant decline of the rate expectations in November and December. So, banks continued tightening lending standards for all major consumer credit categories in 3Q23, 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. Hence, consumer loans growth decelerated significantly in recent months, adding just 3.8% yoy at the end of 2023 vs 10.6% yoy at the end of 2022. Moreover, all this growth was caused solely by credit cards, while the rest of the segments continue to decline on a yoy basis. Nonetheless, debt service ratios still remain strong and quite 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 so far, but the speed of deterioration of key metrics has accelerated recently, especially in cards. We expect that credit quality indicators will continue deteriorating across the board in the near future, especially taking into account further deceleration of economic activity and quite probable growth of unemployment in 2024.

Consumer finance fundamentals remain resilient so far albeit with quite limited improvement opportunity in the near future. In this environment, re-rating of the segment looks unlikely, especially taking into account downside risks for the US economy and still cautious investor sentiment, even despite key multipliers still remain lower than historical averages. So, we don’t expect that the current rally in the sector will be any long-lived, given still challenging revenue environment and inevitable deterioration of the credit quality in 2024. But we will be more constructive when the rate of key fundamentals deterioration starts decelerating. So, we remain neutral on the sector as potential rewards are more than balanced by risks at the moment.


AC - Consumer Finance Report - Jan-2024
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