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  • Writer's pictureArbat Capital

Consumer Finance Report - November 2023

US consumer finance companies underperformed the broad market again in October, the third consecutive month of underperformance following stronger dynamics in 4 previous months. Given decline in March 2023, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies still run behind the broad market ytd.


EXECUTIVE SUMMARY


US consumer finance companies underperformed the broad market again in October, the third consecutive month of underperformance following stronger dynamics in 4 previous months. Given decline in March 2023, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies still run behind the broad market ytd. Median decline of consumer finance companies on an absolute basis was -5.5% in October vs -2.2% MoM of SPX index. It was meaningfully higher decline than average monthly decline over three previous years of just -0.1% MoM. So, consumer finance companies increased by 14% ytd (as of November 15, 2023) vs +17.3% of SPX index. The segment remains quite volatile with a median price change ytd ranged from -5% in early May to more than +20% in mid-February and July. In turn, the difference between the best and the worst performers was 45% in October vs just 27% in September and 105.8% in July. It was mainly driven by ESMT, which skyrocketed by 26% MoM in October due to the news about its acquisition by Vista Equity Partner, and OPRT, which tumbled by 19% MoM as a result of weaker 3Q23 results. However, despite quite weak performance in the last three months as well as in March, just 6 out of 18 companies in our sample remained in the red ytd.

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 during summer months. Thus, median P/B of the sample was just 1.4x (as of November 15, 2023) vs an average figure since 2014 year of 1.7x and current SPX’s P/B of 4.3x. Moreover, the current discount to SPX’s P/B is 68% 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 64% while an average figure since 2014 year is 48%. Median P/E of the sample was just 7.9x (as of November 15, 2023) vs an average figure since 2014 year of 10.6x. Median P/S of our sample was 1.0x (as of November 15, 2023) vs an average figure since 2014 year of 1.6x. So, the current discount to SPX’s P/S is 59% while an average figure since 2014 year is just 23%. On the other hand, median EV/EBITDA of our sample was 12.5x as of November 15, 2023 while an average figure since 2014 year was just 7.9x. So, the current discount to SPX index of 13% 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 nearest quarters after very strong GDP growth in 3Q23. Thus, despite skyrocketing rates growth, still elevated inflation, inverted yield curve since 3Q22, the regional banking crisis in 1H23 and significant tightening of lending standards, the US economy increased by 2.1% qoq and 4.9% qoq at annualized rate in 2Q23 and 3Q23, respectively. Nonetheless, both hard and soft data qtd imply that the GDP growth rate will decelerate significantly in 4Q23. However, a recession does not look so inevitable at the moment as it was few quarters ago. At least, current both market and the Fed expectations imply that the US economy will be able to avoid it. Also, FOMC economic projections for 2023 year were revised up noticeably again at the September meeting vs the June one. Nonetheless, the risks are still tilted to the downside, from our point of view, and the US economy is far from being out of the woods, at least at the moment. At least, majority of key macro data revealed so far in November were worse than expected. Thus, headline payrolls missed estimates slightly in October, for the first time over the last three months. Preliminary consumer sentiment published by Michigan University also missed expectations noticeably in November, the third consecutive month of weaker figures. In turn, both CPI and PPI figures were markedly better in October, having reassured many in the thought that the monetary policy is restrictive enough. So, rates moved notedly down in the first two weeks of November. However, it is still expected that FF rate will remain higher 4% even at the end of 2025 while the yield curve will remain inverted even in 1 year. In other words, quite challenging revenue environment for CF companies as well as ongoing strong pressure on consumer balance sheets remain on the agenda for the near future.

"Soft landing" isn’t a blue sky scenario for consumer finance companies given more and more signs of gradual deterioration of US consumer financial health, accompanied by gradual deceleration of the US economy. 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. Also, 3Q23 earnings season wasn’t strong, from our point of view. Thus, 14 out of 18 companies from our sample beat revenue estimates with a median surprise of +2%, while EPS were better for just 11 companies with a median surprise of +5%. So, market perception of the results wasn’t strong, which is not surprising as forward guidance of many companies were weaker than expected. Hence, 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. However, contrary to all challenges, a growth of consumer loans remained resilient so far but decelerating very fast in the recent months. Thus, consumer loans increased by 4.1% yoy (as of November 1, 2023) vs +12.3% a year ago. Nonetheless, it was driven only by credit cards growth while other consumer turned already negative yoy. Moreover, auto loans were negative both on ytd and yoy bases. Debt service ratios 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 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 120 bps yoy, but -6 bps MoM, to 3.64% in July 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 will continue deteriorating across the board in the near future, especially taking into account further deceleration of economic activity and inevitable negative impact of the cancellation of student loan moratorium.

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.


AC - Consumer Finance Report - Nov-2023
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