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  • Writer's pictureArbat Capital

Consumer Finance Report - October 2023

US consumer finance companies underperformed the broad market slightly in September 2023. It was the second consecutive month of underperformance following stronger dynamics in 4 previous months.


EXECUTIVE SUMMARY


US consumer finance companies underperformed the broad market slightly in September 2023. It was the second consecutive month of underperformance following stronger dynamics in 4 previous months. Given March 2023 decline, 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 -5.2% MoM in September vs -4.9% MoM of SPX index. It was meaningfully higher decline than average monthly decline over three previous years of -0.1% MoM. So, consumer finance companies increased by 10.7% ytd (as of October 13, 2023) vs +12.7% 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 – a median price change ytd ranged from -5% in early May to more than +20% in mid-February and July. In turn, a difference between the best and the worst performers was just 27% in September vs 67% in August vs 105.8% in July. It was mainly driven by RKT which tumbled by 23.4% MoM in September as a result of ongoing growth of the long end and rate expectations. In turn, OPRT managed to end the month in the green, one of just the two companies from our sample.

Given growing risks in 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 1.2x (as of October 13, 2023) vs an average figure since 2014 year of 1.7x and current SPX’s P/B of 4.1x. Moreover, the current discount to SPX’s P/B is 72%, 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 more than 64%, while an average figure since 2014 year is 47%. Median P/E of the sample was just 7.6x (as of October 13, 2023) vs an average since 2014 year of 10.7x. Median P/S of our sample was 1.0x (as of October 13, 2023) vs an average since 2014 year of 1.7x. So, the current discount to SPX’s P/S is 60%, while an average since 2014 year is just 21%. On the other hand, median EV/EBITDA of our sample was 10.3x as of October 13, 2023, while an average figure since 2014 year was just 7.7x. So, the current discount to SPX index of 26% is noticeably lower than an average since 2014 of 39%.

The US economy continued growing above expectations, and hard data indicated that economic activity even accelerated in 3Q23, but soft data suggested that the start of 4Q23 wasn’t strong. Nonetheless, the Fed increased FY23 GDP growth forecast significantly at the September meeting. Thus, it is implied that GDP will increase by 2.1% yoy in 2023 (vs just +1% yoy implied growth a quarter ago). It is implied that GDP growth will decelerate to 1.5% yoy in 2024, and the soft landing is the Fed’s baseline scenario at the moment, even despite a number of indicators still pointing to a recession while higher rates will remain for longer. In turn, the September FOMC minutes indicated that downside risks were still relatively high even despite more optimistic outlook. In any case, given the still very tight labor market, robust consumer spending as well as picking up housing activity and waning inflation pressure, a recession does not look so inevitable at the moment. On the other hand, there were more and more signs of gradual softening of the labor market in recent months even despite quite high August payrolls, with manufacturing activity remained relatively weak, while inflation was still noticeably higher the Fed’s target. So, it is too early to say that the US economy has already been out of the woods, at least because the inverted yield curve has never been wrong before, while the lag effects of the very tight monetary policy on the economic activity may not be fully taken into account in current forecasts, from our point of view. Moreover, at first sight, soft landing scenario should be more favorable for consumer finance companies than the recession one, due to better asset quality and higher loan growth. On the other hand, given current inflation expectations, the key rates will remain higher for longer with the FF rate above 4% at least for the next 3 years and flat yield curve, implying quite challenging revenue environment for CF companies as well as ongoing strong pressure on consumer balance sheets.

Nonetheless, the soft-landing scenario is just better 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%. So, market perception of the results wasn’t strong, which is not surprising as forward guidance of many companies were weaker than expected. Also, 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 5.2% yoy (as of September 27) vs +12.3% a year ago. Nonetheless, it was driven only by credit cards growth while other consumer turned already negative yoy. Thus, auto loans were negative both on ytd and yoy basis. Debt service ratios remain strong and quite low from the historical point of view, mainly due to active refinancing of mortgage loans during 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 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 a 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 - Oct-2023
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