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  • Writer's pictureArbat Capital

Consumer Finance Report - September 2023

US consumer finance companies underperformed the broad market significantly in August 2023, the first month of underperformance since April 2023. Given March 2023 decline, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies run behind the broad market ytd again.


EXECUTIVE SUMMARY


US consumer finance companies underperformed the broad market significantly in August 2023, the first month of underperformance since April 2023. Given March 2023 decline, when median underperformance of our group of companies was -14.8% MoM, consumer finance companies run behind the broad market ytd again. Thus, median growth of consumer finance companies on an absolute basis was -7.3% in August by contrast with -1.8% MoM of SPX index. It was a meaningfully higher decline than an average monthly decline over three previous years of -0.1% MoM. So, consumer finance companies increased by 9.6% ytd (as of September 21, 2023) vs +14.7% 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 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 67% in August vs 105.8% in July. Nonetheless, despite quite weak performance in February, March and August, just 5 out of 18 companies in our sample remained negative ytd (as of September 20). Thus, LC decreased by 27.2% ytd, while TREE lost 26.3% ytd. In turn, UPST already increased by 110.6% ytd, while SOFI added 80.5% ytd.

Given growing risks during 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 September 21, 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 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 more than 63%, while an average figure since 2014 year is 47%. Median P/E of the sample was just 7.8x (as of September 21, 2023) vs an average figure since 2014 year of 10.7x. Median P/S of our sample was 1.0x (as of September 21, 2023) vs an average figure since 2014 year of 1.7x. So, the current discount to SPX’s P/S is 59%, while an average figure since 2014 year is just 21%. On the other hand, median EV/EBITDA of our sample was 5.7x as of September 21, 2023, while an average figure since 2014 year was just 7.7x. So, the current discount to SPX index of 58% is noticeably higher than an average since 2014 of 39%.

The US economy continued growing above expectations, and it even accelerated in 2Q23 and 3Q23. Despite skyrocketing rates growth, still elevated inflation, inverted yield curve since 3Q22, the regional banking crisis and tightening lending standards, it increased by 2.0% qoq and 2.1% qoq at annualized rate in 1Q23 and 2Q23, respectively, vs the consensus of 0.8% qoq and 0.6% qoq as of the end of 2022. The recent macro data only confirm that the economy remains noticeably stronger than it could have been, taking into account all the risks realized over the past 12 months. Moreover, both hard and soft data qtd imply that the GDP growth rate will accelerate in 3Q23. Unsurprisingly, the Fed raised GDP growth estimates noticeably at the September meeting as “recent indicators suggest that economic activity has been expanding at a solid pace, and so far this year, growth in real GDP has come in above expectations”. The US labor market still remains very tight, even despite small misses in June and July, while inflation has been decreasing slightly faster than it was expected in recent months. 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. However, we believe that growth of unemployment in coming years will be much smaller than it has been typical for recent recessions. Nonetheless, economic sentiment improved significantly in the past months. 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 +2.0% yoy in 2023, +0.9% yoy in 2024 and +1.9% in 2025 (vs January 2023 forecasts of +0.5%/1.2%/- yoy, 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%. So, 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 5.4% yoy (as of September 6) vs +12.4% a year ago. Nonetheless, it was driven only by credit cards growth, while other consumer turned already negative yoy. Moreover, auto loans were already 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 as well as loan growth will continue deteriorating across the board in the near future, given expected 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 - Sep-2023
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