PPDAI Group: China's 'Lending Club' Is In A Buy Range Now

|
About: PPDAI Group Inc. (PPDF)
by: Aiden Wang
Summary

PPDAI Group Inc. is the pioneer of China’s P2P lending market, and is often referred to as China’s Lending Club.

The company suffered a bad Q4 earnings performance due to temporary losses (from rising delinquency) and accounting adjustments (accretion loss from preferred shares).

Without the temporary losses and accounting adjustment (as they are not going to be sustaining), there is a potential 100% up space for the stock price.

Investment Thesis

The Chinese version of Lending Club, PPDAI Group Inc. (NYSE: PPDF), is now believed to be within the BUY range. The company has been undervalued because of some one-time accounting adjustments that largely impacted the Q4 earnings results. When the temporary factors are eliminated, the company shows a potential double-up in stock price. It is a good time to long the stock now, as the price is likely to rally after the next earnings release.

The Company

PPDAI Group Inc. is often referred to as the “Chinese version” of Lending Club. The company was founded in 2007 among the earliest batch of online lenders, and it has been marketing itself as the very first P2P lending platform in China.

According to the IPO prospectus, the main business of the company is its lending marketplace, which primarily offers short-term loan products in three categories:

  • Standard loan products: Up to 24 months loan term and larger loan amounts;
  • Handy cash loan products: Shorter loan term (less than six weeks) and smaller loan amounts; and
  • Consumption loan products: Provide finance solutions to customers at retail stores for their purchases of electronic appliances.

With tremendous growth in customer base and loan volume, the company successfully went public on the NYSE on November 10th, 2017. Unfortunately, shortly after the company went public, the government initiated a brutal regulatory enforcement on the online lending industry (see my previous post here). As a result, the Q4 growth of the company was significantly slowed down and stock price has been trending down from $13 (at IPO) to $6.87 as of April 13, 2018, representing a nearly 50% drop.

Big loss in Q4 2017: Rising Delinquency Expectation

Adding to the concern of regulatory shock to the industry, the company’s Q4 earnings results (see the earnings call results here) have caught investors’ nerves as well:

  • Net loss was RMB 507.1 million (US$77.90 million) for the fourth quarter of 2017, compared with a profit of RMB 266.0 million in the same period of 2016. More specifically, the loss was due to:
    • Net interest income/(expense) and loan provision losses for the fourth quarter of 2017 was an expense of RMB 13.2 million (US$2.0 million), compared to an income of RMB 3.6 million in the same period of 2016. This was primarily due to a one-time provision of RMB 107.7 million (US$16.3 million) for expected discretionary payments to investors in investment programs protected by the investor reserve funds caused by the increase in delinquency rates.
    • Other income recorded a loss of RMB 694.8 million (US$106.8 million) for the fourth quarter of 2017, compared with income of RMB 124.7 million in the same period of 2016. The loss was caused mainly by an expense of RMB 271.9 million (US$41.8 million) related to the quality assurance fund and an expense of RMB 460.4 million (US$70.8 million) from a fair value change of financial guarantee derivatives due to increased credit risks across the industry which led to upward adjustments to the company's expected default rate for loans protected by the quality assurance fund and underlying loans in investment programs protected by the investor reserve funds.

As we can see, the major problem for the Q4 result is the rising credit default expectation. Since the credit loss provision has to take a forward-looking perspective in accounting treatment, the fair value change of their risk reserve fund has been reflected in the earnings results.

Indeed, when we look at the delinquency rate by balance at each quarter, there was a significant jump in every delinquency bucket at 2017 Q4:

As of

15-29 days

30-59 days

60-89 days

90-119 days

120-149 days

150-179 days

March 31, 2015

0.79%

1.75%

1.10%

1.01%

0.87%

0.67%

June 30, 2015

0.88%

1.06%

0.67%

0.54%

0.89%

0.67%

September 30, 2015

0.67%

0.89%

0.61%

0.54%

0.44%

0.35%

December 31, 2015

0.80%

0.93%

0.51%

0.49%

0.39%

0.32%

March 31, 2016

0.62%

0.93%

0.72%

0.61%

0.48%

0.32%

June 30, 2016

0.82%

1.01%

0.63%

0.43%

0.47%

0.44%

September 30, 2016

0.83%

1.11%

0.80%

0.63%

0.49%

0.39%

December 31, 2016

0.63%

0.91%

0.75%

0.79%

0.69%

0.57%

March 31, 2017

0.57%

0.95%

0.79%

0.59%

0.54%

0.51%

June 30, 2017

0.86%

1.11%

0.79%

0.51%

0.55%

0.52%

September 30, 2017

0.89%

1.40%

1.15%

1.02%

0.79%

0.60%

December 31, 2017

2.27%

2.21%

1.72%

1.63%

1.36%

1.20%

Source: PPDF’s Q4 ER release

Now, although it’s impossible to know the details of the credit risk scenarios in PPDF's fair value calculation, based on PPDF’s earnings call, they believe “these losses are largely non-cash expenses in the fourth quarter and we believe we have taken most of the losses off the table due to reasons such as the peak of the current credit cycle having been reached making it unlikely to be subscribed by the delinquencies going forward and a full reversal to be made of our previously recognized gains from the IRF”.

This means that the credit loss provision we have seen in the Q4 results is most likely to be a "one-time shock", which won't have a future impact on PPDF's earnings. As shown in the Q4 financials, there was about US$129 million loss related to rising delinquency expectations:

  • a one-time provision of US$16.3 million from IRF;
  • an expense of US$41.8 million related to the quality assurance fund; and
  • an expense of US$70.8 million from a fair value change of financial guarantee derivatives.

Had the delinquency related losses not occurred (or to be more fair, if we assume the delinquency level has returned to the “normal” level already, as PPDF has stated for recent development), the company would have reported a net profit of US$51.1 million instead of a net loss of US$77.90 million, representing an EPS (per ADS) of $0.33 instead of -$0.89 for 2017 Q4.

Accretion losses on the company's preferred shares

Another major cause of the deterioration in PPDF’s financials is the accretion loss on the company's Series A, B and C preferred shares. In 2017, there was a US$472.3 million accretion loss on Series A, B and C convertible redeemable preferred shares to redemption value. This has led to the final net loss attributable to ordinary shareholders of the company at US$305.9 million for fiscal year 2017.

What we need to pay attention here is that this "accretion loss" is not really a “loss”, but more like a dilution on ordinary shares. This loss occurs when preferred shareholders convert their preferred shares into ordinary shares, which caused a dilution in equity value, and thus was reported as a downward adjustment to the net profit attributable to ordinary shareholders.

Although there is no public information on how many preferred shares are still out there with potential to be transferred into ordinary shares, I am not quite concerned with this accounting adjustment. After all, this is not something that materially impacts the business operation. On the contrary, it may reflect the confidence from preferred shareholders on the firm’s future, similar to the signal that PPDF wanted to deliver to the market through their US$60 million stock purchase plan announced in the Q4 ER call.

Theoretically, there should be a 100% up space

If we add back the non-operational loss (accretion loss from preferred shares) and the temporary loss (from rising delinquency), we would get "actual" 2017 net profit attributable to ordinary shareholders of US$ 217.5 million (instead of a net loss of US$305.9 million), representing an EPS of $1.39 instead of -$1.96.

If we take P/E ratios from other comparable Chinese Fintech companies, such as Qudian (NYSE: QD, currently at about 8) and Yirendai (NYSE: YRD, currently at about 11), PPDF’s fair price should be at about $13-$15, representing a 90% to 110% possible gain from the current price level.

Risk Factors

What I have discussed so far are theoretical cases, and there are certainly risk factors that can impact the firm’s true value:

  • The delinquency rate could keep rising. If this happens, there will be more loss from the firm’s investment reserve fund, quality assurance fund, etc.
  • The regulatory impact could further slow the business and even lead to business interruption. As a long time player in the market, I think the possibility of PPDF getting seriously interrupted by regulation is minimal. In the long run, the regulatory barrier could be a good thing for major market players like PPDF.

Conclusion

PPDF's stock price is in a good BUY range. The temporary losses shown in Q4 2017 won't have a sustaining impact on future performance. The stock price has the potential of doubling based on "fair" value.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PPDF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.