Better Stay Away From Hexindai

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About: Hexindai Inc. (HX)
by: Annual Report Reader
Summary

Hexindai can no longer stimulate unsustainable growth by excessive promotions.

The new micro lending business under the subsidiary Wusu company shows signs of loss.

The company has not adjusted its strategy to improve operation efficiency to fight against the revenue decline.

Hexindai distributed $10 million cash dividend in July, in the business downturn, which only seems to benefit the founder.

The company stopped disclosing monthly operation report after July and the loan origination seemed to be obstructed by undisclosed events.

Subsequent to two-year rapid growth, Hexindai (NASDAQ:HX) reported a huge net loss for their second quarter recently. It is quite shocking to see such a deep decline in loan volume and revenue, even within the background that the P2P lending industry has been going under enhanced regulation and crackdown. In my opinion, not only does Hexindai have serious problems in their business strategy and daily operation, but it also possibly encountered undisclosed devastating events.

Here is a brief comparison of prior quarters, from which we can clearly see that the company experienced two year rapid growth, but earnings dramatically fell even below the 2016 level. It seems that everything had been gained in two years just evaporated overnight. This is devastating to investors.

USD

2019 2Q

2019 1Q

2018 2Q

2017 QUARTERLY (*)

2016 QUARTERLY(*)

Net Revenue

3,621,162

51,651,497

27,163,160

5,730,136

2,973,557

Income from Operations

-17,452,572

36,093,754

20,620,670

2,478,387

1,035,096

Net Profit

-17,400,575

29,678,615

12,665,041

2,142,716

884,602

Source: Annual report and quarterly earnings release.

*Because no quarterly results were public, these are averaged amounts from annual report.

Compared across the industry and other competitors, HX is the most troublesome company, as it experienced the largest decline in terms of loan volume and fell to the bottom of the market.

2018 Loan Volume (billion rmb)

3Q

market share

Change

2Q

market share

Change

1Q

market share

Industry

403.00

-23.76%

528.60

-5.18%

557.46

HX (*)

0.20

0.05%

-93.10%

2.90

0.55%

YRD

6.55

1.63%

-44.21%

11.74

2.22%

-1.84%

11.96

2.15%

PPDF

14.80

3.67%

-11.90%

16.80

3.18%

36.59%

12.30

2.21%

XRF

0.19

0.05%

-52.39%

0.41

0.08%

-16.92%

0.49

0.09%

Source: Industry loan volume

Others: Earnings release of Q1, Q2, Q3 2018, of each company, which you can see here: HX, YRD, PPDF, and XRF Q3, Q2, and Q3.

*Because HX has a different fiscal year that ends on March 31, its Q2 and Q1 correspond to the Q3 and Q2 of other companies.

So what went wrong?

Cash Incentive Reward Program

The company has a cash incentive program which is a primary strategy to attract investors. The program offers existing investors cash reward upon each successful referral of a new investor. The annualized cash incentive is around 1% of funds invested by the new investor in the first year. Meanwhile, the post origination service fee revenue from those loan investments represents 0.7%-2.2% of the loan investment amount. It may seem to work well in attracting investors, as we all have seen the huge increase in operation in the past two years, until we notice that the cash incentive has grown way more than the revenue from investors.

2016

2017

change

2018

change

2019 1Q

2019 2Q

Change from

(US$)

% of

(US$)

% of

from 2016

(US$)

% of

from 2017

(US$)

% of

(US$)

% of

1Q TO 2Q

revenue

revenue

to 2017

revenue

to 2018

revenue

revenue

Post-origination service revenue

1,193,737

8.20%

1,219,897

4.10%

2%

4,213,862

3.40%

245%

2,364,879

4.14%

4,328,279

7.57%

83.02%

Cash incentives

837,418

5.70%

1,629,316

5.50%

95%

15,170,406

12.30%

831%

4,969,479

8.69%

6,235,442

10.91%

25.47%

Source: Annual report and quarterly earnings release.

Starting from 2017, the cash incentive began to exceed the post origination service revenue, which is the financial statement line item reporting revenue earned from investors. Especially in fiscal year 2018, the increase speed of cash incentive is sky rocketing, several times the increase of post-origination service revenue and the total net revenue. Even in the second quarter of fiscal year 2019 when business is going down, the cash incentive still keeps growing in double digits.

In the annual report of fiscal year 2018, the management claims that "due to the timing difference in bookkeeping, for the fiscal years ended March 31, 2017 and 2018, our cash incentive payments were higher than the post-origination revenue recognized. However, over the term of each individual loan, our total post-origination service fee from each investor, generated from loans with funds invested through our cash incentive program, is expected to exceed the incentive payments." We should wonder: When is the turning point?

In my opinion, the growth of the company has been stimulated by excessive promotions. The snowball keeps rolling while the inner core is melting. Such a snowball can not sustainably grow and it will collapse until the melted inner hole is big enough.

Wusu Company and the Micro-Lending Business Is in Trouble

On Aug. 28, 2017, HX established a new subsidiary, Wusu company in a far out city, Wusu, Xinjiang Province, to engage in micro-lending business. Wusu provides individual borrowers short term loans, typically within 12 months terms and the interest rate is 8% per annum. Wusu only earns interest on those loans and does not charge loan origination fees. This is a different type of business than P2P in which HX acts as an agent, whereas Wusu acts as a creditor, which bears more risk.

9/30/18

change from

6/30/18

change from

3/31/18

USD

prior quarter

prior quarter

Loans receivable--Current

56,756,803

93%

29,469,103

3%

28,696,234

Loan receivable - noncurrent

16,328,520

100%

-

0%

-

Interest receivable

913,803

-16%

1,085,739

95%

555,502

Interest income from the quarter

681,599

-9%

749,727

27%

590,122

Source: Annual report and quarterly earnings release.

We should first notice that some loans became long term, although Wusu was originally providing short-term loans. The earnings release did not disclose whether the long-term loan is a new product or the earlier short-term loan turned into a long-term one. Without clear disclosure, we might suspect the collectability of those loans. Second, the loan balance grows very fast, but interest income and interest receivable, not so much, or even decreased. What happened here? Apparently, Wusu is not earning an annual 8% interest in this business. Big question mark here!

Receivable, Prepayment and Other Assets Became Suspiciously High

This is another balance sheet line item that has caught my attention. It increased tremendously this year, which no reason has been disclosed in the quarterly report. As of March 31, 2018, per the annual report, the balance was mostly rental deposit, prepayment to suppliers and staff advances, nothing too out of ordinary. But I really want to know what is building up the balance now, which could potentially hurt earnings.

9/30/18

change from

6/30/18

change from

3/31/18

USD

prior quarter

prior quarter

Receivable, repayments and other current assets

20,320,402

99%

10,211,490

718%

1,248,562

Source: Annual report and quarterly earnings release.

Operating Expense Keeps Increasing Even When Revenue Declines Sharply

The revenue is going down, but HX has not reduced any expenses yet.

2019 2Q

% of

2018 2Q

% of

Change from

2019 1Q

% of

2018 1Q

% of

Change from

Change from

USD

revenue

revenue

2018 1Q-2019 1Q

revenue

revenue

2018 1Q-2019 1Q

2019 1Q--2Q

Net Revenue

3,621,162

27,163,160

-86.67%

51,651,497

15,112,921

241.77%

-92.99%

Operating expenses

Sales and marketing

11,749,563

324.47%

3,691,570

13.59%

218.28%

11,665,104

22.58%

2,568,544

17.00%

354.15%

0.72%

Service and development

2,177,233

60.13%

1,901,117

7.00%

14.52%

1,364,568

2.64%

1,334,985

8.83%

2.22%

59.55%

General and administrative

2,236,523

61.76%

949,803

3.50%

135.47%

2,313,793

4.48%

894,747

5.92%

158.60%

-3.34%

Share-based compensation

4,910,415

135.60%

-

0.00%

100.00%

214,278

0.41%

-

0.00%

100.00%

2191.61%

Total operating expenses

21,073,734

581.96%

6,542,490

24.09%

222.11%

15,557,743

30.12%

4,798,276

31.75%

224.24%

35.45%

Source: Quarterly earnings release.

Overall, the operating expenses are increasing, both from prior quarter, and the same period of prior year. In particular, sales and marketing expense increased more than revenue when revenue was growing, and still kept increasing when revenue went down. This is the similar symptom as the previously discussed cash incentive program. Promotion pushes growth until it can no longer work, and yet the company has not switched strategy.

Second, service and development expense strangely increased significantly in the second quarter of fiscal year 2019, by 59.55%. This line item covers related employee expense, custodian bank account management fee, and rental and property management fee. Why? The management explained in the second-quarter earnings release that "service and development expenses remained stable when compared to the same period of last fiscal year, which was primarily due to improvements in operational efficiency." Not helpful! I would suspect either the company is spending a ton collecting delinquent loans or they are spending lavishly on some property rental.

Third, general and administrative expense slightly decreased from the first quarter to the second quarter of fiscal year 2019, but increased significantly from fiscal year 2018. This line covers related employee expense, professional service and rental expenses, so I would suspect the increase partly due to office lease. The 2018 annual report listed office lease payment for years 2018, 2019, 2020, and 2021 as $1,163,326, $1,904,999, $1,513,330, and $705,574, respectively. This committed expense is most hurtful when revenue is drastically dropping. In addition, rent increase apparently does not cover all the increase in general and administrative expense, so another reason might be that the management is paying themselves too well.

Overall, HX has not changed strategies to improve operation efficiency to fight against the revenue decline.

Cash Dividend Benefits the Founder, but Hurt the Company

On July 23, 2018, HX declared a cash dividend of $0.40 per ordinary share, which is equivalent to US$0.40 per American Depositary Share (ADS), each of which represents one ordinary share. The cash dividend consisted of an annual dividend pursuant to the newly adopted annual dividend policy of $0.27 per ordinary share (or $0.27 per ADS), and a special cash dividend of $0.13 per ordinary share (or $0.13 per ADS). As a result, the company distributed approximately $10 million cash. This means, the founder An Xiaobo, with 63.4% beneficiary shares received $6.34 million, his brother, An Xiaoning, with 15.8% beneficiary shares received $1.58 million and the public received around $ 2 million. To put the numbers in perspective, the IPO in November 2017 brought in $43.3 million financing, and about a quarter of it was used to distribute dividend 8 months later!

In addition, the dividend policy is approved to announce 15%-25% of the anticipated net income of the year. Let's look at the timing of the dividend announcement, July 23, 2018, when everyone in the P2P industry was cautiously dealing with the market crackdown from top regulation. One of HX's competitors, Yirendai (NYSE:YRD), suspended the semi-annual dividend policy in August 2018, due to the challenging market environment with business uncertainties. Another competitor, PPdai (NYSE:PPDF), does not plan to distribute dividend in the foreseeable future. With such market background, HX was quite courageous to distribute such a large amount of dividend. Second, although HX had a quite profitable first quarter, by July 23, 2018, management must have already smelled the decline of their business. I don't believe that they were still anticipating a profitable fiscal year and neither do I believe they were just innocently over confident to approve a large dividend distribution.

Lack of Sufficient Disclosure

In compliance with Chinese regulation on information disclosure, companies in the P2P lending industry need to disclose monthly operation information, which mainly includes investment volume, loan volume, number of investors, number of borrowers, delinquency rate, etc. I was hoping that such monthly disclosure can help investors find out more details about the operation. However, as of today when I write this article, HX's website only discloses operation reports up till July 2018, and no more reports for the month of August, September, October and November. In addition, the July and June 2018 operation reports miss the accumulative loan volume information which were included in all previous reports.

So I have to take the monthly investment volume to estimate the loan volume, following the pattern that the monthly investment volume was usually slightly more than the loan volume historically. The July investment volume was RMB 1,080.77 million, and I estimate the loan volume to be around RMB 1000 million for the month of July. Then I further expect the loan volume for the second quarter to be somewhere over RMB 1000 million. However, the second quarter earnings release reported loan volume of the quarter to be RMB 230 million.

Two questions should be raised here. One, why could HX attract investment funding but no borrowers, all of a sudden? Two, why doesn't HX continue to disclose operation report? Does it imply any huge problem? Furthermore, I couldn't help thinking back to the dividend distribution in July. How could the company distribute huge amount of dividend facing such an operation turmoil?

Management Team Not Competent

Now, with all the above question marks, I have to read through the profiles of the executive officers in the annual report. The founder and the key officers only have an average background, no technology expertise, no oversea experience, no top university education. I don't have any prejudice against certain criteria, but just to compare with other peer companies, HX's management team is not impressing. Especially, I don't see them having any core technology advantage in this emerging fin-tech industry.

In addition, when HX went IPO in 2017, they chose underwriter Network 1 Financial Securities, Inc. which seems to be mainly targeting small customers from emerging markets. Nasdaq.com has a list of its offering history here: Network 1 Financial Securities, Inc - Offering History. I also came across another article raising flags on this broker: Network 1 Financial Securities Named in Bad Broker Study To be fair, I cannot verify the reliability of this article, but wanted to just share with my readers as a side note.

Conclusion

There are enough issues here for He Xin Dai. Along with Bloomberg News noting a few days ago that "Chinese authorities are planning to wind down small to medium sized P2P lending platforms across the nation," even management is not confident when they provided their outlook for the year in the earnings release of the second quarter:

Three Months Ending Dec. 31, 2018:

Total loans facilitated will be in the range of US$56.0 million to US$60.0 million.

Net revenue will be in the range of US$1.4 million to US$1.6 million.

Fiscal Year Ending March 31, 2019:

Total loans facilitated will be in the range of US$700.0 million to US$720.0 million.

Net revenue will be in the range of US$66.0 million to US$70.0 million.

This newly provided outlook expects that the rest of the year will just keep at the current level without much improvement.

I'd suggest you stay away from Hexindai.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.