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YRD: What To Expect In Q3 Earning

|Includes: QD, Yirendai Ltd. (YRD)
Summary

CreditEase looks cheap and Q3 earning may be on track

However, loan growth should start to be negative in Q4, compared to 50-100% annual growth expectations

Longer term, the business model may be in question

YRD has 12.5x P/E, Revenue and Earning growth all in the 50-100% range, with ~30% net income margin, very little leverage, and connects to a vast Chinese consumer credit market. Isn't it super cheap?

It helps to identify what kind of business it is. It is a FinTech company that facilitates lending and borrowing of consumer credit in China, with all prime borrowers. At least on paper. But it's worth considering these facts: First, the expect credit loss on their prime customer is ~7-9%. In the US, prime consumer loans have not averaged loss that high, not even half, not even 1/3. Second, the annualized average interest/fees for borrowers is somewhere between 30-40%, let's say 35%. The average investor gets ~8% of interest. The rest (~27%) goes to YRD. This makes LendingClub blush (~4% fee). The cost is not low: ~8% of credit loss absorbed by a credit guarantee, ~6% marketing cost (ads in WeChat is not cheap, and 6% fee paid to parent CreditEase on loans sourced through it), 5% operating cost. It still leaves plenty of profitability (8% of loan). Because the loans are not on balance sheet, the RoE looks very healthy. All these are estimates based on 10K.

A common critique of YRD is that it is high-interest loan (Gao Li Dai): who can afford to borrow at 40% annual interest rate and still be a prime consumer? can they really pay off? is the 8% credit loss really enough, given that the newest vintage loans are migrating more and more into low credit buckets? Is it moral, is it sustainable? Is it tolerated by the regulators in China?

It is possible that China has such a bad credit system there are so many 'prime' customers who want to borrow at 30-40% annual interest rate and still only incur 8% of loss, and this growth can go for a long time; although the fact they were reaching lower into bucket D indicate that this portion of market is more saturated than before. But, its the last question that I want to discuss today. 

With QD's IPO in October, there is a shift in regulator's attitude toward consumer lending in China. They reemphasized the 36% redline (usury rate). It's estimated that about half of YRD's loans have effective annual interest rate of 36% or above. So far they probably get by with labeling majority of these as 'Fees', but that's getting harder. That's why in October, YRD loan origination was down 4% MoM. This is accompanied by peer declines too, but has to catch some eyebrow for a company with 50-100% expected loan growth rate. The information is from an article on YRD at xueqiu.com (DaWangLu Monthly Oct 2017).

The same source showed a very healthy growth in September, so my guess is that for Q3, growth is in previous range, or even faster, and profitability should not show serious problems. But once growth slows, problems will show. E.g., loss rate of older loans. The reason of slowing is probably because they pulled back from loans with higher than 36% interest rate, to avoid scrutiny or punishment. If that's the case, consider their cost: 8% for investor, 6% for marketing, 5% for operating, 8% for credit loss (which is hit already and on a rising trend). If your charged rate is 35%, your margin on loan is 8%. If your average charged rate is 30%, your margin is 3% (or a 62.5% decline). Add that to the volume decline, you will quickly get the picture.

In summary, I think October loan volume is not a separated incident but represents a sustained crackdown on high interest loan industry in China. This will make all P2P lenders including YRD to pull back, lowering volume and the profit margin (dramatically). Unless cost structure is collapsed quickly, or profitable growth elsewhere is quickly found, earning will suffer inevitable and the platform may not be worth much. In a medium case (a subprime lending platform with prospect of dramatic decline), I will give a 6x P/E, which means half of today's price of ~$40.