Morningstar | FlexiGroup’s FVE Unchanged Following Previously Guided to Poor 1H19 Results. See Updated Analyst Note from 26 Feb 2019
Our fair value estimate for struggling no-moat FlexiGroup remains at AUD 1.50 per share following previously guided to disappointing first-half fiscal 2019 results. New CEO Rebecca James unveiled another strategy to simplify the business and surprised with an AUD 21.5 million placement to Tanarra Capital. A solid performance in its core Cetergy business as well as its New Zealand leasing and new Australian consumer leasing business was not enough to offset the weakness in its Australian and New Zealand cards and commercial leasing businesses. In addition to the guidance to impairment losses, another disappointing feature of the results is the company’s continuing inability to convert strong receivables growth into commensurate net income growth. At our fair value estimate, the company has a fiscal 2019 P/E of 7.6 times and a dividend yield of 4.7%, with these undemanding metrics reflecting continuing macroeconomic and regulatory headwinds.
We are generally sceptical the company’s new turnaround strategy will achieve the guided to results. It seems to be very similar to the strategy under previous CEO Brewis-Weston. Specifically, it focuses on simplifying the business, removing duplication, reducing the number of products and brands, and streamlining the systems that support its products to make the business more scalable. Management expects the new strategy will improve services and reduce costs to serve by about 40% over three years. However, we are cautious of this guidance. FlexiGroup continues to battle likely disruptions from implementation of recommendations from the Financial Services Royal Commission and recent Senate Inquiry, as well as our expectation of a weakening economic environment and continuing strong competition. We are also unwilling to give the company the benefit of the doubt in our modelling given its poor record of meeting guidance.
An encouraging new product development borne out of the company’s simplification strategy which we think has merit is the consolidation of its two buy-now-pay-later products of Oxipay and Cetergy into one new product called “humm.” We believe humm should provide customers with more frictionless access to credit by providing one digital wallet for customers to access finance from as low as AUD 1 to as high as AUD 30,000. The long repayment schedule of up to 60 months should also be attractive to potential customers and the circa 1 million customers that already use the company’s products should be attractive to potential retailer partners. Oxipay targets a younger demographic (18-to-35-year-olds) with low transaction values that average AUD 274 and competes with companies like Afterpay. Cetergy targets an older demographic (35-to-45-year-olds) with larger average transaction values. Merging the two products together should also provide marketing and other costs savings. Nevertheless, there continues to be fierce competition in the rapidly growing buy-now-pay-later sector, which more recently has been dominated by new entrants. We expect it will take a solid marketing effort and time for humm to compete more effectively with these fintech disruptors.
One positive from the generally disappointing half-year results was the continued turnaround of the Cetergy business. Cetergy’s cash NPAT increasd an impressive 9% in the first half of fiscal 2019 relative to the corresponding period in 2018. This was primarily driven by a 17% fall in operating costs. This reflects the prior periods' investments in product development which was not repeated. However, this more positive result was not able to compensate for the increased impairments suffered in its Australian credit card business and commercial leasing business.
Although net income increased by an impressive 48% from the first half of fiscal 2018 in its Australian cards business due to more of its growing receivables becoming interest bearing, this was more than offset by a 149% increase in impairments. Management continue to confirm the increase in impairments is not a credit problem but rather a cash collection problem. Regardless, we expect impairments as a percentage of receivables to remain elevated at about 5% over the next five years. Increased investments to improve cash collections as well as costs related to the launch of the new Skye card product also resulted in operating costs jumping by 38%, driving an 88% fall in cash NPAT in its Australian cards business.
In contrast, the cash collections performance was strong in its New Zealand cards business, but this improvement was more than offset by margin decline in its receivables and increased operating costs to support further future growth. The commercial leasing business’ strong 34% growth in receivables relative to the first half of fiscal 2018 did not convert into commensurate growth in net income. Net income fell by 4% due to lower margins from a change in product mix to managed services. Commercial leasing’s loss after tax of AUD 7.6 million was also due to the already guided to increase in aftertax impairments provision of AUD 12 million and an increase in operating expenses due to an investment in its sales team.
Another area of concern was the sharp jump in gearing (corporate borrowing/equity less intangibles) to 70% at Dec. 31, 2018 from 36% at June 30, 2018. However, this masks the true extent of the balance sheet deterioration as it was primarily due to a timing issue with respect to securitisation of its receivables. Corporate debt was used to fund its financing volume growth and management expects the capital release from securitisation of receivables scheduled for March 2019 should reduce the gearing back to about 36% very shortly. Nonetheless, we believe gearing of 36% is still relatively high given the macroeconomic and regulatory headwinds and the volatility of its earnings.
One of the key regulatory risks that has the potential to disrupt the company’s business is the recommendation that the exemption for retail dealers from the operation of the National Consumer Credit Protection act 2009, or NCCP, should be abolished. This is the recommendation from both the Senate Inquiry Report into credit and financial products and Financial Services Royal Commission Final Report. Specifically, the Royal Commission’s Final Report recommends that the sales people at retailers who originate point-of-sale credit for purchases should be required to comply with the NCCP. Currently, these retailers are not required to hold an Australian Credit licence under the NCCP or comply with key NCCP responsible lending obligations. If these recommendations are implemented, they have the potential to disrupt the receivables growth particularly in the company’s credit card and new consumer leasing business. As these recommendations were only made in the last few weeks, it is unclear how they would be implemented given we expect lobbying against the recommendation from retailers.
We also believe there is likely to be disruptions to the buy-now-pay-later sector while the industry works through a potentially new regulatory framework and industry code. However, the most significant disruption to these products of being under the responsible lending obligations of the NCCP increasingly appears to have been avoided, at least in the near-term. The Senate Inquiry did not go so far as to require buy-now-pay-later products like the company’s new product humm to come under the NCCP but did recommend further consultation with the Australian Securities & Investments Commission, or ASIC, on an appropriate regulatory framework. While not being subject to the NCCP means buy-now-pay-later products will not need to comply with the responsible lending obligations, the Senate Inquiry did suggest the regulatory framework should ensure that credit providers “appropriately consider consumers’ personal financial situations.” Among other things, the Inquiry also suggests the regulatory framework should ensure products are affordable and offer value for money as well as ensure consumers are properly informed prior to entering into an agreement.
How these types of recommendations are ultimately converted into legislation has the potential to impact how easy it is for consumer to access finance via the company’s new humm product. This is important for future growth as the frictionless access to finance via these products has been a key driver of their strong recent growth.
Significantly, the Senate Inquiry did not recommend any major new regulations over consumer lease products, instead recommending the enactment of current draft legislation that covers these products. FlexiGroup’s management indicate its new consumer lease product, Lisa, already broadly complies with this legislation subject to a few important exceptions. While this is a positive for the company, given the Inquiry’s concerns over these products, we expect ASIC to continue to proactively regulate them. The Inquiry appeared to be particularly concerned with consumer leases and payday loans (FlexiGroup does not issue payday loans) as they believed these financial products are “clearly targeted to low income Australians who do not have access to other credit products” whereas they felt that products like buy-now-pay-later products were targeted to a much broader range of Australians. The Senate Report suggested that the worst-case study evidence before it concerned payday loans and consumer leases. Notwithstanding, the Inquiry addressed these issues by primarily recommending the passing of the current National Consumer Credit Protection Amendment (Small Amount Credit Contract and Consumer Lease Reforms) Bill 2017, or SACC Bill.
We expect the new SACC Bill and ASIC’s likely proactive regulation of consumer leases has the potential to disrupt the company’s new Lisa product. With respect to consumer leases, the SACC Bill, among other things, requires a cap on the total amount of payments on a consumer lease calculated as the base price plus 4% of that price for each month of the lease, with a maximum repayment period of 48 months. Management confirm that Lisa already complies with this obligation, and the 4% per month effective interest rate cap should still allow the company to generate a reasonable return. Nevertheless, it may find it harder to comply with other requirements of the SACC Bill. For example, the SACC Bill requires a cap on all consumer lease payments to be 10% of the net income of the consumer. Currently, the company is unlikely to have the means to check whether a consumer lease repayment would represent more than 10% of the consumer’s net income.
One of the Senate recommendations we don’t expect to be implemented, to the advantage of FlexiGroup, is Recommendation 18. This recommends the government consider what tax and other incentives could be used to encourage mainstream credit providers to offer low interest products to vulnerable Australians. We believe it very unlikely financial institutions like the major banks will be enticed into this market. The strategy of major banks has been to retreat into focusing on their core banking products of providing mortgages and deposit-taking and getting out of noncore businesses.