To The Moon

The online loan facilitator is bearing more credit risk as its use of third parties to insure and guarantee the loans it brokers becomes costlier

Lufax Holding Ltd.(NYSE:LU), the largest of China's online loan facilitators, appears caught between a rock and a hard place as Beijing sticks to its "zero Covid" policies.

One special feature of the Ping An Insurance-backed (OTCPK:PNGAY; 2318.HK; 601318.SH) company's business model, targeting "unmet demand" for credit among small business owners, has been its role connecting institutional lenders and borrowers without directly exposing itself to a lot of credit risk. It does that by using third-party companies to insure or guarantee the loans it arranges.

But costs for loan insurance and guarantees have also risen due to higher default risks of mom-and-pop shops that are often forced to close or limit their operations under China's strict Covid control restrictions, even though Lufax relies on affiliate Ping An Property and Casualty Insurance for the bulk of such services.

So, Lufax is biting the bullet and bearing more credit risks itself. But to minimize defaults that are more likely in the current environment, it is also becoming more selective over borrowers, which naturally slows its business growth. Worse yet, losses from loan impairments are still surging, hitting the company's bottom line hard.

The many pressures facing Lufax and its peers were evident in its latest quarterly earningsreleased last week. New loans the company facilitated shriveled by about 30% in the third quarter from a year earlier, causing the company's total outstanding loan volume to shrink 1.3% - the first time that figure has declined since its October 2020 IPO. As a result, Lufax's total revenue declined about 17% year-on-year to 13.2 billion yuan ($1.9 billion).

But the revenue decline looks modest compared with a 67% drop in the company's net profit for the three months, largely the result of a 138% surge in credit impairments that became the company's second-largest cost behind only sales and marketing expenses.

A little more than 2% of Lufax's total loans were delinquent for 90 days or longer at the end of September, up from 1.7% just three months earlier. That rate is in the middle of the pack among its peers, higher than360 DigiTech's(QFIN) 1.44% at the end of September, but lower than LexinFintech's(LX) 2.66%.

As of the end of September, Lufax bore credit risks from slightly less than a quarter of the loans it facilitated, including through its guarantee subsidiary. That means the company will have to cover losses incurred by its lending partners when any of those loans go bad. The proportion of loans that Lufax directly guarantees has increased sharply in the past few years from as small as about 2% at the of 2019, the last pre-Covid year.

Lufax has also increased its direct exposure to credit risks by boosting its use of trust plans for loan facilitation, which the company says helps lower funding costs. Under such a model, a third-party trust company collects a pool of funds from investors, then lets Lufax distribute the money to borrowers. Lufax also sometimes contributes funds to trust plans, in which it cases it carries the loans on its balance sheet and earns interest income. As Lufax increasingly cuts out guarantors for such loans, it exposes its own balance sheet to growing credit risks.

Grim outlook

To minimize losses from new loans, Lufax is trying to target small businesses owners that are faring relatively well, even if that costs the company revenue growth. As it becomes more cautious, Lufax expects to generate only about two-thirds of the loan volumes it processed during the good times, Chairman YongSuk Cho said on a conference call to discuss the latest results.

Cho added that Lufax isn't anticipating its profitability will improve notably until 2024. That's a pretty grim outlook, but the company's management can't be blamed for being too downbeat as things stand now in China. For one thing, there's no clear sign that the Chinese government will completely give up on its zero-Covid policies despite their massive economic costs and growing public frustrations.

The government did ease some rules earlier this month. But as Covid cases surge again, lockdowns have come back. That's bad news for Lufax because small business owners that are its primary borrowers are among the most vulnerable to shutdown orders.

The company's loan performance tends to fluctuate widely as lockdowns come and go. For example, in Shanghai, which was shut in April and May, Lufax saw the ratio of loans expected to be nonperforming in three months more than quadruple to exceed 2% in the second quarter from pre-lockdown levels. Then the figure dropped dramatically quickly after the city reopened.

Lufax's gloomy third-quarter earnings, which missed analysts' forecasts, sent its shares plunging 20% the day after the report's release, as some investment banks, including JPMorgan (JPM) cut their price targets for the stock.

Lufax shares have lost nearly 90% of their value since its IPO just two years ago. Looking back, the company couldn't have picked a worse time to go public since its debut coincided with the pandemic's early period, combined with an ongoing clampdown by Chinese regulators on fintech companies.

Lufax has still managed to grow its annual revenue and profit in each of the past two years, but that run seems to be ending. The company's revenue and net profit are both projected to decline this year, according to average estimates compiled by Yahoo Finance.

Lufax shares trade at a price-to-earnings (P/E) ratio of 2, far below the nearly 4 for FinVolution Group(FINV), a consumer financing platform that is weathering the current economic downturn better with continued revenue growth and a lower bad debt ratio. The valuation gap indicates the focus on small businesses is making life harder for Lufax than other loan facilitator, none of which are exactly having a great time.

For Lufax and its peers, the only way forward may be just to "lay flat" - a popular expression in China these days for taking a breather - and wait for the hard times to pass.