Look to Credit Corp for a leading indicator of economic health: Reporting season roundup

-- | 30/09/2021

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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport, today with me is Shaun Ler. He covers one of the most talked about sectors here at Morningstar, it's the buy now, pay later sector. And he also covers some of our more traditional financial services stocks like Challenger, Magellan.

Shaun, thank you very much for joining us today.

Shaun Ler: Thank you. It's my pleasure.

Rapaport: So we've just finished reporting season or are a couple of weeks away from out of reporting season. I'm curious to get your thoughts on how you think your sector performed over the month, maybe a highlight and a lowlight?

Ler: Well, to start with, on average I think the diversified financial sector is fairly valued. I think, in aggregate performance have been strong. The greatest value is being found in misunderstood asset managers like Magellan, or firms with underpriced future earnings like Humm. Now, on the other hand, expensive names include growth stocks, like Pinnacle, where the market is either valuing them at lower discount rates, or under estimating competition risk. Looking ahead, we might see more financial distress, firms may sell more, return of bad debts with debt collector, credit card provisioning more loans than before to prepare for more arrears and more losses. And this also points towards challenging conditions, for finance providers like Zip and Humm. Moving on to the traditional wealth and asset manager space, you know, there is greater need for financial advice, there is greater need for retirement income, but with competition and the balance of power shifting to investors, I think firms need to do a few things. They need to cut product costs and differentiate. Now some firms looking ahead could see operating margins compress. But some firms could see better operating leverage.

Rapaport: Shaun, I want to focus specifically on Zip, a buy now, pay later stock under your coverage. We're seeing some really big news out of Zip. They're now in 12 different countries, they've had a lot of new product launches, they've done a lot with Zip business. And we've also seen enormous customer growth over the last year. But at the same time we've seen that, they're really spending a lot of money to bring about these big numbers. Can you talk to me about the competitive landscape in which Zip is operating? And whether or not you think that they're doing the right things to survive?

Ler: Well, yeah, absolutely Emma. So, what really stood out to me was in this first half or the second -- from the FY'21 results, strong customer engagement and very strong customer engagement, especially in the U.S. Now, this is more than Afterpay, to our surprise, but you know, as we suspected, this is not without cost, with operating expenses far exceeding even our very bearish forecast. So, if you look beyond the top line growth, you will realise increases in loss provisions, arrears, net bad debts and you know, this reaffirms our view that in order to grow in a commoditised and highly competitive business Zip would need to differentiate itself and lower its lending standards. So, the takeaway from here is that you know, while investors are excited about growth. It pays to remember what Zip's customer acquisition cost looks like competition, regulation, execution, and dilution from outstanding options, or convertibles. So, in my opinion, differentiation, speed and agility is key. And for investors, proper valuation is key and ignoring valuation comes at a risk of permanent capital loss.

Rapaport: They really seem to be throwing their hat at everything, as opposed to some of the other buy now, pay later businesses that are staying more within their core business, their payments business. Are there particular numbers that investors should look at within an earnings release or any other release that Zip does, that really go to the core of whether or not they're going to perform well?

Ler: Well looking forward, there are a few metrics to look at when it comes to buy now, pay later players. The single most important metric to look at would be the frequency of use as this indicates client creditworthiness. This indicates this is a source of operating leverage. This indicates client resonance naturally you would also pay attention to metrics like underlying sales per customer, underlying sales per merchant. Naturally, these are all top line numbers to look at. You will also want to analyse the revenue margins such as Quadpay's revenue margins of 7%. And, you know, trying to benchmark that against what its competitors are charging, and to see whether or not these are sustainable, and you will also want to look at things like their bad debt ratios. I mean, you can achieve top line growth very strongly, but what does this signal about the underlying financial health.

Rapaport: I want to move on to talk about a very different business, I want to talk about Challenger, who sells annuities and also some funds management. And that business has really struggled over the last half mainly, you say because of the low interest rate environment. Can you talk through how they performed during reporting season? And their outlook?

Ler: So yeah, so for Challenger, the thing that stood out to me was that annuity issues were at record levels. So this is a clear sign of recovery. And it's due to broadening of its sales and distribution to a more diversified client base, which includes the industry super funds, independent financial advisors or individual investors. So top line growth is recovering. However, its guided maturity rate, and proportion of term annuity sales were more than we expected. Now, this signals this could potentially mean more competition. Investors may note that Challenger is evolving its strategy from being just a plain annuities seller to becoming a partner in designing retirement income solutions for super funds. Now, I think this is a clever strategy as the Retirement Income Covenant which will take effect sometime next year, is non-prescriptive in nature and highlights the importance of providing tailored solutions, which I believe Challenger is poised to benefit given its industry expertise and prudent growth.

Rapaport: Yeah, so you currently put it on the the best ideas list. And that means that you think the stock is currently undervalued? Is there anything that investors should be looking for in this business to look for it to have a bit of a turnaround? Or are you saying that the sheer number of annuities that they sold is going to put them in a good position for the next couple of months?

Ler: Well, if we look at the catalyst rating, there are few catalysts that will support rating. Well, the first one has been the CIPR regime or the comprehensive income product for retirement regime kicks in sometime next year. I believe that this has opportunity to substantially accelerate their top line growth. Because as I've mentioned, it is evolving its strategy from being just selling annuities to helping super funds develop something that suits them. About four or five industry super funds have already pre-emptively partnered with Challenger. And this would set the blueprint for future partnerships. Another one will be margins. And, you know, I believe that there's room for Challenger to prevent excessive margin compression from annuity repricing, from realising higher returns from investments and upselling more longer dated annuities, to ensure higher margin in the long run.

Rapaport: Another business under your coverage that has had a particularly tough year is Magellan. We saw in the reporting season that they really struggled with performance fees over the last half, as well as putting a lot of money into investing in new businesses like Barrenjoey. However you believe that the dip in this performance will be short lived and that it might be a good opportunity for investors. Can you talk us through why you think that?

Ler: Well, Emma, Magellan in my opinion, is a clear sign of market short termism and overreaction. I believe that the market is overreacting to its short-term obstacles such as recent underperformance or startup costs for principal investments. To give you an analogy, the market is essentially pricing Magellan like a closed end ETF with zero net inflows over the next five years. And market returns of less than 9% per year over the next five years. Now I think that is quite pessimistic as effectively Magellan's active management capabilities. I think the proper thing to do is for investors to look at what Magellan is doing today and ask themselves how does this look like in three to five-years time.

In my opinion, Magellan has a few latent earnings catalysts. The first one which is quite obvious which is a mean reversion in equity markets. Which should help Magellan deliver greater investment returns moving forward, by our analysis the top 10 holdings in Magellan Global and Magellan Infrastructure is more undervalued than the broad global equities and infrastructure asset costs. And as we know, the greater the undervaluation, the greater the potential for a rerating and vice versa. The number two is, in my opinion, a cleverly designed product suit which would allow Magellan to take advantage of emerging investor trends in funds management for example, it has the MFG core series products which appeal to fee conscious investors, energy sustainable for ESG conscious investors and Magellan future pay for investors who seek retirement income.

And lastly, I do see earnings upside from its principal investment's portfolio, such as Barrenjoey, Guzman y Gomez and FinClear. Remember Magellan is running its principal investments, just like how it picks stocks. Now these investments align with Magellan's knowledge in financial services, tech and consumer franchises. So considering what I've said above, I believe that the prevailing share price, is a very compelling entry point to this high-quality asset manager.

Rapaport: We're coming to the end of our time. So just going to ask you a quick question on earnings season, you've listened to a month worth of earnings calls and gone through a lot of reports and PDFs and lots of other things. Is there anything that you picked up from an earnings call that you can share with our viewers that maybe they may have missed or you know an insight that you drew?

Ler: Well a particularly interesting moment or particularly interesting company would be Credit Corp. now I recommend investors pay a lot of attention to what Credit Corp. has to say. Now Credit Corp. often reports its results early. And in my opinion, the company's results can be used as a leading indicator as to where the economy is heading. Now in its results Credit Corp. said that charge off volumes are growing across all markets. Now this suggests increasing levels of financial distress, which may induce firms to sell more return on bad debts. Now remember, Credit Corp. is entering a highly unusual fiscal 2022 with more virus mutations as we speak, stimulus programmes that are being winded down and credit growth recovering off a low base. So the prevailing environment that we are in with low defaults, low hardships, might just not be sustainable and investors who are projecting a clear blue sky moving forward need to be aware of the inherent risk.


This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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