Earnings Call Transcript - LU Q4 2023

Xinyan Liu, Head of Board Office and Capital Markets

Thank you very much. Hello, everyone, and welcome to our fourth quarter 2023 earnings conference call. Our quarterly financial and operating results were released by our newswire services and are currently available online. Today, you will hear from our Chairman and CEO, Mr. Y.S. Cho, who will provide an update of our latest business strategies, the macroeconomic trend, recent developments of our business and special dividends. Our co-CEO, Mr. Greg Gibb, will then go through our fourth quarter results to provide more details on our business priorities and outlook. Afterwards, our CFO, Mr. David Choy, will offer a closer look into our financials before we open up the call for questions. Before we continue, I would like to refer you to our Safe Harbor statement in our earnings press release, which also applies to this call as we will make forward-looking statements. With that, I'm now pleased to turn over the call to Mr. Y.S. Cho, Chairman and CEO of Lufax. Please.

Yong Cho, Chairman and CEO

Thank you. Thanks for joining today's call. During the fourth quarter, the economic environment remains complex and SBOs continue to come under pressure. Nevertheless, as we prioritize quality over quantity, we have now completed our major derisking actions and will continue to carry out a prudent strategy. We are confident that the strategic initiatives we have implemented provide a solid foundation for long-term control and profitability. We believe that the cumulative impact of our strategic upgrades will optimize and recalibrate our risk-return profile to align with the prevailing macro environment in China. Now, let me provide some updates for the quarter. First, the broader macro environment remained challenging for SBOs. This is reflected in the SME development index published by the China Association of Small and Medium Enterprises, which declined slightly to 89.1 in the fourth quarter of 2023. Furthermore, the SME business conditions index published by Cheung Kong Graduate School of Business declined from 49.9 in September to 47.8 in December. This indicates that the SBO segment is likely to recover at a somewhat slower pace. Next, let's turn to our business. Throughout 2023, we've made five major derisking and diversification actions, including four mix changes and one business model adjustment. First, we have changed our segment and product mix. Our heavier concentration in the SBO segment and offerings of both business loans generated hasty profit prior to 2022. However, with the change of macroeconomic environment, such concentration drove a deterioration in both our operational and financial results in the past 18 months. To address this, we have strategically adjusted both product offerings and segments. In terms of product offerings, we have shifted from a predominant focus on SBO loans to a more balanced offering of business and consumption loans. For our product portfolio, we've expanded our offerings to be more comprehensive, encompassing both installment and revolving payment options. Within the SBO segment, we refined our focus by targeting customers with better risk profiles, specifically those in the R1 to R3 rating range. Second, we have adjusted our regional mix. Since the second half of 2022, we observed significant variations in credit performance and resilience across different areas. Accordingly, we have reduced our footprint and are focusing on higher-quality geographies with expected greater economic resilience. Third, we have optimized our channel mix, especially our direct sales channel, which is the most important for our business. We recognize that our rapid historical expansion resulted in lower productivity and higher risk within our direct sales team, and we responded by optimizing the scale of our direct sales team. As a result, the number of direct sales team members reduced from 47,000 at the end of 2022 to around 21,000 at the end of 2023. Fourth, we have adjusted our industry mix, reflecting the relative sustainability of industries under the changing macro environment. In our internal assessment, we have assigned great importance to conservation of each industry's economic cycle stage within our models and increased KYB and industry factors for enhanced model predictiveness. Finally, we have completed migration of our business model. As discussed previously, the high CGI premium charged by our business partners had negatively impacted our revenue and profit. We recognized that the high third-party reliance reduced our technical freedom, therefore restarted negotiations with our funding partners at the end of 2022 and successfully transitioned to a 100% guarantee business model by the end of the third quarter of 2023. In the fourth quarter of 2023, all the new loans were either granted by our customer finance subsidiary as on-balance sheet loans enabled by our guarantee company under the 100% risk-bearing business model, thus eliminating the drag factor of CGI. On a single account basis, new loans enabled under the 100% guarantee model are expected to realize lifetime profitability. However, we recorded a net accounting loss for the first calendar year due to higher upfront provisioning as compared with the launch of the CGI model. While this strategic shift enables us to capture greater economic value, it has also increased our risk exposures. Therefore, we remain prudent and prioritize quality over quantity throughout 2024. In terms of asset quality, compared to the third quarter, the C-M3 flow rate experienced an increase in the fourth quarter. This was mainly driven by the reduction in our outstanding loan balance and short-term impacts from the restructuring of our direct sales team and branches. With the completion of all restructuring measures, we have seen gradual improvement in the flow rate in the first quarter of 2024. To sum up, during the fourth quarter, with the completion of our derisking initiatives, the downsize of our business is under control, and we have strong visibility of our businesses. However, we still require more time due to our prudent strategy and transformation of our business model. Finally, over the past quarters, we have consistently heard our shareholders' requests for us to improve investor returns and capital efficiency. Considering the progress in business derisking and business model transformation as well as our outlook for growth and capital requirements for the next several years, we believe we have the capability, and now is the right time to return value to our shareholders through a special dividend with an estimated size of approximately RMB 10 billion. Thanks. I will now return the call to Greg.

Gregory Gibb, Co-CEO

Thanks, YS. I'll now provide more details on our fourth quarter and full year 2023 results and our operational focus for this year. Please note all figures are in renminbi unless otherwise stated. I'd like to start with an overview of our performance during the fourth quarter. During the fourth quarter of 2022, our performance remained under pressure from the complex macro environment and challenges faced by SBOs. Our overall new loan sales were RMB 47 billion, representing a year-on-year decline of 39.6%. This was mainly due to subdued demand for high-quality loans from SBOs, coupled with our prudent strategy as we transition to the 100% guarantee model. Among total new sales, approximately 40% was contributed by consumer finance as we transition our portfolio mix. Fourth quarter revenue was RMB 6.9 billion, a decrease of 44.3% year-over-year. This was primarily due to the reduction of our outstanding loan balance, which stood at RMB 315 billion at the end of 2023, a decline of 45% on an annual basis. We recorded a net loss of RMB 832 million in the fourth quarter. This was mainly driven by elevated credit losses stemming from front-loaded provisions associated with loans enabled under the 100% guarantee model, heightened risk exposure under the model, and certain one-off non-operating losses. Now, let's delve into our derisking initiatives that we have made progress on in 2023. As YS just explained, we have executed five major derisking strategies, which included four significant changes to our business mix and the transition to the new business model. First, our segment adjustments have fundamentally shifted the new business mix in favor of R1 to R3 rated customers. In 2023, 73% of unsecured loan new customers were rated R1 to R3 compared to 49% in 2022. In addition, strategic adjustments to our product offerings have resulted in a new business mix that reflects our significant derisking measures. This has prompted a gradual transformation of our existing portfolio mix. In 2023, consumer finance sales accounted for 34% of new loan sales, up from 12% in 2022. Concurrently, the proportion of unsecured loans and secured loans decreased to 44% and 22%, respectively, from 64% and 24% in 2022. As a result, our balance mix has shifted, with consumer finance balance as a percentage of total balance rising to 12% at the end of 2023 compared to 5% at the end of 2022. The proportion of unsecured loans decreased from 66% to 73% as of the end of 2022, while the proportion of secured loans remained flat. During 2024, we anticipate continued consumer finance diversification, and the majority of the unsecured balances will fall under the 100% guarantee model by the end of 2024. Next, our regional adjustments have involved the target reduction of our footprint in less economically resilient regions characterized by relatively higher risk. This strategic shift is reflected in our geographic coverage, which has decreased from over 300 cities at the end of 2022 to 146 cities at the end of 2023. In terms of channel adjustments, we have concluded the restructuring of our direct sales. The number of direct sales team members was reduced from 47,000 at the beginning of the year to 21,000 by the end of the year. In 2023, the direct sales channel contributed to 63% of new sales, up from 57% in the previous year. Turning to our business model, starting in the fourth quarter, we completed a strategic pivot as we fully transitioned to the 100% guarantee model. This move has transformed our portfolio mix and increased our risk-bearing as vintages run off and the loans under the new model take shape. As a result, our risk-bearing by balance increased to 39.8% at the end of 2023, up from 23.5% at the end of the previous year. During the fourth quarter, our overall C-M3 increased to 1.2% from 1.1% in the prior quarter. This was primarily due to a reduction in our Puhui business outstanding balance and temporary negative impacts from our geographic and direct sales restructuring in the past quarter. Although we have seen improvement in the C-M3 ratio in the first quarter, given our increased risk exposure under the new model, we continue our prudent strategy to prioritize quality over quantity in 2024. Now, let's turn to our outlook for 2024. We expect new loan sales for 2024 to be in the range of RMB 190 billion to RMB 220 billion, and the ending balance to be between RMB 200 billion and RMB 230 billion. Meanwhile, although we expect loans under the 100% guarantee model will be lifetime profitable on a single account basis, it is important to highlight that loans under this model may record accounting losses in the first calendar year due to higher upfront provisions. Under our projected business scale, we believe we have a strong balance sheet to support the business operations, capital, and liquidity requirements. At the end of 2023, the leverage ratio of our guaranteed subsidiary was 1.8x, far below the regulatory limit of 10x. Our consumer finance capital adequacy ratio stood at approximately 15.3%, well above the required 10.5%. As for the balance sheet, we hold liquid assets of RMB 84 billion, with our cash and bank balance outstanding at RMB 39.6 billion. With the strong capital position and visibility into our business growth in the medium term, we are well positioned to further respond to our shareholders' consistent feedback to increase shareholder returns. And on top of the regular dividend and share buybacks that we have performed over the past three years, our Board of Directors has approved, subject to shareholders' approval, a special dividend of USD 2.42 per ADS or $1.21 per ordinary share with a total estimated size of approximately RMB 10 billion. To offer our shareholders full flexibility, each shareholder may elect to receive the dividend either all in cash or all in scrip. As we are dual listed in the U.S. and Hong Kong stock markets, the shareholders in each market will have to follow the respective procedures for receiving the special dividend. More details will be disclosed in our announcements and statutory circulars in due course. The special dividend is subject to the approval of shareholders at the Annual General Meeting, which will be held on May 30, with a record date of April 9. I will now turn the call over to David, our CFO, for more details on our financial performance.

Siu Choy, CFO

Thank you, Greg. I will now provide a closer look into our fourth quarter results. Please note that all numbers are in renminbi terms and all comparisons are on a year-over-year basis unless otherwise stated. As YS and Greg mentioned before, our performance was impacted by the macroeconomic environment in which the small business-owned sector has been under pressure throughout the period. Through strategic adjustments to the 100% guarantee model and prioritizing higher-quality customer segments and better geographical regions, we sacrificed some of our business scale for backlog quality in the future. This strategic transition has caused our average loan balance and total income to continue to decrease. Whilst the expected credit loss provision is required to be booked upfront in day one, boosting the accounting loss in the early quarter lifecycle under the business model. In the fourth quarter of 2023, our total income was RMB 6.9 billion, decreasing by 44.3%. During the quarter, our technology platform-based income was RMB 3 billion, representing a decrease of 29%. Our net interest income was RMB 2.3 billion, a decrease of 47%, and our guarantee income was RMB 886 million, a decrease of 47%. All are basically in line with the decrease of outstanding loan balance, in which guarantee income decreased by a lesser magnitude due to the offsetting effect of an increase in fees by the company. Turning to our expenses, we remain committed to cost optimization. Our total expenses, excluding credit and asset impairment losses, finance costs, and other losses decreased by 33.2% year-over-year to RMB 4.4 billion this quarter, as we continue to enhance operational efficiency. In the fourth quarter, total expenses decreased by 38.5% to RMB 7.9 billion from RMB 12.9 billion a year ago. This decrease was primarily due to a decrease in credit impairment losses and sales and marketing expenses. Highlighting just a few of the key expense items here: Our total sales and marketing expenses, which mainly include costs for acquisition as well as general sales and marketing expenses, decreased significantly by 45.9% to RMB 2 billion in the fourth quarter. The decrease was mainly due to reduced loan-related expenses as a result of the decrease in new loan sales and decreased retention expenses and referral expenses from the platform service attributable to decreased transaction volume. Our credit impairment losses decreased by 43% to RMB 3.6 billion in the fourth quarter, primarily due to the lower provision for loans and receivables as a result of the decrease in loan volume. Our finance costs decreased by 90.1% to RMB 50 million in the fourth quarter from RMB 501 million in the same period of 2022, mainly due to the decrease of interest expenses as a result of the repayment of Ping An and C-Round Convertible Promissory Notes during the year. As a result, the net loss for the fourth quarter was RMB 832 million, basically flat compared to RMB 806 million net loss in the same quarter of 2022. Meanwhile, our basic and diluted loss per ADS in the fourth quarter were both RMB 1.48 or USD 0.21. Turning now to our balance sheet. With abundant cash, we repaid the outstanding bond of RMB 2.1 billion, an optionally convertible promissory note of RMB 8.1 billion for the year 2023. After all these payments, as of December 31, 2023, we have total equity attributable to the owners of the company of RMB 92.1 billion and a cash balance of RMB 39.6 billion, and financial assets through fair value through P&L of RMB 28.9 billion. In terms of capital as of the end of December 2023, the two main operating entities are well capitalized. Our guaranteed subsidiary's leverage ratio was only 1.8x as compared to a maximum regulatory limit of 10x, and our consumer finance company capital adequacy ratio stands at approximately 15.3%, well above the required 10.5% regulatory requirement. Overall speaking, we are in a net cash position after taking into account all external bank debt. All of these factors offer substantial backing for the company to navigate through the challenging macroeconomic environment and the transition period while providing foundations for us to continue rewarding back to our investors. That concludes our prepared remarks for today. Operator, we are now ready to take questions.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Your first question comes from Emma Xu with Bank of America Securities.

Emma Xu, Analyst

I think, first and foremost, everybody cares about the special dividend. So, what's the consideration behind this RMB 10 billion special dividend? What are the key numbers or information that you rely on to arrive at this RMB 10 billion special dividend? And I have another question about your asset quality. So, your flow rate, a leading indicator for the delinquency continued to rise in the fourth quarter to 1.2%. But I also noticed in your report that you mentioned you actually see improvements in the flow rate in the first quarter or quarter-to-date. So, could you tell us how much improvement you have already seen in the first quarter? And what's your expectation for the overall asset quality trend in the coming quarters?

Yong Cho, Chairman and CEO

Thanks for your question. Let me answer. Let me start with why we believe now is the right time for this special dividend. With the successful completion of our five major derisking initiatives I mentioned, including four mix changes and one business model adjustment, we believe now the risk is under control and we have clear visibility of our capital requirements for the next two to three years. Our stock has been traded at less than 0.2x PV, and we have been continuously requested by investors to enhance investment return. Our ADS price, if you compare with our cash per ADS, is far lower. The market has not effectively reflected the operational cash on our book in our valuation. We hope to unlock hidden value behind our cash on hand by increasing our shareholder value through this dividend. If I explain why we arrived at this amount, why RMB 10 billion, this is how we arrived at it. First, we evaluated our future three years' development potential and how much capital we need to support this development. We also assumed, in this characterization, a reasonably large buffer to ensure our stable operation in the future. Therefore, this is why we arrived at RMB 10 billion. The size of the dividend may seem large considering our market cap, but I want to emphasize that it is only roughly 10% of our net assets. This is a reasonably good amount, I believe. And to answer your last question about asset quality, let me explain first what's going on with our consumer finance business. Their NPL ratio has been consistent at around 1.5%, 1.4%. If I explain the Puhui side, we said C-M3 net flow ratio for Puhui loans increased from 1.11% in the third quarter last year to 1.25% in the fourth quarter last year. This increase was mainly due to the reduction of our Puhui's outstanding loan balance and the temporary impact from our adjustment in our geography and direct sales restructuring. But in the fourth quarter, we see improvements in net flow. We believe that with the completion of all those restructuring measures, we will see gradual improvements of flow rate in the coming quarters. Also, you understand that the old portfolio that we booked before 2023 is of worse quality. That portfolio is now running off, so by the end of 2024, the legacy portfolio, accounts we booked before 2023, will take nearly 10% of total portfolio. In that sense, I think our gradual continuous improvement is undoubted.

Operator, Operator

Your next question comes from Richard Yu with Morgan Stanley.

Ran Xu, Analyst

A couple of questions from me. First of all, on capital gain, after the special dividend, what do you think the capital needs to support the growth of loans? Will there still be enough buffer given, obviously, most of the loans will be guaranteed by your own capital at the moment? So on the flip side, given the projection on the reduced loan volume, is there room to further reduce maybe the capital base and then do more special dividends with the smaller loan balance? Lastly...

Gregory Gibb, Co-CEO

You were just cutting off there. Could you just repeat the last two sentences?

Ran Xu, Analyst

Sure. I just want to say, like, one, are there enough capital to support the loan volume growth after the special dividend? And secondly, are there still potentially excess capital if the loan volume will be smaller? I mean whether there's opportunities for another release of dividends down the road. And then lastly is the funding cost trends that we're seeing at the moment. So, two on the capital. One is on the funding cost.

Gregory Gibb, Co-CEO

Richard, thanks. This is Greg speaking here. Overall, we have gone through, as YS was just laying out, quite a comprehensive process looking out over the next couple of years on expected industry trends, our relative growth trend, capital requirements, liquidity requirements, buffer, and the multiple licenses we operate under. We obviously have the guarantee license, and we have the consumer finance license, and we always keep our minds open for other licenses in the future. So after going through all of that, we arrived at a view on what we could release today that gives us still a very substantial buffer going forward over the next couple of years. Obviously, our outlook for the market right now is still quite prudent. We're still focusing on quality over quantity. But in a year or two, if the macro situation were to change and there were more opportunities, we've certainly retained enough capital that we can deploy in our current licenses to meet higher growth. Your question was whether or not there could be additional capital released down the road. We're not considering that for the moment. We want to keep our flexibility for maybe a more positive market outlook, let's say, 12 to 24 months down the road. I think our strategy here has been to provide the reward to make it meaningful and deliver it in a way that allows investors to choose whether they want to take some cash or effectively double down with the company by taking shares to make that a meaningful number today, while leaving the company flexibility to continue to do the right thing and capture opportunities going forward with sufficient capital buffer. In terms of funding costs, we did see funding costs over the last twelve months continue to come down. There have been two drivers of that. One has been the overall lower rate environment. The second, though, has been the change in the mix of our new business between guarantee and consumer finance. Consumer finance is able to tap the interbank market, and multiple funding sources have a lower net funding cost than the facilitation model with banks and trust companies. So as we continue to see the mix change towards a greater proportion of consumer finance, even though we don't think the rate environment will necessarily drop much in the foreseeable future, we do believe that our mix change will continue to slightly optimize the overall cost of funds in the model.

Yada Li, Analyst

This is Yada with CICC. And my first question is by Q4 '23, the company has completed the transition into the 100% guarantee model, but the bottom line was still under pressure. I was wondering what are the main causes and how long does it take before profits could be released? What are the main drivers for the profitability recovery? Secondly, for the consumer finance company, how was the profitability and the future development? How could we balance the growth of the SBO and consumer finance segments and which one could be the strategic focus? Lastly, are we considering additional buybacks? What is the main cost that we chose the special dividend instead of buying back?

Yong Cho, Chairman and CEO

Let me pick up your first question. This is YS speaking. The decline in new loan volume and the revenue we generate from the new book cannot offset the decrease caused by the overall contraction. Under the 100% guarantee model, as you know, we have to accrue much higher provisions which delay the profitability of our new business. However, on a single account basis, new loans enabled under the 100% guarantee model are delivering lifetime profitability, but we are facing record net accounting losses for the first calendar year due to higher account provisions. This is originally delaying our profitability. As for the main drivers of profitability recovery, I would say three things: first is portfolio credit performance, which we can measure by net flow rate; second is further optimization of what Greg mentioned, operating costs; and thirdly, the pace of new sales growth. We believe these three factors will predominantly determine our profitability recovery in the coming years. Regarding your last question about why we opted for special dividends over buybacks, we believe that considering our situation, dividends have several advantages. First, our ability to deliver returns to shareholders through buyback is limited because of low liquidity. Second, as a dual primarily listed company in the U.S. and Hong Kong, we maintain a public float of 25% mandated by Hong Kong listing rules. Our current public float is only less than 32%, limiting our buyback potential right now. Moreover, our dividends come with options for cash or scrip, providing more flexibility than buybacks for our shareholders.

Gregory Gibb, Co-CEO

Yes, Greg here. On consumer finance, basically, 2023 was the third full year of operation for the company, and it has been scaling up from scratch since the license was acquired. Therefore, 2023 is a profitable year for consumer finance. As the scale of that business continues to grow, its relative efficiency also improves. There remains some room for further scaling as the overall mix of the portfolio changes. The question of how do we balance this and what is our main strategic focus going forward: our main strategic focus and differentiation in the market continues to center around serving small business owners. However, consumer finance presents good opportunities to work through multiple channels to diversify our product offerings into providing smaller-ticket, shorter-term loans. This makes us more nimble in a dynamic environment, also allowing us to cater to small business owners whose individual needs may arise alongside their companies' financial needs. We intend to view these customers from a broader credit perspective. Our goal is to serve small business owners on a longer life cycle with ongoing touchpoints to better understand their needs and behaviors. Thus, while we maintain our SBO capability as a core focus, the mix between the Puhui model and consumer finance will increasingly continue to evolve toward a more balanced development going forward.

Xinyan Liu, Head of Board Office and Capital Markets

Thank you. This concludes today's call. Thank you for joining the conference call. If you have more questions, please do not hesitate to contact the company's IR team. Thanks, again.

Operator, Operator

Thank you. This conference is now concluded. You may now disconnect.