Earnings Call Transcript - LU Q1 2023

Operator, Operator

Thank you for joining us, and welcome to Lufax Holding Limited's First Quarter 2023 earnings call. I will now turn the call over to Ms. Liu Xinyan, the Company's Head of Board Office and Capital Markets.

Liu Xinyan, Head of Board Office and Capital Markets

Thank you very much. Hello, everyone, and welcome to our first quarter 2023 earnings conference call. Our quarterly financials and our briefings were released by our newswire services earlier today and are currently available online. Today, you will hear from our Chairman and CEO, Mr. Y.S. Cho, who will provide an update on our latest business strategy, the macroeconomic trends, and the recent developments of our business. Our co-CEO, Mr. Greg Gibb, will then go through our first quarter results and provide more details on our business priorities and the key drivers. Afterward, 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 be making forward-looking statements. With that, I now pleased to turn over the call to Mr. Y.S. Cho, Chairman and CEO of Lufax. Please.

Y.S. Cho, Chairman and CEO

Thank you for joining. As reflected in the first quarter, it is clear that macro and operating environments continue to pose challenges for many small business owners. However, we are encouraged by some indications of an economic bond, giving us cautious optimism in our U-shaped recovery. We remain committed to navigating the challenges that lie ahead and maintain our unwavering focus on building a more resilient business. We continue to exercise patience, prudence, and preparedness for the anticipated macro upturn in our SBO segment. Let me provide some updates for the first quarter. First, there are signs of a great recovery in the macro environment, though they remain unevenly distributed at a nascent stage. China's first quarter GDP growth expanding by 4.5% year-on-year indicates that the country is on track for its 2023 growth target of 5%. In addition, China's National Bureau of Statistics stated that the first quarter was a promising start to the macro recovery. However, Chinese industry profits declined 21% year-over-year, and we continue to see a divergence in the pace of recovery across industries. While small business owners are becoming more confident, it may take some time for macroeconomic tailwinds to flow through to our core SME segments. To give an example of this improving sentiment, a Peking University survey published in February showed that approximately 80% of SBOs are optimistic about their business outlook in 2023. Over half of the survey participants expect business volume increases of more than 50% this year. However, it is important to note that SBOs had less than 2 months of normal operations in the first quarter after the spike in COVID cases and the Chinese New Year holiday. It will take time for SBOs to fully resume new business investments, which underpins lending demand. Now let me talk about the impact on our business. I would like to start by showing our outlook on the U-shaped recovery. During the first quarter, we witnessed an improvement in credit rating mix and credit quality for new loans initiated in the last 2 quarters. 82% of new unsecured loans in the first quarter fell within our top 3 credit rating categories versus 41% a year ago. Year-on-year growth is increasingly concentrated in our preferred top-third and middle-third regions, which we believe will prove to be more resilient as the macro environment improves. Notably, the deterioration in asset quality has slowed down substantially in the first quarter. We have also witnessed early signs of improvements in asset quality in certain economically vigilant regions and industries. We expect that the flow rate will continue to improve gradually through the end of this year, as operations of SMEs gradually recover. We also expect that credit charge-offs for the risk-bearing loans will likely peak in the second quarter and then gradually decline in the second half of this year. In the second half, we do expect total credit costs to remain elevated, but the underlying driver will shift from past charge-offs to provisions arising from the increasing portion of loans for which we provide full guarantees. This will support net margins in 2024 and beyond as new growth and the portion guaranteed by us increase progressively over the next several quarters. We anticipate that revenues will decline at a slower pace than they did this quarter. By year-end, we expect the portion of loans that we bear risk as a percentage of the entire portfolio to exceed 40%. This ratio stood at 24.5% at the end of the first quarter. Our ability to focus more on new business is made possible by three factors: one, the improving macro environment; two, ongoing progress with funding partners for our deployment of the model where we provide the entire guarantee; and three, the recent completion of our frontline restructuring, which was difficult but necessary. As a result, the main drivers of our U-shaped recovery are taking shape. But as we have stated previously, we expect a notable recovery in profits to materialize in 2024. As part of our U-shaped recovery plan, we have implemented several strategic initiatives. We have completed the restructuring of our direct sales force and further optimized our headquarter and frontline operating costs. Total expenses, excluding credit impairment losses, finance, and other costs in the first quarter decreased by 21.5% versus a year ago. The total number of that exchange costs decreased from the end of 2022 to around the end of the first quarter. We managed to retain the most productive members of our direct sales team, whose average productivity is more than double that of those who departed. In line with our plan, 80% of new business in the first quarter came from top-third and middle-third regions versus 70% a year ago. Now that we have completed our organizational restructuring, we are focusing on several priorities. Firstly, we continue to increase the proportion of risk-bearing new loans under which our guaranteed subsidiary provides 100% credit enhancement. We are encouraged to see our funding partners support for the model where we provide the entire guarantee. Furthermore, as we deepen our position as an SBO adviser, we will focus on product diversification and cross-selling between our retail credit and customer finance business to meet customer needs. This will diversify our lending duration mix, gradually adding shorter duration products to our longer-term duration base. Finally, we continue to enhance our post-loan recovery efforts to claw back a portion of past credit losses. These key initiatives are supported by our continued investments in technology. During the first quarter, we deployed new technology to help us gain deeper insights into our small business owners’ daily operations. For customer onboarding, we strengthened our capabilities by further embedding facial, voice, and location verification features. As a result, we enhanced our ability to assess owners' business status. For the underwriting process, we introduced real-time assessment of customers' online marketing activities, allowing us to further evaluate their business momentum and repayment capabilities. These changes in the credit process are augmenting our historical individual credit assessments—KYC—with deeper insights into owners' businesses and industries—KYB. Next, let's move on to the capital markets. We successfully completed our Hong Kong listing by production on April 14, marking an important milestone in our corporate development. The listing will increase our exposure throughout the Hong Kong market and broaden our investor base to continue creating value for our shareholders. Additionally, we are pleased to announce that we paid out the second half of the 2022 dividend, an aggregate amount of USD 114.6 million, in April 2023, demonstrating our commitment to maintaining a stable dividend policy. Finally, as we heard in our last earnings call, we have substantially completed our regulatory rectification efforts, and the industry is now entering a phase of normalized supervision. We believe this normalized supervisory framework will provide greater stability and predictability for our industry, and we will work closely with regulatory authorities to ensure our compliance with all relevant regulations. I will now turn the call over to Greg for more details on our operating results.

Gregory Gibb, Co-CEO

Thank you, Y.S. I will now provide more details on our first-quarter results and our operational focus for this year. Please note all figures are in renminbi unless otherwise stated. In the first quarter of 2023, our top line and bottom line performance were adversely impacted by the challenging macro environment. Our total income was CNY 10.1 billion, representing a decrease of 18.2% compared with the last quarter of 2022. This was mainly driven by the decrease in new loans and the pricing pressure from our credit insurance partners. Despite the challenges on our top line performance, we did turn the corner and achieved profitability this quarter, with a net profit of CNY 732 million, primarily due to a decrease in credit impairment losses. Now let's dive into the details of our key drivers of the top line performance. One of the key drivers is our loan volume. In the first quarter of 2023, our new loans enabled were CNY 57 billion, representing a year-over-year decrease of 65%. This was mainly driven by our tightened credit standards on new loans enabled. Executing on our strategic initiative in response to the elevated credit impairment losses in the first quarter, we continue to prioritize higher-quality SBO customer segments concentrated in economically resilient geographies. The proportion of new unsecured loans enabled in the R1 to R3 customers, which are our top 3 rankings in our R1 to R6 scale, increased to 82% in the first quarter from 41% in the same period of last year. Meanwhile, the contribution from customers in the top third and middle-third regions continued to increase and reached 80% in the first quarter of 2023 compared to 70% a year ago. New loans were adversely impacted in the short run by the optimization of our direct sales team, which was difficult but necessary for the long-term development of the company. The optimization was completed in the first quarter, and we managed to retain the more experienced and productive members of our direct sales force. The average productivity of retained direct sales employees is more than double that of those who departed. We believe that we are on the right path, and we expect to see the results reflected in upcoming quarters. Additionally, we have observed that new loan vintages enabled after we tightened our credit standards demonstrate improved asset quality compared with older loan vintages. As we focus on higher-quality SBOs, the average ticket size has naturally increased as a result. The average ticket size of unsecured loans for the first quarter of 2023 increased to CNY 270,000 from CNY 240,000 average for the year of 2022. Our Consumer Finance business saw healthy growth in the first quarter despite the challenges in our retail enablement model. The total outstanding balance for consumer finance loans in the first quarter of 2023 was CNY 29.6 billion, up 39% year-over-year, and credit performance was in line with the industry credit performance. Contribution from our consumer finance business grew as a percentage of new loans enabled and increased from 11% in the first quarter of 2022 to 24% this quarter, further diversifying our product offerings. Another key driver of our top line performance is the take rate. As mentioned earlier, our take rate remains compressed, which is mainly due to the elevated premiums charged by credit insurance partners. Although our tightened credit standards have improved asset quality of new loans, credit insurance premiums have remained elevated to date. We are proactively addressing the take rate pressure by continuing to modify our credit enhancement arrangements. Under these arrangements, our guaranteed company provides full credit enhancement without the involvement of external credit insurance partners. We are encouraged by the fact that our funding partners are supportive of the shift; as of mid-May, 5 out of 6 Trust partners and 37 out of 78 bank partners have agreed to extend credit under the model where we provide the entire guarantee. In addition, 31 of our funding partners are already extending new loans under the model where we provide the entire guarantee. As a result, our credit risk-bearing balance in the first quarter further increased to 24.5% and is expected to exceed 40% by the end of this year. We believe we have adequate capital to support the increase in risk-bearing loans as the leverage ratio of our guaranteed subsidiary was less than 2x and, as of the end of the first quarter, well below the regulatory limit of 10x. As such, we expect our take rate to gradually improve over the next several quarters as we increase the guarantee portion for new loan business. Next, let's go to the details of our bottom line drivers. The main driver of recovery in our bottom line was a decrease in credit impairment losses. In the first quarter, credit impairment losses declined to CNY 3.1 billion from CNY 3.8 billion in the fourth quarter of 2022. This was mainly driven by a notable decrease in provisions compared with the previous quarter as we've taken a more conservative view on the outlook for credit quality prior to the post-pandemic reopening. As the macro environment gradually normalizes and activity picks up in the first quarter, we partially released a portion of the previously established provisions, which had a positive impact on our P&L. The improvement in our credit impairment losses is also visible in our C-M3 ratios, the forward indicator on asset quality that we monitor closely, which stood at 1% in the first quarter, remaining unchanged compared with the fourth quarter of 2022. This was primarily attributable to the increase of C-M3 for general unsecured loans from 1.1% in the fourth quarter of 2022 to 1.2% in the first quarter, but this was partially offset by a decrease in the flow rate for secured loans from 0.6% to 0.5%. While the asset quality of secured loans is clearly improving, it is worth noting the deterioration in asset quality of unsecured loans has slowed down substantially in the first quarter, and the delta of C-M3 flow rate was a 10 basis point increase versus a 20 basis point increase in the fourth quarter of 2022. We will continue to monitor close such indicators in the coming quarters as they are critical to determining the speed of our U-shape recovery. Looking ahead for the remainder of 2023, we expect credit impairment losses at each quarter to be on par with those during the first quarter. This is mainly due to our planned expansion of the model where we provide the entire guarantee during the coming quarters. The extension of such model will increase upfront provision levels but should result in improved net margins over the medium term. During the first quarter, we continued to make progress on our new SBO ecosystem. As a recap, our new value-added services platform, branded LuDianTong, is an open platform populated with digital operating tools and industry content to support business development for our small business owners. We intend to use this platform to engage potential customers at an earlier stage, deepen our interaction with existing customers, and create both new cross-sell opportunities and a new source of customer referrals. As of March 31, 2023, we had approximately 1.9 million registered customers on LuDianTong who had submitted their complete business or personal information, an expansion of roughly sevenfold from the end of 2022 and through this first quarter. As Y.S. mentioned, in the face of an uneven post-pandemic economic recovery, we are cautiously optimistic about realizing our U-shaped recovery. However, we will remain prudent on absolute levels of new growth until we see definitive improvement in overall lending demand and credit quality. While we expect to see gradual recovery in our core business metrics in the second half of this year, notable bottom line performance improvement is expected to be a 2024 event. I will now turn it over to David, our CFO, for more details on our financial performance.

David Choy, CFO

Thank you, Greg. I'll now provide a closer look at our first-quarter results. Please note, all numbers are in renminbi terms, and all comparisons are on a year-on-year basis unless otherwise stated. As Y.S. has mentioned before, our performance was impacted by the macro environment and our customer selection, resulting in a 41.8% drop in our top line total income to CNY 10.1 billion for the first quarter. Loss of total expenses decreased by 8.8% to CNY 9 billion, resulting in a net profit of CNY 732 million in the first quarter of 2023. During this quarter, our technology-based income was CNY 5 billion, representing an increase of 46.1% of our revenue. Our net interest income was CNY 3.3 billion, a decrease of 32.8%, and our guaranteed income was CNY 1.4 billion, representing a decrease of 25.5%. As a result, our technology platform-based income service fees as a percentage of total income declined to 49.7% from 53.7% a year ago. In addition, due to the increase of income from consumer finance loans, our net interest expense of total income actually increased to 33.2% from 28.8% a year ago. Furthermore, as we continue to better utilize our guaranteed company's abundant capital to bear more credit risk by ourselves instead of through our P&C insurance partners, we generated more guarantee income, reaching 14.1% of the total income compared with 11% a year ago. Our other income, which mainly includes account management fees, collections, and other value-added service fees charged to our credit enhancement partners as part of the retail credit enablement process, was CNY 227 million in the first quarter of '23 compared to CNY 704 million in the same period of '22. The change was mainly due to changes in the fee structure that we charge to our primary credit enhancement partner. Turning to our expenses, we continue to prudently manage our operational expenses. Our total expenses, excluding credit and asset impairment losses, decreased by 21.5% year-over-year to CNY 5.7 billion quarter. Returning to the operating efficiency, in the first quarter, our total expenses decreased by 11.8% to CNY 9 billion from CNY 10.2 billion a year ago. This decrease was primarily driven by sales and marketing expenses. Our total sales and marketing expenses, which mainly include expenses for borrowers and investor acquisition costs as well as general sales and marketing expenses, decreased by 32.4% to CNY 3 billion in the first quarter. The decrease was driven by three factors: first, a decrease in new loan sales and a reduction in commissions; second, a decrease in investor acquisition and retention expenses and referral expenses for platform services; and finally, the decreased general sales and marketing expenses, which was driven by the decrease in new sales. Our general and administrative expenses increased by 4.2% to CNY 756 million in the first quarter, mainly due to fixed costs, which decreased with lower volume. Our operating and servicing expenses decreased by 2% to CNY 1.6 billion in the first quarter, mainly due to expense controlling measures and decreased loan balance and new loan sales. Our credit impairment losses were CNY 3.1 billion in the first quarter compared with CNY 2.8 billion a year ago, an increase of 10.9%. This was primarily driven by the increase in indemnity losses as a result of worsening credit performance due to the economic environment, partially offset by the increase in recoveries driven by the pace of collections. Our finance costs decreased by 10.5% to CNY 189 million in the first quarter from CNY 211 million in the same period of 2022, mainly due to the increase of interest from bank deposits, partly offset by the increased interest spent driven by increased business rates. As a result, net profit for the first quarter was CNY 732 million compared with net profit of CNY 1.3 billion in the same quarter of '22. Meanwhile, our basic and diluted earnings per ADS during the first quarter were both RMB 0.30 or USD 0.04. On the balance sheet side, our balance sheet remains strong, and solid cash at bank products increased as of March 31, 2023, with a cash balance of CNY 51.3 billion as compared with CNY 43.9 billion as of the end of last year. In addition, liquid assets maturing in 90 days or less amounted to CNY 40.2 billion as of the end of March 2023. Our guaranteed subsidiary's leverage ratio is well below the regulatory limit of 10x. All this provides strong support for the company to maintain our dividend payout policy. That concludes my prepared remarks for today. Operator, we are now ready for the questions.

Operator, Operator

We now have our first question from Alex Ye from UBS.

Alex Ye, Analyst

My question is mainly about the pricing outlook. Could you provide some insight into the average loan pricing for our portfolio and the pricing for new unsecured loans? There are two parts to this question. First, regarding the regulatory front, we have been lowering loan prices over the last 2 to 3 years due to regulatory pressure. Are there any updates or comments from the regulators about our current position? Do you believe we have reached a pricing level that makes regulators more comfortable? Second, if we set aside the regulatory pressure and focus on the supply and demand dynamics for the SBO segment, should we anticipate further downward pressure on loan pricing, especially since we are upgrading our customer profile to attract better quality borrowers and the pace of economic recovery seems to be modest? I look forward to your thoughts.

Y.S. Cho, Chairman and CEO

Thanks, Alex, for the question. So far, we haven't received any further instructions from regulators about further rolling APR. If you look at the first quarter APR—the blended APR for all new loans in the first quarter is already less than 20%. Compared with other peers, our APR is lower than that of our competitors. We are in good shape in terms of our APR level. I believe we are meeting regulatory requirements and we also have more flexibility in adjusting our APR upwards or downwards whenever necessary. Our overall price is primarily determined by market demand and supply. Additionally, we consider our operating costs, which include funding costs and the credit costs, as well as sales expenses. Therefore, we don't think that the high-risk segment will necessarily lead to further revisions of our APR, as we are already below 20% for all loans. I do not expect any notable changes in terms of APR in the near future.

Operator, Operator

We now have our next question from Emma Xu of Bank of America.

Emma Xu, Analyst

I have two questions. The first one is about asset quality. On one hand, we see some encouraging signs in your portfolio as management mentioned earlier that there are already some green shoots in the business and you expect the flow rate to gradually improve in the coming quarters. However, on the other hand, we see the flow rate of your unsecured loans continued to increase in the first quarter while the total flow rate just remained flat quarter-over-quarter. Could you give us more discussion about the asset quality of your legacy loan portfolio? A related question is how is the collection of your charge-off loans, as the management also mentioned in the report that you are trying to increase efforts to recover past credit losses, which may contribute to the net profit in the future. So could you provide more details on this? The second question is about the loan demand. How is the loan demand so far? Is the high CGI cost the major reason limiting your loan growth in the first quarter? What’s your progress in moving to the 100% guaranteed model? Will we expect to see stronger loan growth in the second half once you move to this entire guaranteed model?

Y.S. Cho, Chairman and CEO

Thanks, Emma. The situation regarding asset quality has slowed down substantially in the first quarter. The C-M3 growth rate for total loans was 1.0% in the first quarter this year, which remained unchanged from the first quarter last year. However, if we consider that our loan balance has been declining month after month, we are analyzing this, and for example, if you only compare the accounts, whose milestone book is less than 6 months or 12 months, and if we remove the impact from declining balance on our net flow rate, then we can already see a trend of improvement. I believe we will see more evident progress starting from the next quarter. As the company continues to carry on new sales for credit plans, we observe an improvement in credit rating mix and credit quality for new loans initiated in the last two quarters. Yes, we had a large amount of charge-off last year, which is one of our focuses this year. We are now strengthening our cost recovery actions to claw back more from the past credit losses. To answer your question about loan demand, our loan demand depends on how our SBO customers perceive the future economy. Though we haven't seen any obvious change in the overall demand, it’s worth noting that our monthly new sales volume and our market share indicate that loan demand is not a concern since compared to the market size, our market share is very small. Thus, we don't worry about loan demand at this moment. The recent decrease in new loan growth was mainly driven by our tightened underwriting credit policy and also partially due to our GST reform. Regarding the 100% guaranteed model, we are making great progress. Our funding partners have provided good support for the model where we provide the entire guarantee; currently, 5 out of 6 trust partners and 37 out of 78 bank partners have agreed to expand credit under this model. In addition, 31 of our funding partners are already providing loans under this model. So we are making good progress, and I believe the transition can be relatively quick.

Operator, Operator

We now have our next question from Richard Xu of Morgan Stanley.

Richard Xu, Analyst

I have questions regarding funding costs. I am wondering what the funding cost is at the moment, especially as we change from the insurance model to the guaranteed model? What is the overall impact on take rate and what should we expect the level to stabilize at once the shift to the guaranteed model is largely complete?

Gregory Gibb, Co-CEO

Thank you, Richard. It's Greg here. If we look at the funding costs, it stands at about 6% overall. They have decreased about 30 basis points year-on-year in the first quarter. As we shift to the 100% guaranteed model, we are not seeing much change in that funding cost. In fact, we are likely seeing the market more broadly coming down. Therefore, any shift to the guaranteed model is not having a net impact in terms of funding cost increase. We think it will be quite stable as we look forward through the remainder of the year. On the take rate, if you look historically, our take rates have been in the sort of 8% to 10% range. Recently, due to the higher credit guarantee insurance costs, that take rate is closer to about 7% to 8%. As we move to the 100% guaranteed model, over the next 1 to 1.5 years, as more of the portfolio becomes 100% guaranteed, the credit premiums formally paid to our CGI partners will instead be earned by us. This number was historically about 5% to 6%. So if you take a base today of 7% to 8%, which is somewhat compressed due to higher CGIPs, and we shift to the guaranteed model, you should expect a stabilized long-term take rate of about 14%. We think that’s where things will end up in about 1.5 years from now when we've completed more of the transition.

Yada Li, Analyst

This is Yada from CICC. My question today is regarding the risk-bearing percentage. I was wondering what the trend of this percentage is going forward and how to view this change and its potential impact on our top line, credit impairment losses, and the bottom line.

Gregory Gibb, Co-CEO

In terms of the risk-bearing percentage, as of the end of this first quarter, it was about 24%. We expect this to exceed 40% by the end of the year on a portfolio basis. This means as you move through the second half of the year, a much higher percentage will be under this 100% self-guarantee model. As we go through this process, similar to the question that Richard just asked, this will increase our top line revenue because you're shifting what was previously paid to credit guarantee insurance partners onto our balance sheet, and consequently, the revenue will come with it. While we take on more credit risk, we initially have to provision for the new loans, front-loaded in the model. So, you'll see in our overall credit impairment costs, we had credit impairment costs in Q1 of CNY 3.1 billion. We expect this number to remain stable in the next couple of quarters, but as we move into the second half of this year, more of it will reflect the new business, which carries a higher percentage of self-guarantee. While this leads to a higher upfront cost, and if we look forward into 2024, it should improve our net margin. You’re shifting from very high credit insurance costs today of over 10% to a model where we think the new business will perform more in line with our historical levels. This should be constructive for our 2024 profitability.

Operator, Operator

There are no more questions on the line. That concludes our question-and-answer session for today. I will now turn the call back over to our management for closing remarks.

Liu Xinyan, 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

This concludes today's call. Thank you for joining. You may now disconnect your lines. Thank you.