Earnings Call Transcript - QFIN Q2 2021

Mandy Dole, IR Director

Thank you. Hello everyone and welcome to our second quarter 2021 earnings conference call. Our results were issued earlier today and can be found on our IR website. Joining me today are Mr. Wu Haisheng, our CEO and Director; Mr. Alex Xu, our CFO and Director; and Mr. Zheng Yan, our CRO. Before we begin the prepared remarks, I would like to remind you of our Safe Harbor statements in our earnings press release, which also apply to this call. We may refer to forward-looking statements based on our current plans, estimates and projections. Also, this call includes a discussion of certain non-GAAP measures. Please refer to our earnings release for a reconciliation between non-GAAP and GAAP ones. Last, unless otherwise stated, all figures mentioned are in RMB. I will now turn the call over to our CEO, Mr. Haisheng.

Haisheng Wu, CEO

Hello, everyone. I am very happy to report another quarter of record-breaking operational and financial results. During the quarter, financial institutions originated RMB88.5 billion loans through our platform, marking another record high, up 50% year-over-year and 19% quarter-over-quarter after reaching the RMB100 billion milestone in Q1. Outstanding loan balance continued to grow to RMB111.6 billion in Q2, up 50% year-over-year and 15% quarter-over-quarter. Total revenue was RMB4 billion in Q2, up 20% year-over-year and 11% quarter-over-quarter. Non-GAAP net income was RMB1.62 billion, up 71% year-over-year and 15% quarter-over-quarter. Despite a continuously changing macro and regulatory environment, we've delivered five consecutive quarters of record-breaking results. Over the past few years, we have built a comprehensive operational system that demonstrates remarkable resilience through cycles. To be more specific, our diversified user acquisition channels and scenarios allow us to effectively benefit from any volatility from a particular channel. Our extensive network of diverse financial institutional partners gives us sufficient flexibility in terms of funding cost, geographic coverage, and pricing. Our improved risk management capabilities allow us to target different user segments with effective pricing based on different market dynamics. Our access to some key financial licenses at ecosystem bridge capacity allows us to comply with the average changing regulatory environment. Over the last six weeks also, QFIN along with other Chinese ADRs has experienced extreme volatility in the market. While there are several risk factors triggered such as share price movements with the risk of the market overreacting to the elements and ignoring the solid fundamentals and strong growth prospects of QFIN. As such, after evaluation with the approval of our board, management decided to launch a share buyback program. The company intends to repurchase up to US$200 million of its ADR through open market or other forms of transaction over the course of the next 12 months. We believe that in the current market conditions, share repurchase offers an extremely attractive opportunity to restore our cash and to generate great returns for our shareholders. We continue to make progress on multiple strategic initiatives and gradually unlock tremendous growth opportunities. We made significant progress on our diversified user acquisition strategy. Our customer base continued to expand, and customer quality improved. Our embedded finance model drove significant growth. The number of new borrowers in Q2 peaked at the highest level in the past six quarters at more than 10% sequentially. The number of SME borrowers acquired offline also increased significantly. Our embedded finance model contributed close to 40% of our new customers with approved credit lines in Q2. So far, we have established cooperation with 22 leading traffic platforms, with another eight in the pipeline. Our SMEs finance business also achieved breakthrough performance in Q2 by establishing ties with leading industry partners and optimizing the credit approval process and policies. Total amount of new approved credit lines increased 22% quarter-over-quarter to RMB7.1 billion, and outstanding loan balance increased 45% sequentially with our ticket size exceeding RMB250,000. Meanwhile, we're rolling out new loan products catering to the specific funding needs of different industries. In July, we launched a tobacco business and have served more than 700 offline tobacco business owners. In the second half of this year, we plan to launch other industry-specific loan products targeting cross-border ecommerce supply chain finance as well as agriculture and forestry sectors. Loan facilitation under the capital-light model accounted for roughly 56% of total volume in Q2, and for the month of July, capital-light accounted for nearly 60%, almost reaching our full-year goal for our tech upgrading strategy. For our smart marketing product, I see Intelligence Credit Engine, the number of active users increased 74% quarter-over-quarter. The transaction volume and outstanding balance both went up by 36%. As for the recent regulatory change, we want to share our feedback here. As one of the 13 leading internet companies at the April 29 regulatory meeting, we have maintained regular communications with regulators. Currently, the sales assessment and related ratification processes are moving forward in an orderly manner. We fully understand the regulators' requirements and expectations for the industry. Our business is relatively focused and has a clear path towards full compliance with regulatory requirements. We don't have online payments, online insurance, or online brokerage operations, which have stepped up to more restrictive regulations. For our loan facilitation business, we don't engage in joint lending nor have overlapping over-leveraged ABS insurance. Thus, we are highly confident we will satisfy all of the revised regulatory requirements when everything is finalized. As you may already know, the proposed new regulation will not allow loan facilitation platforms to provide credit assessment-related data directly to financial institutions, and such data transfer must go to a licensed accredited agency. We have preemptively communicated with the regulators to understand the policy direction and to make necessary preparations. We plan to take multiple actions to satisfy this new regulation. On one hand, we can cooperate with existing third-party credit agencies. On the other hand, we can also seek partners to jointly launch a new credit agency. Recently, some media reports indicated that the regulator will require consumer finance companies to implement a 24% interest rate cap for consumer lending. This aligns with the regulator's long-term agenda to support the real economy by lowering financing costs for consumers and SMEs, and is also consistent with our long-term business planning. Our own balance sheet loan and SME loan business are already priced below 24%, while our consumer facilitation business, even under a more restrictive stress test where we assume to cut our pricing to below 24%, we do not expect this price cut to have a significant impact on our operational and financial results in 2021. For 2022, it will be a transitional year when the entire industry will comply with the 24% rate cap by June. In our stress test, we continue to see healthy volume growth in 2022, and our net take rate should be around 3%. There were also some positive factors that may mitigate the negative impact from the 24% rate cap. With lower pricing, we should be able to develop partnerships with larger national banks that typically offer more stable funding at lower costs. Additionally, with all of our assets at or below 24%, we should be able to significantly increase the issuance of ADS, which carries a much lower funding cost of around 5% to 5.5% versus around 7% from banks. Furthermore, at lower pricing, we can attract more high-quality borrowers, which will naturally drive down overall credit costs by 1% to 2 percentage points. Finally, based on our experience, lower pricing normally boosts borrower activities, retention rates, and lifetime value. To conclude, we believe that more prime customers and better quality financial institutions will come along with lower-priced products. This will ultimately enhance our operational efficiency and make our business more resilient and sustainable. Such change may set up a solid base for us to accelerate post-2022. We feel quite optimistic. I would now like to address the temporary removal of our 360 DigiTech app from app stores. The removal was due to our product engineer overlooking one of the functions required by the regulators. We have already fixed the issue, and our app has been restored to all major app stores today. We have conducted a thorough internal review and improved our operating protocol to ensure such incidents never happen again. Thanks to our diversified customer acquisition channels and the balance of our product, the impact from the removal on our operations has been minimal. During the quarter, we continued to diversify our funding sources. We accelerated the pace of ABS issuance with a total of RMB2.1 billion in Q2 at an average coupon rate of 5.3%, which has brought our total ABS issuance to RMB3.1 billion so far this year, ranking us number four in the market. As our risk management system supports more business, we continue to see further enhancements in our asset quality. The 90-day trust delinquency ratio across our platform was 1.19%. The M1 platform rate remained stable at 90.8%, with a day-one delinquency rate of 5%. We continue to expand the scale of our collaboration with KCB. The total accumulated loan facilitation volume as of Q2 was RMB33.5 billion. Outstanding balance was RMB20.4 billion at the end of Q2, up 66% from Q1. We expect the scale of the KCB partnership to remain relatively stable for the time being. We have deep-rooted trust and great flexibility in our collaboration with KCB. Going forward, we will proactively explore new product and business opportunities through our collaboration with KCB. We made some good progress on the ESG front, which is drawing more attention. In the recent event this July, we took swift action to support by donating RMB20 million through the 360 Foundation. Meanwhile, we organized the local team to join the rescue efforts. We're quite satisfied with our performance in the first half of 2021. This fruitful result comes from the dedicated efforts of our excellent team. I would like to express my gratitude for their hard work. Great companies are always in great change. We have successfully demonstrated our capabilities and ambition over the past five years. Financial services is a vast market with huge potential, and financial technology products have profoundly changed the financial service landscape and user experience. We will continuously launch innovative products and are dedicated to becoming the premium player in this market. Now let me turn to our CFO, Alex, to run through more detailed information. Thank you.

Alex Xu, CFO

Thank you, Haisheng. Good morning and good evening, everyone. Welcome to our quarterly earnings call. For the interest of time, I will not go over all the financial line items on the call. Please refer to our earnings release for the details. As Haisheng mentioned, we delivered robust operating and financial results for the first half of 2021, powered by strong consumer demand for credit and further improvement in asset quality. The strong business momentum appears to be continuing into the current quarter. In fact, we have seen record-breaking volumes in recent months, despite some reported softness of microeconomic activities lately. Total net revenue for Q2 was RMB4 billion versus RMB3.6 billion in Q1 and RMB3.34 billion a year ago. Revenue from credit-driven services on a capital-heavy basis was RMB2.4 billion compared to RMB2.45 billion in Q1 and RMB3.08 billion a year ago. The year-over-year decline was mainly due to a facilitation volume mix change, as capital-heavy contributions decreased significantly. Revenue from capital-light services was RMB1.6 billion compared to RMB1.15 billion in Q1 and RMB259 million a year ago. The robust growth was mainly driven by the exceptional progress we have made in capital-light and other technology solutions. During the quarter, capital-light and other technology solutions contributed roughly 56% of total loan volume while the underlying take rates were relatively stable. We expect the capital-light contribution percentage to continue to increase in the second half and to reach roughly two-thirds of our total volume by year-end. During the quarter, the average pricing was 27.2% compared to 26.6% in Q1 and 27.2% a year ago. Assuming the reported 24% rate cap guideline is implemented across the industry, we expect pricing to gradually trend downward in mid-2022 to satisfy the rate cap requirement. In our stress test, even under the more restrictive and steep rate cut scenario, where we assume we cut the rates to below 24% starting from September 1st, we should still be able to maintain housing growth and profitability in the transitional year of 2022 and resume to a more robust growth thereafter. As macroeconomic activities picked up in China in the first half, demand for internet traffic also increased significantly along the way. In addition, we also proactively accelerated the pace of customer acquisition in the last couple of quarters to take advantage of the overall positive business trend. As such, we have experienced some uptick in sales and marketing expenses. The average customer acquisition cost on the consumer lending side for the quarter was about RMB237 compared to RMB206 in Q1. As we discussed in the past, average cost per approved credit line is a calculated number with limited value in our decision-making. We will continue to use life cycle ROI and LTV as key metrics to determine the pace and scope of our customer acquisition strategy. So far in 2021, ROI trends have encouraged us to take a more proactive approach to accelerate the growth of our customer base. Non-GAAP net income was RMB1.61 billion in Q2 versus RMB1.41 billion in Q1 and RMB942 million a year ago. We once again set a new record in quarterly profitability, driven by higher facilitation volume and noticeable improvement in asset quality. The effective tax rate was approximately 18% for the first half of 2021. We see a similar level of effective tax rate for the rest of the year. Longer term, we are expecting our normalized effective tax rate to return to approximately 15%. As we move towards a more technology-driven business model, we continue to see marked improvement in operating margins as increasing contributions from capital-light and other technology solutions generally lead to higher margins. Overall, we expect profitability growth to keep pace with the facilitation volume growth throughout this year. With strong operating results and increased contributions from the capital-light model in Q2, our leverage ratio, which is defined as risk-bearing loan balance divided by shareholders' equity, further declined to 4.8 times from 5.4 times in Q1 and 8.3 times a year ago. We expect to see continued de-leveraging in our business driven by further movement towards our capital-light model and solid operating results. Total cash and cash equivalents were RMB8.8 billion in Q2 compared to RMB9.2 billion in Q1. Non-restricted cash was approximately RMB5.2 billion in Q2 versus RMB6 billion in Q1. The modest decline in cash was mainly due to a more proactive deployment of cash in our operations to support ABS and the pre-ABS assets, which generate higher returns. Meanwhile, a significant portion of our cash was allocated to security deposits with our institutional partners and registered capital for different entities to support our daily operations. As we continue to generate strong cash flows through our operations, we believe our current cash position is more than sufficient to support the expansion of our business, invest in key technologies, and satisfy potential regulatory requirements. Therefore, we believe it is a prudent decision to use some of our free cash to invest in our own stock, which is priced at just around the company's liquidation value. For a company that is still generating healthy growth for the next few years, we believe it is a great bargain. Finally, let me give you an update about our outlook for 2021. The operating results for the first half of 2021 were very encouraging, and the momentum hasn't slowed so far this current quarter. Although we intend to keep our tradition of a conservative approach in providing forward guidance, the numbers start to speak for themselves. As such, we would like to raise our 2021 total loan volume guidance to be between RMB340 billion and RMB350 billion compared to our previous guidance of RMB310 billion and RMB330 billion. The revised guidance represents year-over-year growth of 38% to 42%. As always, this forecast reflects the company's current and preliminary view, which is subject to material changes. With that, I’d like to conclude our prepared remarks. Operator, we can now take some questions.

Operator, Operator

Thank you, management. Our first question is from Richard at Morgan Stanley. Please go ahead.

Richard Xu, Analyst

Basically, two questions from me. One is on the borrowing information through the credit scoring agencies, any detailed discussion on the actual process because it's been a little while. And you mentioned further discussion and different versions are out there. Just want to see what is the latest development on that front? Secondly, it’s obviously very good loan volume, any discussion with regulators regarding their views or guidance on the appropriate pace. Thank you.

Haisheng Wu, CEO

So for the trust version of regulation on the administration of credit assessment business, it was announced and we have been communicating with regulators for a long time that currently there is no standard solution available in the market. Also, as Mr. Zheng has mentioned, there are two or three solutions we care about. The first one is that we apply for a credit agency to launch a new credit agency. And the second one is to cooperate with existing credit agencies to continue our business. Also, with our in-depth cooperation with KCP, which offers us another alternative moving forward. Whatever solution we adopt in the end, the process of product might be different; however, it will not affect our risk management results and models. So for your second question regarding our growth rate, we see that growth is not the problem. The regulators focus more on the standardization of the product and our business. We have seen that in the requirements set forth by the regulators that they want the internet platforms to sustain growth and support the real economy continuously.

Operator, Operator

Our next question is from Alex Ye at UBS. Please go ahead.

Alex Ye, Analyst

I'll translate my question. Firstly, on the regulatory developments, it looks like the current direction from the regulators is to continue to tighten the perks related to data collection by the internet. So I'm wondering, assuming the regulators issue more stringent regulations on consumer data collection and usage in the future, how would that affect our current practices? Secondly, what is your plan regarding the 20% interest rate cap? So you mentioned that in your stress test, you are going to comply fully with the cap by September, but if we stress that, how does your base case or target trajectory align with this new cap? Finally, market concerns about the 20% cap indicate it may only be the beginning of more regulatory requirements that could further pressure overall lending rates. Do you have any comments on that, especially given your ramp-up of the SME loans? We appreciate your insights. Thank you.

Haisheng Wu, CEO

Thank you, Alex, for your questions. Regarding the data capture and usage issue within the industry, we think there are two basic principles from the regulators' side. The first is the minimum standard for data capture. In addition to capturing data from the customer side, such as forecasting before applications, we are actively working with third-party credit agencies for industry standards. The second principle is that customer authorization is mandatory before data capture. As you may know, our 360 account application was removed from app stores due to these issues. We will place greater emphasis on this principle moving forward. We believe that with our relatively standard process, the impact of these regulations will have minimal effects on our business. Regarding your second question, the timeline for all-in interest rate caps at 24% has different timelines for different institutions. Some institutions will follow the guideline that the outstanding balance of loans over 24% will be reduced to zero by the end of June next year. Others will follow guidance that no new originations will be allowed by June next year. We will comply with these requirements accordingly. As for your third question, while the regulators aim to minimize interest rates, they have not set standards similar to those in the consumer finance industry. Although some concerns have arisen about further regulatory involvement, we do not think the current 24% interest rate cap will decrease further. Thank you.

Operator, Operator

Our next question is from Jacky Zuo of China Renaissance. Please go ahead.

Jacky Zuo, Analyst

So let me translate; congrats on these strong results. My first question is related to regulation as well. For the 24% interest rate cap mentioned in the stress test for next year, regarding the margin likely declining to 3%, I would like to understand the assumptions behind this test concerning APR, funding costs, credit card costs, and other expenses. Additionally, is there any chance we can see an offloading of APR in the third quarter? My second question is about estimated loan products. We've seen competitors moving into this new business as well. How do we plan to differentiate our SME loan products, what are our expected APR margins and growth targets this year, and is this SME loan included in our updated guidance? Thank you.

Haisheng Wu, CEO

Thank you, Jackie. Regarding your first question about the stress test, actually what we have delivered now is a relatively static test, with all other factors held constant, especially with no improvement in our efficiency. We expect that there will be no changes in costs for this version of the stress test. However, we know that there will be some improvements in our cost; for example, our funding costs have shifted as we now derive a larger portion of our funding from larger national banks, combined with an increasing ABS volume. Therefore, we expect our funding costs to lower approximately by 1%. We also anticipate a reduction in our credit loss expectations by around 1%. The answer to your third question is, yes, we have started with a lower APR target for the third quarter. While the APR will decrease, we do not expect it to significantly impact our financial results in the next quarter. Regarding your second question about SME loans, there are two aspects to our strategy. First, regarding risk management, our SME business operates differently from traditional operations because we focus more on the SME side. Traditional SME loans, for example, those exceeding RMB10 million, are not fully data-driven. However, we evaluate on an individual and corporate basis with average ticket sizes of RMB250,000. Our accumulated experience in risk management from consumer finance is highly beneficial. Our cooperation with KCP also gives us an advantage, as we are one of three platforms in the Chinese market with deep collaborations with banks. Therefore, we believe we have an edge regarding data and funding costs for the SME business. For our growth target this year for SME loans, we anticipate they will account for around 10% to 15% of our total loan origination and that this is indeed covered in our guidance.

Alex Xu, CFO

Okay. Jackie, just a few clarifications and additions to Mr. Wu's comments. First, the 3% is not a margin; it is the take rate. Our net margin this quarter was 40%. If anything, over the next couple of quarters, we are likely to see some expansion in our net margins compared to Q2. The 3% is the take rate on the loan balances. We've been saying this in the past. Secondly, regarding the pricing trend in the second half, even though our stress test anticipated more drastic cuts beginning September 1, the situation won't work out that way in practice. Just as Haisheng mentioned, it really depends on the pace at which our financial institution partners progress. Most likely, the trend will be gradually down toward that goal by the end of June of next year. If you spread the calculations over the coming quarters, you might see marginal changes in pricing. Finally, regarding how we expect to achieve the 3% take rate, we've taken a back-of-the-envelope calculation. If we assume our current mix is about 60%-70% capital-heavy versus a much lower capital-light component, we see the pricing on the capital-heavy side needing to drop about 2% while our capital-light side might need to see a approximately 6.5%-7% decrease. The overall reduction, however, represents what will be shared with us since we only take part in the capital-light business. Overall, those reductions shouldn't create any significant impact on our loan volumes, pricing, or overall growth in 2021. You can calculate that based on our full-year guidance. The pricing changes along with operational efficiencies will yield a net positive result. Thank you for your questions.

Jacky Zuo, Analyst

That's very clear. Thanks, guys.

Operator, Operator

Thank you so much. That's the end of the Q&A session. I would like to hand it back to management for closing remarks.

Alex Xu, CFO

Okay. Thank you, everyone, for joining our conference call. If you have any additional questions, feel free to contact us. Thank you.