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Morningstar | Macroeconomic and Regulatory Headwinds Conspire to Reduce FlexiGroup's FVE

A deteriorating macroeconomic outlook and a new era of stronger regulatory scrutiny over financial services result in a downgrade in our fair value estimate for no-moat FlexiGroup to AUD 2.05 per share from AUD 2.65. We think the wealth effect of recent house price declines combined with macroeconomic indicators like Australia’s low saving ratio and continuing low wage growth point to lower future retail spending. Although the company’s investments in reducing its operating cost base by AUD 8 million annually as well as investments in digitising and simplifying its business began to bear fruit in the second half of fiscal 2018, we believe it will not be enough to offset the recent negative macroeconomic and regulatory headwinds. At our new fair value estimate, the stock trades on a fiscal 2019 price/earnings ratio of 8 times and a dividend yield of 3.8%. On a longer-term view the stock appears undervalued, trading on a fiscal 2019 P/E of about 5.5 times but with more near-term macroeconomic and regulatory risks.

We forecast underlying net profit after tax of AUD 95.1 million in fiscal 2019 from the previous AUD 96.9 million, at the lower end of the company’s guidance of AUD 95 million-100 million. Macroeconomic headwinds and stronger regulatory scrutiny result in a more material reduction in fiscal 2020, with forecast underlying NPAT of AUD 88.4 million reduced from AUD 99.1 million. At its Dec. 4 meeting, the Reserve Bank of Australia indicated that household consumption is currently stable but was a source of uncertainty because wage growth remained low, debt levels were high, and house prices had declined. House prices have fallen 9% in Sydney and 6% in Melbourne from their respective peaks. Despite this, the RBA’s central case is for steady growth in consumption supported by a strengthening labour market and a gradual pickup in wages. We have taken a more negative view, expecting lower consumer spending growth in fiscal 2019 and 2020.

We expect lower retail spending in combination with continuing fierce competition between nonbank financiers and increased regulatory scrutiny to reduce revenue and increase operating costs and be the key drivers of lower earnings. However, the company is in a better position to address these headwinds following investments in recent years in digital solutions, simplifying the business and reducing operating expenses. It now also has an active customer base of over 1 million (increasing 5% in fiscal 2018) and about 46,000 retail partners (increasing 8% in fiscal 2018). Its core Certegy business also showed marked improvement in the second half of fiscal 2018.

Certegy has been one of the company’s key disappointments in recent years, with management recognising the main issue being a lack of investment in digital technology. In the last few years its investment in digitising Certegy has resulted in 60% of all contracts being settled digitally end-to-end in fiscal 2018 where previously there were none. In the second half of fiscal 2018 this resulted in digital acceptances occurring in 3 minutes compared to 10 minutes and retail partners receiving settled funds with 24 hours as opposed to 7 days. This now better positions Certegy to capitalise on the rapid growth in buy-now-pay-later financing of recent years. There are already tangible signs of improvement, with Certegy volume growing about 10% in the second half of fiscal 2018, the highest second-half volume growth it's ever recorded. Certegy also has an exceptionally high net promoter score of above 50, all of which should set it up for the important Christmas shopping period.

We expect the company’s Australian cards business to be another source of future earnings growth. This business has been able to increase volumes and receivables well above systemwide growth, with receivables increasing about 34% in fiscal 2016, 55% in fiscal 2017, and 34% in fiscal 2018. However, this has not translated into strong NPAT growth yet due to the long interest-free periods on the cards and problems with collections in 2018. The company is already investing in improving collections, and we expect more receivables will progressively become interest bearing, which should help drive higher NPAT in this business. The company is targeting receivables growing to AUD 1 billion by fiscal 2020. However, due to the noted macroeconomic headwinds and more recent regulatory scrutiny on credit cards, we forecast receivables not reaching this target until fiscal 2021-22. One of the recent regulatory headwinds include the Australian Securities and Investments Commission's announcement in September 2018 that credit providers must, before issuing a credit card or credit limit increase, ensure that the customer can repay the credit within three years to meet responsible lending obligations under the National Credit Act.

Other regulatory obstacles include the recently instituted Senate inquiry into financial services targeting Australians at risk of financial hardship and ASIC’s recent investigations into buy-now-pay-later products. The Senate inquiry is focusing on areas not covered by the Financial Services Royal Commission, such as payday lenders, short-term credit providers, consumer lease providers, buy-now-pay-later providers, and debt management and personal budgeting firms. The Senate inquiry was instituted Oct. 17 and has had one day of hearings on Dec. 12. So far, the hearings have focused primarily on payday lenders and personal budgeting firms, and FlexiGroup has yet to face any direct fallout from the inquiry. However, another day of hearings is scheduled for Jan. 22, 2019 (with an agenda yet to be published). The political risks are also high given that the final report is due on Feb. 22, 2019, a few weeks after the Royal Commission final report and in the lead-up to the next federal election expected in May 2019.

We believe ASIC’s November 2018 report on buy-now-pay-later arrangements (Report 600) was generally not a major impediment to FlexiGroup’s Certegy or Oxipay businesses. Importantly, ASIC indicated in this report that it had not yet formed a view on whether buy-now-pay-later arrangements should be subject to the National Credit Act. This is a major win for providers because coming under the National Credit Act would mean complying with, amongst other things, responsible lending obligations and linked credit provider provisions. At the very least this would likely result in less user-friendly onboarding, which would likely affect the growth in receivables. However, even if ASIC eventually determines that these providers need to come under the National Credit Act, FlexiGroup is likely better placed than other buy-now-pay-later competitors as it already has credit licence under the act and already complies with the responsible lending obligations and linked credit provider provisions with respect to its credit card products.

Nevertheless, these buy-now-pay later products are expected to come under ASIC’s product intervention powers. This increases the risk of more proactive regulation by ASIC on the distribution of these products if ASIC believes they may result in harm to consumers. FlexiGroup is also currently in negotiations with the Credit and Investments Ombudsman (now the Australian Financial Complaints Authority) with respect to the now discontinued FlexiRent product. These are legacy issues relating to alleged noncompliance with responsible lending requirements, and the company has already included a provision of AUD 7 million for them.