Should You Buy Into This IPO?

On Dec. 13, Chinese "unicorn" (a term referring to a company with private market valuations over $1 billion) OneConnect Financial Technology will be selling American depositary shares (ADS) on the New York Stock Exchange in an initial public offering. OneConnect (which will trade under the ticker symbol OCFT) is the financial cloud technology platform developed internally by Chinese insurance giant Ping An (PNGA.Y 3.76%).

In the offering, OneConnect will be selling 36 million ADSes, each equaling three shares of the company, for a price between $12 and $14, which will raise up to between $438.2 million and $504.6 million. The share sale will equate to about 9.7% of shares outstanding, creating a valuation for the company of around $4.86 billion at the midpoint.

This valuation is far below the $8 billion valuation the company was seeking earlier this year. In fact, the new valuation will be a huge 42% decline from a 2018 Softbank-led $750-million funding round that valued the company at $7.5 billion, meaning this will be the rare and dreaded "down round" IPO. OneConnect had initially sought to go public on the Hong Kong exchange, but in light of the political turmoil there, it turned to a U.S. exchange instead.

Unfortunately, recent public performances of other hyped-up unicorns have been terrible, with WeWork's IPO cancellation being the worst. Now companies such as OneConnect are receiving pushback on valuation, especially as the company is still incurring large losses -- albeit with impressive revenue growth.

However, in contrast to some other recent IPOs that have disappointed investors, I think OneConnect's potential is actually the real deal.

OneConnect is Ping An's financial technology platform. Image source: Getty Images.

OneConnect's powerful platform

OneConnect is a broad technology platform that serves Chinese banks, asset managers, and insurance companies, as well as those in other Asian countries. OneConnect's products are a combination of infrastructure, platform, and software-as-a-service housed on its own cloud platform. The company currently has 12 "solutions" it offers these industries, with two more on the way in 2020, in the following categories:

• Sales and marketing software: Bank, insurance, and asset-management companies use these products, all programmed with artificial intelligence for efficiency and targeting, to track leads, train agents, and market products to customers.
• Product development software: Bank, insurance, and asset-management companies use these products to digitize their businesses. For example, auto insurers can use image recognition to deliver claims estimates in minutes with just a photo. Asset-management companies can use tech tools to digitally bundle loans into an asset-backed security. Companies with few IT resources can also build websites and apps through these product tools. 
• Risk management: Bank, insurance, and asset-management companies can use OneConnect's big data and AI platform to detect fraud and develop credit models informed by AI and Ping An's 30 years of industry data.
• Operations: These product categories manage asset-liability, AI-powered customer service, and regulatory technology (coming in 2020) to streamline regulatory compliance.
• Technology infrastructure: This involves product categories related to core systems, Gamma-O (an open API platform-as-a-service), blockchain-as-a-service, and cloud management (coming in 2020).

The company isn't just tooting its own horn when it comes to tech leadership. OneConnect has won 15 awards -- including two from Stanford University -- in the fields of AI and blockchain. For instance, OneConnect won Stanford's first AI Algorithm + Cloud Computing global competition this year, in which teams built AI algorithms to identify 50,000 images. OneConnect's algorithm was the fastest. In blockchain, OneConnect's FiMax technology won the FinTech Ranking Real Result award from leading tech research firm IDC.

Breakneck growth

This tech leadership is showing up in OneConnect's impressive customer and revenue numbers. Some might think customers would hesitate to use OneConnect, given that they would be paying for the services of a potential competitor in Ping An -- not unlike a retail store using Amazon Web Services. But that hasn't stopped OneConnect from earning the business of 99% of Chinese banks and 46% of Chinese insurance companies, which appears to prove the usefulness, cost-saving properties, and ease of use of OneConnect's products.

OneConnect also recently expanded to Hong Kong, Japan, Singapore, Thailand, Indonesia, Malaysia, and the Philippines just in the past two years, showing eager adoption even outside of China.

Total customers have more than doubled from 1,600 at the end of 2016 to 3,500 at the end of 2018, though keep in mind that many smaller institutions pay OneConnect little or no money -- at least to start. The company gets most of its revenue from a smaller subset of "premium customers," which pay OneConnect more than RMB 100,000 per year. The number of premium customers grew from 40 in 2017 to 221 in 2018, an increase of 5.5 times. At the same time, the net expansion rate for premium customers was 167%, meaning that existing premium customers increased their spend with OneConnect by two-thirds over the past year. This strong expansion rate is due to 77% of OneConnect's revenue being tied to customer usage, rather than a flat subscription. For instance, a customer may pay according to the number of loans made using OneConnect's analytics, or the number of database queries on OneConnect's cloud.

This led to impressive revenue growth over last year, albeit with net losses that were just as big:

Data source: OneConnect prospectus. Revenue given in millions of RMB.

As you can see, revenue growth has been accompanied by impressive gross margin expansion, yet heavy investments in research and development, sales and marketing, and corporate infrastructure have caused net losses to increase more, leading to a somewhat scary-looking net margin of -67.5%.

A white space opportunity

Still, OneConnect is obviously in high-growth mode as it looks to solidify its leading position in a huge market opportunity. As mentioned, the vast majority of Ping An's customers pay the company very little or no money. In the prospectus, OneConnect claims it's still in the customer acquisition stage of its growth, which will be followed by efforts to get customers to use more products and thus pay the company more since OneConnect's revenue is largely tied to usage.

Therefore, one has to have faith that OneConnect's customers will increase their usage of its products and perhaps pay for services they may be getting for free today. On that front, the opportunity appears very large. According to research consultant Oliver Wyman, tech spending by Chinese financial institutions is forecast to grow at a robust 21.4% average growth rate over the next five years. At the same time, financial services, especially for individuals and small businesses, are very underpenetrated in China compared with the United States.

Should you connect with OneConnect?

OneConnect is a high-growth, money-losing technology platform, but it has vast potential. The RMB 1.55 billion revenue figure in the first three-quarters of 2019 equates to roughly $220 million, which means full-year 2019 revenue will probably come in between $300 million and $350 million. At a valuation of about $4.8 billion, that's about 15 times sales, which is expensive, but less expensive than other U.S. SaaS stocks such as MongoDB or Okta, both of which are growing at lower rates but trade at price-to-sales ratios over 20.

Growth investors may want to take a good long look at OneConnect on Dec. 13. However, a more conservative play on these same exciting trends would be to buy shares of Ping An, which trade at only 13 times earnings, making this the value investor's way to play OneConnect. Not only will Ping An continue to own a large stake in OneConnect, it also owns 10 other incubated technology companies. While these tech companies are still relatively small compared with Ping An's giant insurance operations, that could change a few years out, should the portfolio continue to grow as much as OneConnect has.