LexinFintech Holdings (LX), a leading fintech company in China, has seen its share price decline 47% from its January peak this year. The negative sentiments and lack of understanding toward China's fintech industry, as well as the recent COVID-19 outbreak, drove the company to trade below five times earnings. Nevertheless, there are good reasons to think that these negative factors are temporary, and that the company's stock could at least double from its current level.

Woman with cash

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What it does

Lexinfintech is an online consumer lending platform targeting educated young professionals in China. It provides customers with a credit line -- financed by its funding partners -- which they can use to shop on its e-commerce platform, Fenqile. Customers can also connect Le Hua Card -- a virtual credit card that they automatically receive together with the credit line -- to their preferred payment providers like Alipay, WeChat Pay, and UnionPay to make purchases outside of Fenqile platform. They can then pay back their loans, together with interest and other processing fees, in installments of one to 36 months.

To understand how and why this works, let's look at a hypothetical Lexin customer -- we'll call him Wong.

Wong, a recent graduate, needs some money to buy a laptop. He just started his first job three months ago, earning RMB 3000 per month. He can't afford to buy his favorite laptop, which costs RMB 5000. He has no credit card and has no intention of applying for one; most banks will likely reject his application, given his lack of credit history. Traditionally, people like Wong would have no option but to save up for the next 12 months to buy the laptop.

Enter Lexin. Wong applies for a credit facility with Lexin and is offered a credit line of RMB 6000. He then searches for his favorite laptop on Lexin's e-commerce app and makes his credit purchase. He elects to pay back the principal (RMB 5000), as well as the interest and other processing fees (RMB 750, or 15%), over the next 12 months at RMB 479 per month, or RMB 5750 in total.

Assuming that Wong makes his payment in full and on time, Lexin's funding partners (mainly financial institutions and individual investors) will receive RMB 5000 in principal and RMB 500 in interest over the next 12 months. Lexin will receive the remaining RMB 250, or about 5% of the loan principal for facilitating the transaction. The result is a win-win for all three parties.

Why Lexin's a good opportunity now

Online consumer finance is a new industry in China, with very few established players upon which investors can benchmark. There are even fewer online consumer finance platforms with an e-commerce business, making it difficult for investors to understand what Lexin is doing. Moreover, the industry is still in its earliest stage of development and will likely face numerous challenges (such as competition from traditional banks and regulatory issues) that might hinder its long-term prospects. Hence, most investors have chosen to avoid this sector, causing companies like Lexin to trade at a depressed valuation.

But these concerns might also have caused investors to overlook many positive traits about Lexin's business.

To start with, Lexin has a low customer acquisition cost model, which allows it to quickly recoup its investment cost. Based on its 2019 annual report, Lexin spent less than RMB 200  to acquire its average customer -- and recovered that investment within three months. By diversifying its customer acquisition channels, Lexin keeps the average customer acquisition cost low. For example, when existing customers refer their friends, or when new users visit its e-commerce platform, Lexin incurs a nominal cost to acquire these new customers.

Having a low customer acquisition cost, however, is just one part of the story. Lexin has historically demonstrated strong customer retention  thanks to the personalized services offered to its customers. For example, Lexin can offer flexible payment schedules, higher credit lines, and lower interest rates to reward its existing customers, which usually results in better customer loyalty and lower delinquency.

A study of the customer cohort group Lexin acquired in the first quarter of 2015 shows that 35.2% of these customers were still active in the fourth quarter of 2019. Moreover, their average outstanding loan balance increased fourfold while their 30-day delinquency rate has fallen from 2.13% to 1.11% during this period. 

Another thing to like about Lexin's business model is its low-risk lending practices. It strategically focuses on serving educated young professionals in China between the ages of 18 and 36. These customers generally have lower default risk (as compared to the general population) thanks to their high-income potential, more advanced educational background, and a strong desire to build their credit profile. 

Traditionally, banks have neglected this customer group because:

  1. It's too costly to acquire and serve them
  2. They have a limited credit history.

Lexin lowers its cost of doing business by automating its business processes and reduces its credit risk by using big data analysis. Moreover, Lexin diversifies its credit risk among millions of customers -- it had 9.9 million active users in 2019  with a low average loan balance per user of $1,125 as of December 31, 2019.  

Prospects and risks

The consumer finance industry in China is expected to grow rapidly over the next few years, owing to the growth in private consumption and the low penetration of consumer loans. The per capita outstanding consumer finance loan in China in 2016 is less than 10% of that in the United States. 

According to Lexin's latest investor presentation, the industry's loan outstanding balance is expected to grow in excess of 70% from 2019 to 2022. Since Lexin operates in a segment (educated young professional market) that is growing even faster than the whole industry, its growth rate could be even higher than this. In fact, Lexin itself expects loan origination in 2020 to improve by more than 35% year over year.

Nevertheless, there are risks that might impact Lexin's growth trend. The biggest near-term risk is the outbreak of COVID-19, which might reduce the overall credit consumption in China. Also, the evolution of the regulatory environment in China may hurt the online lending industry's growth, which will directly impact Lexin's performance.

Historically, Lexin has adapted well to these regulatory changes and could continue to do so in the future. Another important risk to note is the competition from other online lenders, especially those with a much larger scale such as Ant Financial, JD Digit, and Webank. Fortunately, China's online lending market is massive (in trillions of dollars) and should have enough room for many players.

Show me the money

So how do investors double their money from Lexin? Through business growth and valuation improvement.

Business growth will likely materialize as Lexin continues to expand its user base and average loan balance per user over the next three to five years. For perspective, Lexin grew its revenue more than fourfold in the last four years. Its user base has more than doubled since its September 2017 IPO, and its average loan balance has expanded more than fourfold since 2016.

An improved valuation, however, is less certain, since it would very much depend on how investors' sentiments toward the company change. Still, as long as Lexin can continue to deliver sustainable growth in revenue and net profit over the next few years, there's a good chance that its valuation might improve over time.

All things considered, if Lexin can grow its business by at least 50%, and multiples improve from 5x to 8x earnings in the next three to five years, investors will more than double their money.