Wednesday, December 26, 2012

Why Free Cashflow for AEON Credit is not that important

Readers of my blog would know that I put a lot of importance on cashflow in my investments. Why? Companies that are not able to generate enough cashflow consistently may run into debt trouble as their businesses would be dependent on cash from other sources for survival. Similarly, as an investor, if you are relying on dividends, capital repayment etc., these cash should come from free cashflow not other forms of cash it generates from unless it is a sale of business or assets. I am really against companies which raised a substantial amount of cash for business expansion but at the same time issuing large dividends as these are inefficient way of managing cash.

Sometimes though, there are some exceptions especially for businesses which rely on one-off large investments into growing their businesses - companies like Genting when it raised funds for expansion in Singapore or Malaysia Airport for the expansion of the KLIA2. Once these projects are completed, the free cashflow should be back to normal or in fact improved.

Another type of business which the cashflow is not that relevant as a benchmark are all the lending organizations - and this include AEON Credit (which is the easiest among the lenders to evaluate on in fact). AEON Credit has two main sources of income - short to medium term lending for hire purchases (such as electronics equipment, motorbikes etc. or even personal lending) and credit card loans. As AEON Credit is not a deposit taking financial institution, it gets its funds from borrowings and its own capital (from profits and fund raising). Unlike the normal businesses, lending organizations make their money from receivables. To illustrate that, let me provide an example from the balance sheet of AEON Credit.


From above, look at the financing receivables - they are basically loans or amount owing from its customers (for credit cards etc). Then I highlighted the equity (which is its own capital which it gained and raised from) and the borrowings which it gotten in order to be able to lend out again. As you can see, from the financing receivables, AEON Credit's receivables grew at a furious pace increasing more than RM600 million over 9 months or grew more than 40% from its total in 20 February 2012. It shows that it is aggressive and doing very well as a lender - if I deem loans growth as doing well. To be able lend, AEON Credit must also be able to borrow as it is not a deposit taking company. Hence, we are seeing its borrowings grew at a similar pace as well.

Turn that scenario into the cashflow report of AEON Credit. What we have learned are different from other types of businesses. The business for Top Glove for example, it borrows mainly for factory expansion, trade financing requirements. Its free cashflow are the net cash amount for its business which is selling gloves as well as the costs for factory expansion. As for AEON Credit on the other hand, its business is dependent on loans. Without loans growth, it is then shrinking. Hence, for the period when AEON Credit was growing at a fast pace, its cashflow statement looks like below. Operating cashflow negative while investing cashflow is almost irrelevant. On the other hand, it is getting more borrowings itself which causes the financing cashflow to have a substantial net increase.

What does that tell of the company? Read the performance review below. While the receivables growth is important, almost another important benchmark is the NPL. Note that its NPL dropped from 1.94% to 1.81%. While this is a good number, usually during a period of high loans growth, this is quite normal as fresh loans are normally healthy. Seldom, you will see bad debts in new loans and quite a substantial percentage (more than 25%) of AEON's receivables are new loans.

Another important benchmark for a lending organization such as AEON Credit is the Capital Adequacy. As in the name, basically the authorities are saying to be able to lend, you cannot depend entirely on borrowings (or deposits for deposit taking banks) alone. You need to put in, raise your own money or build enough reserves, hence the Capital Adequacy Ratio (CAR). However, the CAR for AEON Credit I do not think is as tight as the ones imposed onto banks.

Of course, CAR is not as straight forward as that and there are weightings given for different kinds of loans or risks. It is actually quite complex (quite a fair bit of people make a living out of it) and based on the BASEL Accord (google it, the place where Roger Federer was born) continues to come out with new guidelines on this. Nevertheless, the above CAR for AEON Credit seems sufficient even despite the CAR drops to below 20% for this year due to the high receivables growth.

13 comments:

Value Investor said...

Thanks for your very insightful analysis. On AEON CREDIT, I have the following follow-up questions:

(1) What are the risk of AEONCR in not able to sustain its current rosy profits growth?

(2) If there is a increase in lending rates by central banks resulting in higher financing costs for AEONCR, can this be "passed" to its borrowers, thus maintaining its profit margin?

(3) Is the current high household debt to GDP in Malaysia a growing risk for AEONCR in view of its dependence on loans to the lower and middle income earners?

Value Investor said...

Thanks for your very insightful analysis. On AEON CREDIT, I have the following follow-up questions:

(1) What are the risk of AEONCR in not able to sustain its current rosy profits growth?

(2) If there is a increase in lending rates by central banks resulting in higher financing costs for AEONCR, can this be "passed" to its borrowers, thus maintaining its profit margin?

(3) Is the current high household debt to GDP in Malaysia a growing risk for AEONCR in view of its dependence on loans to the lower and middle income earners?

felicity said...

This is a tough question as it involves knowing the portfolio of receivables that AEON Credit has.

1. On risk, AEON Credit's portfolio should be riskier than banks as most of them are unsecured. I would think the credit cards that they issued are mainly to lower income group hence the asset quality are riskier.

2. I think it is governed as interest rates on credit cards cannot be charged simply. AEON Credit's other portfolios would probably be the same. As for costs, it is good as now credit is cheap. Notice they actually gotten some foreign borrowings. Not sure, how's the attractiveness but US Dollar loans are definitely cheaper, but I am not too sure on the hedging part (as in what are the costs).

3. I would say AEON credit is definitely enjoying the consumer credit boom. Its strength is the reach. While we are mindful of the high dependency on consumer credit, the main purpose of this product I would believe is to support the retail segment, but now it is holding on its own. However, in terms of risk I would think it is definitely riskier.

khengsiong said...

ah... I need some time to digest this post.

Carina said...

Hi Felicity, what measures would you use to find the "instrinsic value" and hence "margin of safety" for a company such as Aeon Credit?

I'm not sure that DCF would be useful here? Appreciate your thoughts.

khengsiong said...

CAR is the higher the better?

felicity said...

Hi Carina

Return on Equity and Return on Assets. Also a lot of times a financial institution, many would look at Price to Book Value - but I guess you can take that out for AEON Credit as it is out of wag seriously.

I seldom bother about DCF as DCF is only for those companies you would be able to project its income over many many years to come with a good degree of accuracy. My experience as financial guy as well as in many instances, nowhere can my projection be correct even for my own company. I would think DCF is only good for companies like IPPs, PLUS etc.

felicity said...

Definitely CAR is higher the better. However, for some companies they do not want to keep it too high as it is an inefficient way of managing money.

Look at it this way - if you own a house - a bungalow is better or medium size apartment better. Definitely bungalow. However, if you are just an individual with no family member with you, a bungalow is an inefficient way to live in.

Craig Thompson said...

given information is really very useful to understand cash flow statement for everyone i appreciate the way you cover the subject.

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Bernard Alice said...

Great post. Cash-flow financing is often used by companies seeking to fund their operations. They acquire major company or major vendors for their financing task.
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Malaysia Investor said...

Hello Felicia,

Where is AEON loan coming from?

Malaysia Investor said...

Dear Felicia,

Where is AEON's loan coming from?