Description

Issuing credit cards can be a good business.  In many cases seasoned borrowers carry small balances with high interest rates that are disconnected from their creditworthiness.  Returns on assets have frequently been above other forms of consumer finance and, with modest gearing and good underwriting, returns on equity can be excellent.

Credit cards largely originated as a type of store card that enabled merchants to increase both sales and customer loyalty.  Over time, many of these cards became “general use” which may have offered extra discounts on a lawn mower but which could also be used to pay for dinner.  In fact, the Discover Card was introduced by Sears only to be later spun-off as part of Dean Witter.  In the ensuing decades, many store branded cards came under the umbrella of specialty finance companies (such as Capital One or Synchrony).

AEON is one of the largest retailers in Asia, with a market cap ~$14bn and consolidated sales of ~$70bn which have grown meaningfully in the past ~10 years.  AEON also issues credit cards through separately listed subsidiaries that are generally focused on specific geographies.  One of these is AEON Credit Service (Asia) (“AEON HK”), focused on the Hong Kong credit card market.

The major expenses of running a mono-line credit card company are generally staff, customer acquisition, interest expense, and losses from bad debts; and AEON HK seems to have a competitive advantage in two of these categories.  As the store card of AEON, customer acquisition cost has been fairly low for the company’s core consumer demographic (married older women), and this group of borrowers has generally had low delinquencies.  As such, AEON HK’s return on assets is significantly higher than its global credit card competitors.

However, these “strengths” directly relate to the company’s historical core weakness.  AEON’s customers aren’t getting any younger and AEON HK (while growing in absolute terms) has lost market share in the HK credit card market.  Additionally, despite issuing ~6% of HK credit cards AEON HK only accounts for ~3% of loan balances outstanding, as the cards aren’t as likely to be “front of wallet.”

AEON HK has been somewhat cheap for a while partly due to these issues as well as their initial foray into the high-interest-rate installment loan business, where poor underwriting caused the division to just break-even while consuming a fair bit of capital.  But despite depressed multiples, shareholders have generally been treated very fairly, with dividends paid every year since 1996, rising from 5c/share to 40c/share (~50% payout ratio) while growing TBV/Share from 63c to $6.88 (HKD) with shares outstanding flat since 1998.

In mid-2015 AEON HK brought in Hideo Tanaka as their new CEO.  I think Hideo has some good ideas to improve the business (mostly blocking-and-tackling initiatives) and is a good leader for the organization.  He understands their core problems and, while not sharing all of my capital allocation philosophies, seems to have high integrity and ambition about what they can accomplish.  Since coming on board, Hideo and his team have made significant progress improving the business, reducing headcount, stabilizing or exiting loss-making Chinese subsidiaries, and turning around the installment loan division.  The company has also successfully launched co-branded cards outside of its store network and has refocused its advertising budget to improve customer acquisition costs.  These changes have increased earnings, allowed them to grow the dividend (near a ~6.5% forward yield) and positioned the company to be more competitive in the HK credit card market.

Going forward, AEON HK wants to issue more co-branded (non-AEON) cards targeting younger consumers.  This is a challenging endeavor but seems to be the right strategic direction and, if done intelligently, could materially increase the long-term business value of the company.  Given the meaningful impact Hideo has made in ~2 years, it seems conceivable that he’ll continue to make progress on these strategies.  Since the business is ludicrously over-capitalized, any modest failure on these endeavors seems unlikely to materially harm the business.

All these things considered, the company appears to me as very cheap and fairly high quality.

AEON HK appears to have among the highest ROA of the listed credit card companies while trading near the lowest P/TBV levels.  This translates to an earnings yield that appears to be near the highest in the space (~13-14% of my estimate) with a high dividend yield (~6.5%) despite having an extremely overcapitalized balance sheet (equity is an absurd ~45% of assets).  I don’t believe a Hong Kong listing or their company specific challenges justify these metrics.

Perhaps if AEON HK is unable to grow its market share in credit cards and there is no multiple re-rating, then a return on this investment may approximate a little less than its earnings yield (~13%).  With shareholders getting nearly ~6.5% as a dividend, retaining the rest and continuing to trade at 0.9x TBV would contribute the remaining appreciation.  Given their very solid balance sheet, fairly prime customer base, and depressed valuation metrics, the downside seems fairly low.

A bull case would partly depend on Hideo being a driven and capable leader for what has historically been an under-managed (but still basically successful) business, which I believe may be the situation here.  In that case the investment returns could exceed the above levels since AEON HK has a very large excess of equity capital (which is effectively earning nothing) that could fuel new business ventures in a very earnings accretive fashion (most credit card companies don’t run near a 1:1 debt to equity ratio).  It is conceivable that such developments could coincide with both earnings growth and multiple re-rating, which may drive very attractive returns on the investment.

Select Credit Card Competitors:

Source: Capital IQ

Tangible Book Value/Share:

Source: Capital IQ

Dividends/Share:

Source: Capital IQ

Risks

·         Credit cycle

·         Liquidity

·         Bad underwriting on new business

·         Hong Kong macro

Disclosure

Have ownership interest in AEON HK at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of AEON HK without notice for any reason at any time.

Catalyst

Shift towards new card offerings, the continued restructuring of the high-yield loan business, and operational execution.