Description

Norwegian Finans Holding (NOFI) – Extremely attractive & scalable Fintech business available at attractive valuations

Disclaimer: I/ We have investments in this name and hence my views are biased. Please verify and do your own research on the name. I have used some images from NOFI’s investor presentation, Capital IQ, SEB report, Stifel and Danske bank report in this note.

The core investment thesis is that NOFI provides an attractive risk-reward set up for investors to buy a scaled-up Nordics fintech lending business that is highly profitable (>30% ROE) with multiple growth opportunities at 1.8X book and 7X trailing earnings. The current price warrants an entry position and then we can scale-up or down the position based upon how the situation unfolds. While NOFI is not a fat pitch at this moment because of meaningful uncertainties, I believe that the current risk-reward is too attractive to ignore.

NOFI - Brief Overview

NOFI is an extremely successful FINTECH business with a pan-EU banking license. It has scaled up well in the Nordics unsecured consumer lending space through instalment loans and credit cards on the assets side and retail deposits on the liabilities side. The bank operates on an extremely scalable business model as shown from the fact that it started a decade back with 50 employees and has scaled up its loans book to 3.8 Billion Euros with just 70 full time employees. The top management team has been very stable with strong insider ownership and have executed their strategy flawlessly. It is a branchless bank with all the employees operating out of central headquarters and a small customer centre team operating out of a low-cost location. The bank uses technology for everything from marketing, origination, credit scoring, data analytics, portfolio monitoring, risk management and customer service. The bank was incorporated as a subsidiary of Norwegian Airline Shuttle and currently has a market capitalization of 2 Billion Euros which is double the market cap of its parent.

History of Bank Norwegian:

NOFI – Business Model:

NOFI – Focused Strategy:

Market Share & Growth:

On an incremental basis, NOFI is gaining around 1/3rd of the total market growth in the Norwegian unsecured consumer lending space. The reputation risks for the larger banks along with smaller market size makes them less aggressive players. More importantly, their distribution and funding cost advantages aren’t very useful in this space of small ticket lending where the pure online players are more efficient and better suited.

Highly Valuable Real-Estate:

Convenience is more important than price for consumers in some of the small ticket lending space. With a strong mobile banking application, the distribution of future products becomes easier for the incumbent. The amount of data that the bank gets from a mobile application is much better for credit and behaviour modelling

NOFI – Huge Customer Base:

NOFI has a huge customer base especially in the credit card segment that can be mined for its instalment loans in the future. The parent airline has around 30M customers and that provides a strong brand advantage and also a precious database. The bank has flawlessly executed in scaling up its customer base across geographies despite high competition from incumbents.

Extremely Strong Engagement Metrics:

NOFI’s mobile app currently has 2.6 Transaction every Second on its app, even though the full scaled roll out of the application happened less than 2 years ago. The market share on credit card swipes is increasing at a rapid pace. NOFI’s cards market share as % of total credit card spending in Norway has grown from 11.3% in Q3 2017 to 13.5% in Q4 2017 to 15.3% in Q1 2018. On an average, a credit card customer of NOFI is using his card almost 15 transactions per month. It is a front of the wallet card. The increasing market share and transactions improves the fee income and provides scale advantage is negotiating with vendors.

Flawless Execution

Strong Growth across metrics:

Loans has grown at a 49% CAGR between 2010 and 2017. Deposits have scaled up in line with loans growth. Deposits/ Loans ratio is at a healthy 1.06

Significant Operational Leverage :

Almost 70% of NOFI’s cost base is marketing. NOFI’s cost to income excluding marketing is sub-10%. ROE dip is because of decreasing leverage. ROA’s increased during this phase.

Strong & Liquid Balance Sheet :

Liquid assets are 24% of the balance sheet, Liquidity coverage ratio is 220% and Net stable funding ratio is 142%.

Less leverage to withstand crisis:

NOFI’s Debt: Equity ratio is only around 4.28X. Average deposit size is 200K NOK which is below the state deposit insurance guarantee. The regulator last year added a 4.2% pillar 2 requirement.

Stable Team with insider ownership:

Tine Wollebekk took over as CEO last year after heading  Telenor’s fintech team. The previous CEO led the company from founding until retirement. Pal, the CFO, has been with the team since the founding of NOFI and was also the interim CEO during the transition last year. He owns around 5 Million Euros worth of shares in the firm. The parent airline owns around 20% shares in NOFI (including the total return swap). The promoter family also owns 5% of NOFI directly as well. Bjorn Kjos was asked to step down from the board of NOFI by the regulator as he continues to run the airline. The net financial interest for the promoters currently is higher in NOFI than in NAS and that provides us comfort on aligned interest.

Variant Perception

NOFI - Key Investor/ Market Concerns

• Commoditized Business                                              

• High Credit Costs

• Lowering Provisioning Coverage

• Increasing Competitive Intensity

• New Regulatory Pressure

Hugely attractive Airline Loyalty program:

NOFI has exclusive rights as the financial partner for the loyalty program of its parent airline. This gives it a sustainable origination edge. Customers globally have always liked airline loyalty programs over any other merchant. Instalment Loans : Credit Card loans will be 50: 50 in future.

Airline + Loyalty Program + Bank = Powerful combination:

The airline loyalty program in Nordics is close to a duopoly and NOFI being the only firm that has its parent as partner. Loyalty programs are sticky and the ease of use through a mobile-first platform only makes it more valuable.

Dominance of Norwegian Air Shuttle:

The parent airline’s dominance in its Nordic markets is a powerful edge for NOFI. The airline has growth strongly over the last decade and that has also helped the fintech subsidiary directly and indirectly. Other than its ownership, the airline also derives fees for its origination of loyalty cards, but unlike other airline-bank partnerships, the fee is a variable as % of the portfolio income. This has created a good Win-Win relationship for both the parties. The contract was recently extended for another 10 years which removes a big uncertainty.  

Channel Strategy:

Increasing scale provides tremendous advantages on both marketing and underwriting. You are able to bid higher on search words and spend better on SEO than peers. Also, your larger data sets help you to target better. Similarly, big data on customer portfolios and credit card spending models helps in better risk modelling through automated behavioural scorecards. Some of these advantages will keep growing for an early entrant like NOFI.

Unsecured lending in Nordics has protection as well:

Sophisticated Credit Infrastructure:

Creditor friendly policies – Germanic roots:

Better credit losses than other geographies:

Result = Modularized lending ecosystem:

Independent Originators + Underwriters + Collection Agencies, creates focused players in the ecosystem.

• Origination companies = Marketing strength + SEO effectiveness + Day to Day execution

• Underwriters = Credit Risk selection + Pricing + Balance sheet & Liquidity management + Quick Turnaround Time

• Collection = People + Data intensive strategies for better collection combined with legal recourse

While every company does most of the above, we can clearly see that different companies have different strengths. I believe that NOFI is the best placed in terms of Origination and Underwriting because of its parentage, scale, execution history and first mover advantage. It works with a lot of debt collection companies through bad debt sales as well as on-book collection. The company wants data and hence doesn’t sell all of its bad debt to collection companies despite the latter releasing immediate capital for growth.

There are origination brokerages that have become very important in the ecosystem such as Lendo, Axo Finans, Aconto etc. Some of the new banks work with debt collection companies on a forward flow basis and a clean balance sheet strategy by quickly selling all loans that get delinquent. The bankruptcy and regulatory protection in the Nordics results in very strong collection gains for the debt collection companies and hence they are ready to pay up to 50 to 70% of the facevalue of delinquent debt. Similar number for the US market is only around 20 to 30 cents on the dollar. All of these make Nordics a great market for unsecured lenders. This needs to be taken into account while comparing NOFI with unsecured names in other markets.

Better Customer Profile than peers:

NOFI is somewhere in between its peers in terms of interest rate charged and the average size of a loan. Newer incumbents without any origination edge or underwriting edge are still charging similar or higher interest rates than NOFI, leading to adverse credit selection risks. Sub-scale operations increases funding costs as raising deposits has been tougher than lending money. The upstarts need strong growth on their loans books for several years to get to a healthy cost to income ratio.

Conservative Provisioning Policies:

In the past, the bank has always sold bad loans at a higher price than its book value. Last year, the sales happened at 20% higher than book. Bank still has a large delinquent loan that is still performing, meaning the real credit costs and the gross NPA’s differ meaningfully. I believe that the firm has 8 to 9% delinquencies and net credit costs of around 3.5%. A default happens usually 6 months to 18 months after origination. The delinquent loans on book will keep building up as most aren’t reversed even if start to perform after a gap. This year’s shift to IFRS 9 revealed the firm’s conservative provisioning. There was a reserve release of 73 M NOK, which is equivalent of 2.8% of delinquent loans. It indicates that NOFI had 20 to 30 bps higher provisioning. Axactor – NOFI bad loan sale deal was at 2X money multiple or 65% of face value of the debt. Similar forward flow deals are seen even at Mono Bank and Komplett Bank, showing the strong collections in Nordics.

Profitability of a mature market:

Increasing Competition from upstarts:

While competition has certainly increased from digitally savvy upstarts, we should see that all online lenders put together are still small part of the system and they can continue to take market share in this product from the large banks with outdated distribution models. In terms of scale, NOFI last year had a growth of loans & deposits that is equivalent to the whole of Komplett Bank and Ya Bank and 4X of Insta Bank and Mono Bank. In terms of customers, NOFI last year alone added 3X total customers of Komplett Bank and 30X the customers of Mono Bank.

Hawkish Regulator – Counterintuitively +ve:

The Norwegian regulator has been hawkish and wants to curb the growth of unsecured consumer lending. I guess the new regulations leads to a healthy market place in the long-term and helps established players like NOFI compared with the new upstarts. The biggest items in the Norwegian guidelines are:

• 5x total debt-to-income cap including all kinds of loans.

• Customers need to be able to handle 5% higher interest rates and still pay for the necessities

• Maximum duration of five years and the loan has to be paid down over the course of its lifetime.

• Risk weighting of 100% for new players versus 75% for established players.

New regulations improves long-term sustainability & makes it difficult for upstarts to scale:

Bank Norwegian isn’t dependent on brokers:

NOFI gets almost 40% to 50% of customers from repeat sales to its old customers or top-up of existing customers. Also, majority of its instalment loan customers are from its credit card book. This helps the firm to better tackle the new marketing regulations.

NOFI – Strong organic search from good brand:

Organic unpaid leads are 40% of the overall leads for Bank Norwegian. At the end of the day, origination is an execution game and NOFI’s experienced team has executed well on a day-to-day basis against competition in the search bidding war and SEO optimization process.

Sticky Lending Yields despite competition:

The lending yields are sticky despite higher competition in the market place. As with most higher yielding products, convenience and turnaround time are more important than pure pricing. The deposit costs are currently low and we expect that to increase over the cycle. The liquidity yield would also improve. The compression in margins from higher funding costs is manageable. Origination and Credit selection are the primary determinant of success in this lending product.

NOFI’s lending standards:

Here is the latest snapshot of product and geography Stage 3 assets and its % of ending gross loans.

On the concern of sharp increases in provisioning requirements, it can be seen from the geography level analysis that NOFI is taking larger hits on its newer geographies as it builds its businesses from scratch in these regions and it will take a while for the portfolios to mature/ season. The core Norway market in which it has been present for long is showing stable provisioning requirement and real credit loss. With the recent sale of the large Finnish bad loan portfolio (almost 160 M), the recovery rate uncertainty in the new geography is eliminated. Since there is a lag effect in terms of growth and NPA creation, the % delinquency number is often lower initially if there is strong growth because of base effect. The delinquencies % will continue to rise as growth slows down, as is the case in NOFI. Hence this doesn’t say much about the deterioration of NOFI’s actual portfolio quality or underwriting ability.

Stress test with 2x or 3X credit costs still generates a profit:

Not just in terms of earnings capacity, NOFI also has a strong equity buffer on its balance sheet to survive a crisis (19.5% of its net loans is backed by equity). Let’s say even if we believe that the current allowances on the balance sheet are very low and there is a need to double or triple it in a stress scenario, the equity write-off would ensure that the stock at current price is trading at 2.3X book if allowances need to double and 3.65X book if allowances need to triple. A similar stress test on the other lenders would provide far worse outcomes.

Growth Options – Products + Geographies:

NOFI’s high engagement platform is a good distribution tool for other capital light financial products and services as can be seen from other successful fintech examples across the globe like Tinkoff, Paytm, Kakao etc. Also, the new PSD2 regulations allows the firm to break into the attractive payments space.

With an pan-EU bank license, the firm can also enter new geographies as it has done before. There are enough growth possibilities before NOFI. Other than revenue growth, profit growth would be faster with higher seasoning of portfolios and operational leverage. NOFI had recently announced its entry into Ireland. While it will take time for it to build its Irish business, this move shows the intent of the management to scale up the model across geographies outside the Nordics as well in which the airline has a strong market share.

Risks to our thesis

No big recession in the last 2 decades:

The personal balance sheets of Nordic consumers are levered higher with big mortgage loans. With an increasing rate cycle, the discretionary income would be much lower post mortgage payments. Most of these countries have never seen a big unemployment cycle and have also been buffered with generous welfare payments over the last 2 decades. The long-term credit risks for all financial companies in the region can be huge if the real estate prices drop substantially.

Funding/ ALM Issues:

Since NOFI’s liabilities are retail deposits without any term, there is always a significant Asset-Liability mismatch. If there is an issue with the airline, there could be deposit withdrawals, forcing the bank to borrow at higher prices in the wholesale market. While the current ALM mismatch is healthy from the duration gap, it is a potential risk.

The parent airline’s stretched balance sheet is a big risk even though the new agreement between NAS and NOFI would be valid even under a new owner or post-bankruptcy firm. The airline has around 3 Billion of operating leases and 2.4 Million of net financial debt, while the book equity is only around 385 Million and market equity of less than 1 Billion Euros. This is the true risk in this idea.

Potential Margin Compression:

While the bank has the ability to reprice its assets and liabilities, if there is change in interest rates, I believe that the liability repricing will happen much quicker than asset repricing. This lag effect can compress margins in the near term. Also, higher credit costs and higher funding costs are both pro-cyclical and hence margins across the cycle will definitely be lower than today. Also, there could be regulatory changes on higher deposit insurance fee for specialized lenders like NOFI and that could impact profits by 3 to 4%.

Conclusion

Strong Financial Parameters:

While it is true that financial stocks aren’t what you buy during a late stage cycle, I believe that the risks in NOFI are priced in the markets unlike several other financials. I believe that a long-short fund manager can identify a good basket of potential shorts to hedge out the broader economic cycle risks (higher credit costs and funding costs) against a long on NOFI.

We haven’t hedged out those risks but are managing that risk through our lower position size than what this Risk-Reward would have warranted. We will fully scale up our position if we get better prices and the company continues to execute well.

Attractively priced after the de-rating:

While the share price has done well over the years, the stock is currently trading at its lowest P/E and P/B multiple in its history. While some of the de-rating is rational, we believe that the current multiples of 1.8X book and 7X earnings provide an attractive entry point for a well-run business with significant growth opportunities.

Final Summary:

The recent market correction in all high beta sectors including financials and airlines across the globe has created an environment of strong drawdown in NOFI’s share price. I believe that the current concerns on the airline health is allowing us to buy a well-run scaled-up fintech company at attractive valuations. I believe that the market is over estimating the concerns on credit quality and underestimating the potential growth opportunities and competitive strength of the franchise. Even without revenue growth, the firm will have better profit growth purely from higher seasoning of portfolios and building scale in newer geographies.

I believe that the firm can deliver 25% ROE across the cycle with the core ROA’s of around 3.5% even after adjusting for higher credit costs and decreased margins from higher competition. At the current valuation of 1.8X book and 7X earnings, we believe that the Risk-Reward is ttractive for the investor. We have a healthy starter position in this trade and will scale-up or down the position based on how the story unfolds. The key catalysts for this investment would be dividend pay-out over the next year and stability of the parent airline through equity infusion.  

Catalyst

There is no specific catalyst to this trade. Potential equity infusion into the airline and dividend aproval for NOFI from the central bank can be triggers for re-rating